Letter: Bagehot had much to say on the caution of bankers

Published in the Financial Times.

The run on Credit Suisse “has got every thoughtful banker and regulator in the world looking over their shoulder”, writes Robin Harding (Opinion, May 31).

Congratulations to them! They have understood the fundamental nature of the business they’re in. Walter Bagehot, the great 19th-century economist and journalist, had already explained this in Lombard Street in 1873: “A banker, dealing with the money of others, and money payable on demand, must be always, as it were, looking behind him and seeing that he has reserve enough in store if payment should be asked for.” Bagehot adds: “Adventure is the life of commerce, but caution is the life of banking.”

Alex J Pollock

Senior Fellow, Mises Institute, Auburn, AL, US

Fed Watch Podcast: The Fed Is Insolvent, and That's a Bad Thing

From the Mises Institute:

On this first episode of the Fed Watch Podcast, Ryan McMaken and Senior Fellow Alex Pollock talk about how the Federal Reserve has negative cash flow. The Fed will print money to "solve" the problem.

Be sure to follow the Fed Watch Podcast at Mises.org/FedPod.

Recommended Reading

"The Fed’s Capital Goes Negative" by Alex J. Pollock: Mises.org/FW_01_A

"Who Owns Federal Reserve Losses and How Will They Impact Monetary Policy?" by Alex J. Pollock and Paul H. Kupiec: Mises.org/FW_01_B

"Why the Fed Is Bankrupt and Why That Means More Inflation" by Ryan McMaken: Mises.org/FW_01_C

How much would debt default damage US? History offers clues.

Published in CS Monitor.

The U.S. has repudiated its financial obligations at other times too, says Alex J. Pollock, a senior fellow at the Mises Institute and author of “Finance and Philosophy – Why We’re Always Surprised.” In 1968, it refused to redeem silver certificate paper dollars for actual silver dollars, despite a written guarantee. Three years later, the U.S. went off the gold standard completely, despite its commitment in an international agreement to convert dollars to gold. The agreement, known as the Bretton Woods system, collapsed.The U.S. has repudiated its financial obligations at other times too, says Alex J. Pollock, a senior fellow at the Mises Institute and author of “Finance and Philosophy – Why We’re Always Surprised.” In 1968, it refused to redeem silver certificate paper dollars for actual silver dollars, despite a written guarantee. Three years later, the U.S. went off the gold standard completely, despite its commitment in an international agreement to convert dollars to gold. The agreement, known as the Bretton Woods system, collapsed.

…

“Eight thousand tonnes of gold is not a gimmick,” says Mr. Pollock of the Mises Institute. “Eight thousand tonnes of gold is reality.”

The debt ceiling debates are tainted by these common fallacies

Published in The Hill with Paul H. Kupiec.

After weeks of heated debate, the White House and GOP leadership have reportedly reached a deal to suspend the debt ceiling; the House Rules Committee is considering the deal this afternoon. 

The media is full of stories and opinion pieces about the debt ceiling, many of them repeating administration officials’ and their surrogates’ claims that: It is unconstitutional for the U.S. to default on its debt, the U.S. has never defaulted on its debt and there are no other measures to prevent default, so the only solution to averting an imminent debt crisis is to raise the debt ceiling without reducing deficits. 

These claims are misleading, if not demonstrably false.

The 14th Amendment to the Constitution, ratified in 1868, included language that asserted the validity of war debt incurred by the Union while forbidding repayment of any debts incurred by the states of the Confederacy. The amendment states in part:

“The validity of the public debt of the United States, authorized by law, including debts incurred for payment of pensions and bounties for services in suppressing insurrection or rebellion, shall not be questioned” and “Neither the United States nor any state shall assume or pay any debt or obligation incurred in aid of insurrection or rebellion against the United States.”

The Civil War context is clear.

In the midst of the 1995-1996 debt ceiling negotiations, President Bill Clinton said, if need be, he would use the 14th Amendment as justification for ignoring the debt ceiling “and force the courts to stop me.” In contrast, during the 2011 debt ceiling negotiations, the Treasury general counsel wrote that “the Constitution explicitly places the borrowing authority with Congress, not the President.” The latter is correct legal thought, the former mere political bravado. 

The 14th Amendment argument especially fails because it is obvious that the U.S. could easily pay all its debt by not making other expenditures, and moreover, because the United States has in fact defaulted on its debt multiple times since the amendment’s adoption, once explicitly upheld by the Supreme Court.

The U.S. government refused to redeem Treasury gold bonds for gold in 1933 as the bonds had unambiguously promised. In 1968, it refused to redeem its silver certificates for silver notwithstanding its explicit promise to pay “one silver dollar, payable to the bearer on demand.” In 1971, the U.S. government refused to redeem the dollar claims of foreign governments for gold, as promised in the Bretton Woods Agreement, approved by Congress in 1945. Reneging on its Bretton Woods commitments by the U.S. government in 1971 fundamentally changed the global monetary system, putting the whole world onto a pure fiat currency system — a significant default event by any measure.

The 1933 gold bond default is instructive since the government’s refusal to make the gold payments it had unquestionably promised was upheld by the Supreme Court in a 5-4 decision in 1935. The majority opinion found, “Contracts, however express, cannot fetter the constitutional authority of the Congress.” A concurring opinion wrote, “As much as I deplore this refusal to fulfill the solemn promise of bonds of the United States, I cannot escape the conclusion announced for the Court.”

Also, contrary to assertions by the secretary of the Treasury and the chairman of the Federal Reserve, there is a proven legal measure that could be used to materially postpone the day the U.S. Treasury runs out of cash without increasing the debt limit.

The Treasury owns 261.5 million ounces, or 8,000 tons, of gold that have a current market value of over $500 billion at the market price of just under $2,000 per ounce. However, for government accounting purposes, the value of the Treasury’s gold is set by the Par Value Modification Act of 1973, which “directed the Secretary of the Treasury … to establish a new par value of the dollar … of forty-two and two-ninths dollars per fine troy ounce of gold.“

Congress could allow the Treasury to raise cash and avoid a default by amending this law to value gold at or near its current market price. Such a revaluation would be consistent with the guidance in the Federal Accounting Standards Advisory Board’s Technical Bulletin 2011-1. This change would allow the Treasury to monetize more than $500 billion in new gold certificates with no additional Treasury debt issuance.

Updating the value of gold certificates to avoid default is not a hypothetical idea — it has been done before. In 1953, when the Eisenhower administration faced a debt ceiling standoff and needed more time to negotiate, it issued $500 million in new gold certificates to the Fed to raise cash and avoid a government default. The transaction worked as intended, as it would again.   

In contrast to what is often claimed in the current debt ceiling debate: The 14th Amendment does not allow an administration to ignore a congressional debt ceiling, the U.S. government has defaulted on its obligations multiple times and Congress and Treasury have a proven option they could use to produce large amounts of additional cash without raising the debt ceiling.

Paul H. Kupiec is a senior fellow at the American Enterprise Institute. Alex J. Pollock is a senior fellow at the Mises Institute and co-author of “Surprised Again!—The Covid Crisis and the New Market Bubble” (2022). After weeks of heated debate, the White House and GOP leadership have reportedly reached a deal to suspend the debt ceiling; the House Rules Committee is considering the deal this afternoon. 

Quantum attack would trigger Great Depression, think tank warns

Published in SC Media:

“If you were having a dispute with the United States in other ways and you wanted to make it more complicated, why not take down the financial system as a distraction?,” said Alex Pollock, a former deputy director of the Treasury Department’s Office of Financial Research in response to the report.

“If you were having a dispute with the United States in other ways and you wanted to make it more complicated, why not take down the financial system as a distraction?”

Event video: Hudson Institute: Prosperity at Risk: The Quantum Computer Threat to the US Financial System

Hosted by the Hudson Institute.

May 22, 2023.12:00 p.m. - 1:00 p.m.

Listen to Event Audio

Cybersecurity experts and technology policy officials, including those in the White House, are realizing that quantum computers will pose a significant threat to existing public encryption systems and that they need to act now to make America’s key infrastructure quantum ready and secure.

Join Hudson Senior Fellow and Director of the Quantum Alliance Initiative (QAI) Arthur Herman and QAI Associate Director Alex Butler as they discuss their most recent report. This publication details the potential consequences of a future quantum computer attack on the Federal Reserve, specifically the Fedwire Funds Service, which facilitates large-scale interbank transactions. 

Mises Institute Senior Fellow and former Deputy Director of the Treasury Department’s Office of Financial Research Alex Pollock, and John Prisco, CEO and founder of Quantum Safe Inc., will discuss the implications of the report for the future of our financial system.

Speakers:

• Arthur Herman, Senior Fellow

• Alexander Butler, Associate Director, Quantum Alliance Initiative

• Alex J. Pollock, Senior Fellow, Mises Institute

• John Prisco, CEO and Founder, Quantum Safe, Inc.

Mandating Mortgage Taxes

Published in Law & Liberty.

The Federal Housing Finance Agency (FHFA) is the regulator of Fannie Mae and Freddie Mac. On top of that, it has controlled them as their Conservator since 2008, amazingly for nearly 15 years, since reform of Fannie and Freddie has proved politically impossible. As Conservator, FHFA can exercise the power of their boards of directors. It is therefore not only the regulator, but also the boss of both of these giant providers of mortgage finance. Fannie and Freddie together represent more than $7 trillion in mortgage credit and dominate the mortgage market. FHFA also regulates the $1.6 trillion Federal Home Loan Bank System. Thus, the FHFA has impressive centralized power over the huge US mortgage market, although most people have probably never heard of it.

Housing finance is always political, and a housing finance regulator is always sailing in strong political winds, in addition to the cyclical storms of housing finance crises. The American housing finance system has collapsed twice in the last 40 years, in the decades of the 1980s and the 2000s, with corresponding regulatory reorganizations. The FHFA is a second-generation successor to the unlamented Federal Home Loan Bank Board (FHLBB), the cheerleader-regulator of the savings and loan industry. It presided over the 1980s savings and loan industry collapse, a collapse which also caused the government’s Federal Savings and Loan Insurance Corporation to go broke. The FHLBB was abolished by Congress in 1989 and replaced by the Office of Thrift Supervision (OTS) to regulate savings and loans and the Federal Housing Finance Board (FHLB) to regulate the Federal Home Loan Banks.

Beginning in the 1990s, the federal government made the disastrous mistake of promoting and increasing the amount of risky mortgage loans in the pursuit of increasing home ownership, notably requiring Fannie and Freddie to buy more and more such loans. The riskier loans were promoted as “innovative” mortgages by the Clinton administration. That push was a major contributor first to the housing bubble and then to the housing finance collapse of 2007–09. The homeownership percentage temporarily went up and then fell back to where it had been before. After the crisis, Congress abolished OTS. FHFB was also abolished, with its operations merged into the newly created FHFA. Less than two months after its creation in 2008, FHFA became the Conservator of Fannie and Freddie, which it remarkably remains to this day.

The housing politics and the enjoyment of its power seem to have gone to the FHFA’s head. Now, carrying out instructions from the White House, one imagines, or at a minimum with White House approval, it is trying once again to encourage riskier mortgage loans in Fannie and Freddie. Moreover, it proposes to act as if it were the Congress, trying by its own rule to mandate what are effectively taxes on mortgage borrowers with good credit, in order to provide subsidies to riskier borrowers with poor credit. The FHFA is thus de facto legislating to create in the nationwide mortgage market a welfare and income transfer operation through mortgage pricing. However misguided an idea this is, it could be done by the power of Congress, but the last time we checked, the FHFA wasn’t the Congress. Its project here is remarkable bureaucratic overreach.

In this case, the FHFA wants to politically manipulate Fannie and Freddie’s Loan-Level Price Adjustments (LLPAs). The LLPAs are meant to be credit risk-based adjustments, which reflect fundamental factors in the credit risk of a mortgage loan, to the price of getting Fannie or Freddie to bear the credit risk of the loan. They are an adjustment to the cost of the loan to the borrower, supposed to be based on objective measures of risk. As one mortgage guide says:

A loan-level price adjustment is a risk-based fee assessed to mortgage borrowers … [and] adjustments vary by borrower, based on loan traits such as loan-to-value (LTV), credit score, loan purpose, occupancy, and number of units in a home. Borrowers often pay LLPAs in the form of higher mortgage rates. … Similar to an auto insurance policy, a person loaded with risk will typically pay a higher premium.

Considering the key risks of smaller down payments (higher LTVs) and lower credit scores, there is no doubt that these factors statistically result over time in higher delinquencies, more defaults, and greater credit losses. Simply put, they are riskier loans. The AEI Housing Center has shown that default rates in times of stress differ dramatically based on these factors. For mortgage loans acquired by Fannie and Freddie in 2006–07, for example, the subsequent credit experience was “among borrowers with 20% down payments and credit scores between 720 and 769, the default rate was between 4.2% and 8.8%. Among borrowers with less than 4% down payments and credit scores between 620 and 639, the default rate was between 39.3% and 56.2%.”

Many commentators have pointed out that the FHFA project to manipulate the LLPAs for a political purpose is a distinctly bad idea. It is an “Upside Down Mortgage Policy … against every rational economic model, while encouraging housing market dysfunction and putting taxpayers at risk”; it signals to well-qualified borrowers, “Your credit score is excellent, so prepare to be penalized”; it is income redistribution by bureaucratic fiat; it will encourage the growth of riskier loans in Fannie and Freddie, just as the government disastrously did leading up to the great housing bust of 2007–09; it reduces the incentives to make significant down payments and for establishing a good credit rating—a notably dumb housing credit policy. This is the kind of thing Ed Pinto and I predicted in 2021 that a Biden administration FHFA would do, anticipating “the increased credit risk that Fannie and Freddie, under orders from the FHFA, will be generating.”

The rule is also ethically challenged. As Jeff Jacoby wrote in the Boston Globe, the policy is not only backwards credit logic: “First and foremost, it is egregiously unfair to creditworthy borrowers. … The new mortgage fees amount to a tax on responsible behavior.” In short, “You shouldn’t be punished for having done the right thing.” This seems incontrovertible.

The Congress long ago set up by law a very large, specialized government agency to enable subprime mortgage loans, the Federal Housing Administration (FHA). FHA mortgage loans outstanding total about $1.4 trillion. The FHA provides subsidized mortgage credit, allowing mortgage loans with down payments of as little as 3.5%. The FHA and its sister organization, Ginnie Mae, which guarantees securitized FHA loans, both operate with explicit government support and with direct risk to the taxpayers. The FHFA should not be trying to compete with the FHA for subprime mortgage financing.

The FHFA’s political initiative on loan-level adjustments is a bad idea on the merits, but there is an even more fundamental issue: the creation of a tax and mortgage subsidy program which increases risk to the taxpayers is a question for the Congress to decide—it is not the purview of the FHFA.

Very belatedly, FHFA announced it would issue a “Request for Input” from the public, which would include consideration of LLPAs. This announcement, however, did not alter FHFA’s egregious LLPA changes, which are being imposed long before the “input” will be received.

If the FHFA wanted to pursue its initiative in a constitutional way, it would withdraw its new rule and bring its proposal to Congress, requesting that a bill be introduced to authorize charging those with good credit more on their mortgage loans in order to subsidize those with riskier credit. I imagine that such a bill would not make much progress among the elected representatives of the People.

What to Know About the History of the Debt Ceiling

Published in TIME:

But Alex Pollock, a former Treasury Department official, argued in a 2021 op-ed in The Hill that there are four precedents for U.S. defaults: 1) During the Civil War in 1862, when the U.S. printed paper money after the Union’s reserves of gold and silver coin were depleted; 2) during the Great Depression in 1933, when the government refused to repay bondholders with gold, as agreed to when the securities were sold; 3) in 1968, when the U.S. did not honor silver certificates with an exchange of silver dollars; and 4) in 1971, when the government abandoned the Bretton Woods Agreement, which included a commitment to redeem dollars held by foreign governments for gold.

Joe Biden Could Use Gold to Solve the Debt Ceiling Crisis

Published in Newsweek:

Economists Paul H. Kupiec and Alex J. Pollock recently published an article advocating for Congress to "simply direct the U.S. Treasury to value its gold holdings, which are real, at real market prices."

…

"If Congress were to make a simple, financially sound amendment to the Gold Reserve Act, it would free up nearly $480 billion in new Treasury cash without raising the debt limit," wrote Kupiec and Pollock in their piece.

"These funds would allow the Treasury to pay all its bills past the end of fiscal 2023, thereby giving Congress an entire session to debate, negotiate budgets, reduce deficits, and set the debt ceiling accordingly, all in bills passed under regular order—something that has not happened in years."

For this to work, write Kupiec and Pollock, Congress would need to change just five words of the Gold Reserve Act.

…

For Pollock, 50 years is too long for the statutory price of gold and the Gold Reserve Act to have remained unchanged.

"The government can fund itself past the end of the fiscal year if Congress merely recognizes that the Treasury's gold is a real massively undervalued monetary asset," Kupiec and Pollock wrote.

"Unlike the phony idea of the Treasury issuing a trillion-dollar platinum coin [a solution that was first floated in 2011], the Treasury already has the legal authority to monetize its gold holdings without creating new government debt. It is only because Congress has failed to amend a woefully outdated law that the Treasury values its gold at an absurdly low price."

They add: "To monetize the market value of the Treasury's gold holding, the Congress need only replace five words in the Gold Reserve Act. Replacing '42 and two-ninths dollars' with 'the current market value (as determined by the Secretary at the time of issuance),' would allow the Treasury to use nearly $480 billion in spendable dollars without raising the current debt limit."

How Would Amending It Help Solve The Debt Ceiling Crisis?

"It's already been done in history, it was done under President Eisenhower in the 1950s," Pollock told Newsweek. "It can be done. It does take an act of Congress to do it," he added.

Neither Kupiec nor Pollock see amending the Gold Reserve Act as a definite solution to the debt ceiling crisis—but as an available alternative.

…

"Of course, that's not a permanent solution," said Pollock. "It's a way for them to create space, to have a serious negotiation of expenses and deficits without raising the debt limit. That's what's so intriguing about it, since there's no debt involved in this transaction. You don't have to raise the debt limit."

…

While the solution suggested by Kupiec and Pollock is legal and could technically work, others are skeptical that it would actually help the current situation.

AEI May 9: Addressing the Underlying Causes of the Banking Crisis of 2023

Click here for more details.

View Alex’s address:

AEI, Auditorium
1789 Massachusetts Avenue NW
Washington, DC 20036

In June 2017, then–Federal Reserve Chairwomen Janet Yellen said that because of enhanced Dodd-Frank Act regulations, she did not believe there would be a new financial crisis in her lifetime. Unfortunately, like many Federal Reserve forecasts, this turned out too optimistic as regulators were forced to invoke emergency systemic risk powers to contain contagious bank runs. What went wrong? Was it a failure of monetary policy? Supervision? Regulation? What changes, if any, are needed?

Join AEI as a panel of experts discusses the causes of the recent banking crisis and the federal agencies’ forensic reports and policy prescriptions and shares their own views on what policies, regulations, and supervision practices need to be reformed.

Submit questions to Catriona.Fee@AEI.org.

If you are unable to attend, we welcome you to watch the event live on this page. After the event concludes, a full video will be posted within 24 hours.

Agenda

10:00 a.m.
Introduction:
Paul H. Kupiec, Senior Fellow, AEI

10:15 a.m.
Panel Discussion

Panelists:
Charles Calomiris, Henry Kaufman Professor of Financial Institutions, Columbia University
Andrew Levin, Professor, Dartmouth College
Bill Nelson, Executive Vice President, Bank Policy Institute
Alex J. Pollock, Senior Fellow, Mises Institute

Moderator:
Paul H. Kupiec, Senior Fellow, AEI

12:00 p.m.
Q&A

12:30 p.m.
Adjournment

Chicago’s Morning Answer: Mises Institute's Alex Pollock talks latest finance news

Published by Chicago’s Morning Answer:

JPMorgan Chase, FDIC put an end to First Republic's slow bleed

Published in the American Banker:

"There's a lesson in that for all finance that what seems like a darling and a wonderful winner at one moment seems like the opposite only a little while later," said Alex Pollock, a former Treasury Department official.

…

"Obviously there's a very generalized problem of people making the most classic financial mistake, which is investing in long-term fixed-rate assets and funding them with floating-rate money," Pollock said. "They were lulled into it by the actions of the central banks — by keeping interest rates both long and short-term very low for very long periods of time, and convincing people that it was going to continue."

A Frightening Solution to the Debt Ceiling Crunch

Published in Law & Liberty by Alex J. Pollock and Paul H. Kupiec.

Could the debt ceiling crunch be avoided by the Federal Reserve forgiving treasury debt? Let's hope not.

Much has been written about the Congressional debt-ceiling standoff. US Treasury and Federal Reserve Board officials have insisted that the only way to prevent a federal government default on its debt is for Congress to simply raise the debt ceiling without requiring any reduction in spending and deficits.

However, more imaginative measures could be taken to forestall a general federal government default without increasing the debt ceiling. For example, we have previously shown that legislation that increases the statutory price of the US Treasury’s gold holdings from its absurdly low price of $42.22 per ounce to something close to gold’s $2000 per ounce market value provides an efficient process—one historically used by the Eisenhower administration—to significantly increase the Treasury’s cash balances and avoid default while budgetary debate continues.

In this note, we explore, as a thought experiment, the possibility that the cancellation of up to $2.6 trillion of the $5.3 trillion in Treasury debt owned by the Federal Reserve System could be used to avert a federal government default without any increase in the debt ceiling. We suggest that, given the enforcement of current law, federal budget rules, and Federal Reserve practices, such an extraordinary measure not only would be permissible, but it could be used to entirely circumvent the Congressional debt ceiling.

The Federal Reserve System owns $5.3 trillion in US Treasury securities, or about 17% of the $31 trillion of Treasury debt outstanding. The Fed uses about $2.7 trillion of these securities in its reverse repurchase agreement operations, leaving the Fed with about $2.6 trillion of unencumbered US Treasury securities in its portfolio.

What would happen if the Fed “voluntarily” released the Treasury from its payment obligations on some of all of the unencumbered US Treasury securities held in the Fed’s portfolio, by forgiving the debt? We believe there is nothing in Constitution or the Federal Reserve Act that would prohibit the Fed from taking such an action. This would free up trillions in new deficit financing capacity for the US Treasury without creating any operating difficulties for the Federal Reserve.

There is a longstanding debate among legal scholars as to whether the Fourteenth Amendment to the Constitution makes it unconstitutional for the federal government to default on its debt. But voluntary debt forgiveness by the creditor on the securities owned by the Federal Reserve would not constitute a default and the arguments related to the Fourteenth Amendment would not be applicable.

The Federal Reserve System is an integral part of the federal government, which makes such debt forgiveness a transaction internal to the consolidated government. However, the stock of the twelve Federal Reserve district banks is owned by their member commercial banks. Would it create losses for the Fed’s stockholders if the Fed absolved the US Treasury of its responsibility to make all payments on the US Treasury securities held by the Fed? We don’t think so.

The Fed has already ignored explicit passages of the Federal Reserve Act that require member banks to share in the losses incurred by their district Federal Reserve banks. Under its current operating policies, the Fed would continue to pay member banks dividends and interest on member bank reserve balances even if the entire $2.6 trillion in unencumbered Treasury debt securities owned by the Federal Reserve System were written off. Such a write-off would make the true capital of the Federal Reserve System negative $2.6 trillion instead of the negative $8 billion it is as of April 20.

The Federal Reserve Act requires member banks to subscribe to shares in their Federal Reserve district bank, but member banks need only buy half the shares they have pledged to purchase. The Federal Reserve Act stipulates that the “remaining half of the subscription shall be subject to call by the Board.” At that point, the member banks would have to buy the other half. Presumably, the Fed’s founders believed that such a call would be forthcoming if a Federal Reserve Bank suffered large losses which eroded its capital.

In addition, Section 2 of the Act [12 USC 502] requires that member banks be assessed for district bank losses up to twice the par value of their Federal Reserve district bank stock subscription.

The shareholders of every Federal reserve bank shall be held individually responsible, equally and ratably, and not one for another, for all contracts, debts, and engagements of such bank to the extent of the amount subscriptions to such stock at the par value thereof in addition to the amount subscribed, whether such subscriptions have been paid up in whole or in part under the provisions of this Act. (bold italics added)

To summarize, Fed member banks are theoretically required to buy more stock in a losing Federal Reserve district bank and to be assessed to offset some of the Reserve Bank’s losses. However, these provisions of the Federal Reserve Act have never been exercised and are certainly not being exercised today, in spite of the fact that the Fed’s accumulated losses are now greater than its capital. Indeed, the Fed consistently asserts that it is no problem for it to run with negative capital however large that capital shortfall may become.

Historically, all Fed member banks were entitled to receive a 6 percent cumulative dividend on the par value of their paid-in shares. Subsequently, Congress reduced the dividend rate for large banks to the lesser of “the high yield of the 10-year Treasury note auctioned at the last auction” (currently 3.46%), but maintained the 6% for all others. The Fed is now posting large operating losses but is still paying dividends to all the member banks. We confidently predict it will continue to do so.

Unlike normal shareholders, member banks are not entitled to receive any of their Federal Reserve district bank’s profits beyond their statutory dividend payment. The legal requirements and Federal Reserve Board policies governing the distribution of any Federal Reserve System earnings in excess of its dividend and operating costs have changed many times since 1913, but today, the Fed is required by law to remit basically all positive operating earnings after dividends to the US Treasury—but now there aren’t any operating earnings to remit.

Beginning in mid-September 2022, the Federal Reserve started posting cash losses. Through April 20, 2023, the Fed has accumulated an unprecedented $50 billion in operating losses. In the first 3 months of 2023, the Fed’s monthly cash losses averaged $8.7 billion. Notwithstanding these losses, the Fed continues to operate as though it has positive operating earnings with two important differences—it borrows to cover its operating costs, and it has stopped making any remittances to the US Treasury.

The Fed funds its operating loss cash shortfall by: (1) printing paper Federal Reserve Notes; or (2) by borrowing reserves from banks and other financial institutions through its deposits and reverse repurchase program. The Fed’s ability to print paper currency to cover its losses is limited by the public’s demand for Federal Reserve Notes. The Fed borrows most of the funds it needs by paying an interest rate 4.90 percent on deposit balances and 4.80 percent on the balances borrowed using reverse repurchase agreements. These rates far exceed the yield on the Fed’s investments.

In spite of its losses, the Fed continues to pay member banks both dividends on their shares and interest on their reserve deposits. The Fed has not exercised its power to call the second half of member banks’ stock subscriptions nor has it required member banks to share in the Fed’s operating losses.

Instead of assessing its member banks to raise new capital, the Fed uses nonstandard, “creative” accounting to obscure the fact that it’s accumulating operating losses that have rendered it technically insolvent.

Under current Fed accounting policies, its operating losses accumulate in a so-called “deferred asset” account on its balance sheet, instead of being shown as what they really are: negative retained earnings that reduce dollar-for-dollar the Fed’s capital. The Fed books its losses as an intangible “asset” and continues to show it has $42 billion in capital. While this treatment of Federal Reserve System losses is clearly inconsistent with generally accepted accounting standards, and seemingly inconsistent with the Federal Reserve Act’s treatment of Federal Reserve losses, Congress has done nothing to stop the Fed from utilizing these accounting hijinks, which the Fed could also use to cancel the Treasury’s debt.

Under these Fed operating policies, if all of the unencumbered Treasury securities owned by the Fed were forgiven and written off, the Fed would immediately lose $2.6 trillion. It would add that amount to its “deferred asset” account. Because the Fed would no longer receive interest on $2.6 trillion in Treasury securities, its monthly operating losses would balloon from $8.7 billion to about $13 billion, for an annual loss of about $156 billion. Those losses would also go to the “deferred asset” account. Treasury debt forgiveness would delay by decades the date on which the Fed would resume making any remittances to the US Treasury, but by creating $2.6 trillion in de facto negative capital, the Fed would allow the Treasury to issue $2.6 trillion in new debt securities to keep on funding federal budget deficits.

Under the federal budgetary accounting rules, the Fed’s deferred asset account balances and its operating losses do not count as expenditures in federal budget deficit calculations, nor do the Fed’s borrowings to fund its operations count against the Congressionally imposed debt ceiling. So in short, the Fed offers a way to evade the debt ceiling.

In reality, of course, the debt of the consolidated government would not be reduced by the Fed’s forgiveness of Treasury debt. This is because the $2.6 trillion the Fed borrowed (in the form of bank reserves and reverse repurchase agreement loans) to buy the Treasury securities it forgives would continue to be liabilities of the Federal Reserve System it must pay. The Fed would have $2.6 trillion more liabilities than tangible assets, and these Fed liabilities are real debt of the consolidated federal government. But in accounting, the Fed’s liabilities are uncounted on the Treasury’s books. Under current rules, there appears to be no limit to the possibility of using the Fed to expand government debt past the debt ceiling.

In other words, the Fed’s write-off of Treasury securities and its ongoing losses could accumulate into a massive amount of uncounted federal government debt to finance deficit spending. A potential loophole of trillions of dollars around the Congressional debt limit is an astonishing thought, even by the standards of our current federal government. Let’s hope Congress closes this potentially massive budgetary loophole while the idea of the Fed’s forgiving Treasury debt remains just a thought experiment.

Alex J. Pollock is a Senior Fellow at the Mises Institute and was the principal deputy director of the office of financial research of the U.S. Treasury Department, 2019-21. He is author of Finance and Philosophy—Why We’re Always Surprised and co-author of Surprised Again!—The COVID Crisis and the New Market Bubble.

Paul H. Kupiec is a senior fellow at the American Enterprise Institute, where he studies systemic risk and the management and regulations of banks and financial markets. Before joining AEI, Kupiec was an associate director of the Division of Insurance and Research within the Center for Financial Research at the Federal Deposit Insurance Corporation (FDIC) and director of the Center for Financial Research at the FDIC and chairman of the Research Task Force of the Basel Committee on Banking Supervision. He has previously worked at the International Monetary Fund (IMF), Freddie Mac, J.P. Morgan, and for the Division of Research and Statistics at the Board of Governors of the Federal Reserve System.

PG-15: FEDSOC STUDY BREAK: Cryptocurrency From All Angles

Watch the video here.

The Federalist Society’s Financial Services & E-Commerce Practice Group, Student Division & University of Pennsylvania Carey Law School Chapter

PRESENT

Cryptocurrency From All Angles

Featuring

Alex J. Pollock

Senior Fellow, Mises Institute;

Executive Committee Member,

Financial Services & E-Commerce Practice Group

Tuesday, April 18, 2023

Breaktime: 8:00 P.M. - 8:30 P.M. ET

How High Interest Rates Turn ‘Paper Losses’ Into Real Ones

If you borrowed money to invest in bonds, waiting for them to mature will cost a bundle.

Published in The Wall Street Journal with Paul H. Kupiec.

Thanks to a sharp rise in interest rates since March 2022, the financial system is facing eye-popping mark-to-market losses on its fixed-rate assets. These include more than $1 trillion of market-value losses on the Federal Reserve’s portfolio of bonds and mortgage securities—and according to some estimates, a $2 trillion market-value loss on the fixed-rate securities and loans of the banking system.

Central-bank officials suggest that we needn’t worry, because these unrealized “paper” losses won’t translate to cash losses if the underwater investments are held to maturity. Though the market price is down today, the thinking goes, an institution will receive 100 cents on the dollar if it holds its security to maturity and thus won’t incur a loss.

The argument is appealing yet superficial. The notion that these are “simply paper losses” doesn’t hold up in the real banking world, where investments are financed with short-term borrowing. Even when underwater investments are held to maturity, a mark-to-market loss is a forecast of future high cash interest costs on the funds borrowed to finance the investment.

Suppose that in 2021, when the Fed had kept short-term interest rates near zero, you borrowed money to buy a seven-year $10,000 U.S. Treasury note yielding 2%. In 2023, when the note had five years remaining, the central bank raises the interest rate to 5%. The market price of your note drops from $10,000 to about $8,700, for an unrealized loss of $1,300 and a 13% decline in market value. This is about the same as the year-end mark-to-market discount the Fed has disclosed on its long-term investments.

Like the Fed, you may believe this $1,300 unrealized loss is merely a paper loss since the note will be held to maturity, when it will pay $10,000. But that neglects that you, like the Fed, funded the note with short-term borrowing that must be continually renewed at a cost of 5%.

If interest rates stay at 5% for the next five years, you will receive a 2% yield—or $200 a year in interest—but will pay 5%, or $500 a year, in interest on your debt. Holding the note costs 3% of $10,000, or $300 a year. Over the next five years, the total cash loss to carry this note to maturity will be $1,500, or a loss of 15% of your original investment, even though you never sold your Treasury note and it matured at par. This is a net cash loss with the cash gone forever.

This example is no doubt simplified by assuming a flat yield curve and ignoring fluctuating interest rates. But it nevertheless correctly demonstrates the economics of large mark-to-market losses on leveraged fixed-rate assets held by the Fed and many banks. The soaring costs of financing underwater held-to-maturity investments will generate large operating losses on these investments. If short-term interest rates continue to rise, the loss will be larger. Lower rates would stem the bleeding, but as long as they exceed 2%, holding the note in our example will generate a cash operating loss.

For the Fed and commercial banks, there are some funding sources that impose no or minimal interest costs. The central bank can issue paper currency that bears no interest but in amounts limited by the public’s demand for paper money. Banks can fund some of their investments with transaction deposits, which pay little or no interest to the account holder but impose deposit insurance and other operating costs on the bank. In both cases, though, these funding sources reduce the cost of carrying an underwater asset.

Now, let’s apply this analysis to the Fed’s investments in Treasury and mortgage securities, which totaled about $8.4 trillion as of year-end 2022. These investments have an average yield of about 2%. About $7.2 trillion have a remaining maturity of more than one year, $4 trillion of which have remaining maturities of over 10 years. These long-term securities account for most of the Fed’s reported $1 trillion in mark-to-market losses.

On the liability side, the Fed has about $2.3 trillion in outstanding currency—i.e., dollar bills—that can be used to fund part of the $7.2 trillion in long-maturity assets. The remaining $4.9 trillion are financed with floating rate deposits and reverse-repurchase-agreement borrowings on which the Fed now pays about a 4.9% interest rate.

The zero-interest-bearing paper currency that funds the $2.3 trillion of these 2% fixed-rate assets generates about $46 billion in annual net interest income for the Fed. The remaining $4.9 trillion in assets also yield 2%, but this income is more than offset by the 4.9% cost of financing these assets and, on balance, cost the Fed $142 billion. Combined, its fixed-rate held-to-maturity investments cost the central bank $96 billion annually. Adding its $9 billion in noninterest expenses, the Fed can expect an annual operating loss of about $105 billion.

A $105 billion annual loss equates to an average monthly loss of $8.7 billion. This estimate mirrors reality. The Fed’s actual net loss year-to-date through March 30 has averaged $8.7 billion per month.

If any institution, including the central bank, borrows short-term to finance long-term fixed-rate investments, large mark-to-market losses aren’t merely “paper” losses. They’re a forecast that holding investments to maturity is going to be extremely expensive.

Could the Treasury selectively default on the Fed’s debt?

Published in The Hill with Paul H. Kupiec.

A reporter from this publication recently asked how a debt ceiling standoff might impact the banking system. One obvious answer is that if the Treasury ran out of cash and defaulted on the payments owed on its debt securities, the banking system would suffer since it collectively owns, per our calculations, about $1.3 trillion in Treasury securities that have always been treated as “risk-free.”

U.S. Treasury securities do not have cross-default clauses, so the Treasury could choose to default on only a specific set of selected securities sparing banks and others. This gives rise to a provocative question:

Could the U.S. Treasury save cash by selectively defaulting just on securities owned by the Federal Reserve System? How would this impact the Fed? How much cash would be freed up to pay other Treasury bills?

The Federal Reserve owns about $5.3 trillion in U.S. Treasury securities. The Fed’s 2022 audited financial statements show that $721 billion of these securities mature between April 1 and Dec. 31 and that the Fed received almost $116 billion in interest payments from the Treasury last year, or about $9.6 billion a month. Between now and Dec. 31, the Fed is scheduled to receive about $800 billion in interest and maturing principal payments from the Treasury, cash Treasury could use to pay its other bills if it stopped paying the Fed.

How would the Fed cope with a selective Treasury default? The same way it is managing what we’ve calculated is an ongoing $8.6 billion in operating losses per month — by borrowing the additional money it needs to operate and thus creating more debt for the consolidated government and ultimately a taxpayer liability.

If the Treasury suspended all payments due on its securities held by the Federal Reserve System, presumably by agreement with the Federal Reserve, the Fed would be short the cash it previously received. It would increase its borrowing to fund its operations, but the impact on the Fed’s reported operating loss would depend on the details of the suspension agreement and the accounting treatment adopted by the Fed.

Once Congress lifts the debt ceiling, we presume that the Treasury would pay the Fed its balances in arrears. Would the Treasury also pay accrued interest on the suspended amounts it owes the Fed? If so, at what rate?

The suspension of interest payments would clearly reduce the Fed’s cash interest received but it would not immediately increase the reported Federal Reserve operating losses. The Fed would likely account for suspended interest payments as non-cash interest income earned and create a new asset category, “interest income receivable from Treasury,” on its balance sheet.

The non-payment of interest would increase, dollar-for-dollar, the amount the Fed needs to borrow to pay its bills. Going forward, the Fed would have to continue borrowing to fund suspended Treasury balances. If these balances accrued interest at the Fed’s borrowing cost, there would be no future impact on the Fed’s reported operating income. If the Treasury agreed to a lower interest accrual rate or no interest accrual, the Fed’s reported operating losses would increase.

If the suspended maturing principal payments are merely delayed until Congress increases the debt ceiling, the Fed would likely record these as deferred balances due from the U.S. Treasury and would not create a reserve for a credit loss. The suspension would disrupt the Fed’s quantitative tightening plans as its Treasury security balances would not run off as planned.

With the suspension of interest payments on the Fed’s portfolio of U.S. Treasury securities, the Fed would increase its borrowing to cover not only its ongoing operating losses, now about $8.6 billion per month, but also the additional cash shortfall created by the suspension, about $9.6 billion a month, for a total new borrowing of $18.2 billion a month.

The Fed would fund its cash shortfall by (1) printing paper Federal Reserve Notes or (2) borrowing reserves from banks and other financial institutions through its reverse repurchase program. Because the Fed’s ability to fund its losses by printing paper currency is limited by the public’s demand for Federal Reserve Notes, the Fed will have to borrow most of the funds paying an interest rate of 4.90 percent on borrowed reserve balances and 4.80 percent on the balances borrowed using reverse repurchase agreements.

Loans to the Federal Reserve System, whether from reserve balances or repurchase agreements, are backed by Treasury securities owned by the Fed, or by the full faith credit of the U.S. federal government, since the Fed is the fiscal agent of the U.S. Treasury. However, unlike securities issued by the Treasury, when the Federal Reserve borrows, its loans are not counted in the federal government debt that is limited by the statutory debt ceiling. Indeed, Federal Reserve system cash operating losses are not counted as expenditures in federal budget calculations. Because of these budgetary loopholes, Fed operating losses are excluded from any federal budget deficit cap and its borrowings circumvent the statutory federal debt ceiling.

Could the U.S. Treasury take the extraordinary step of selectively halting interest and principal payments on the Treasury securities owned by the Federal Reserve System? We do not recommend such an action but see nothing in law or current Federal Reserve accounting and operating practices that would preclude it should the Treasury need to take emergency measures to avoid a wider federal government default.

If extraordinary measures are needed, a better alternative is free up funds by updating the Congressionally legislated price of the Treasury’s 8,000 tons of gold to ensure prompt payments on all the Treasury’s debt and maintain the credit performance of the United States government.

The Bill Walton Show: "Are We Really Surprised We're Having Another Banking Crisis?" with Alex Pollock and Steve Dewey

Published by Bill Walton.

It looks like the bill is finally coming due after decades of reckless monetary policy and out of control federal spending. After 40 years of relatively stable prices, we now have raging inflation. Interest rates have risen dramatically. Mortgage rates have more than doubled. And commercial banks are now sitting on more than $600 billion of unrealized bond losses. 

Of course, and as expected, with the Silicon Valley Bank bailout, the Regulators have pulled out their default playbook declaring yet another institution systematically risky, taking another step toward the federalization of our banking system.

But there's also something new to worry about: regulatory mission drift. The Fed's historical mandates are to 1) promote price stability and 2) full employment and a safe and sound banking system. But instead, the Fed - and the Treasury - have changed their priorities to promote the progressive policies of climate change and equity. 

Joining me to talk all this through are Alex Pollock and Steve Dewey. Both are grizzled veterans of the banking and regulatory world, which, as Alex points out, has been hit by a major crisis every decade since the 1970s. Together we have many decades of experience in financial markets. Alex and I have been conversing with each other, and interrupting each other, for almost fifty years.  

Alex is a Senior Fellow at the Mises Institute and was Principal Deputy Director of the Office of Financial Research of the U.S. Treasury Department in 2019 and through 2021. He was also my second boss in the commercial banking world almost 45 years ago and was on my board at Allied Capital Corporation as we worked through the 2008 crisis and its aftermath. 

Steve Dewey worked for several years in Asia during the Asian financial crisis and for the FDIC during and after the 2008 financial crisis where he was involved in the resolution of failed banks. 

According to Alex,

“We are still living in the aftermath of the long manipulation of interest rates and financial markets by the Federal Reserve and the club of central banks worldwide: the vast expansion of money and suppression of interest rates to an abnormally low level. Now we’re seeing the results.” 

Meantime, rather than being the above-the-fray dispassionate wise actor, the Federal Reserve has become part of the problem:  Just in the last six months, the Fed itself lost $44 billion which exceeds its capital of $42 billion. A big portion of its $8.7 trillion in assets are highly vulnerable to rising interest rates. Ironically, the Fed’s interest rate risk is similar to SVB’s. 

So, what’s going to happen next?

The Fed and the Treasury seem likely to take more control in the name of risk management. The banking system holds $17 trillion of deposits and Treasury Secretary Janet Yellen recently declared that these would be de facto insured by the Treasury, the Fed and the FDIC. 

But consider this: the FDIC’s deposit insurance fund is $128 billion, which is - putting it mildly - a little short of $17 trillion. Also, if the Fed continues losing money on its mortgage-backed securities, it will be losing over $100 billion a year.  

Republican Senator Everett Dirksen, the Minority leader during the 1960s Kennedy-Johnson years, once said “a billion here, a billion there, and pretty soon we’re talking real money.” Now we’re talking trillions. Has the banking system become to big to save?

Will the “solution” be a nationalized bank and a digital currency to prevent a collapse of the system? Or something else? How do the woke climate and equity agendas figure into this? 

There’s a lot to speculate about here. Join in our conversation for our take on the crisis. 

As always, we try to make complicated things easier to understand and nothing right now seems more complicated than our money.

The Fed’s Capital Goes Negative

Published by the Mises Institute.

The Federal Reserve’s new report of its balance sheet shows that in the approximately six months ended March 29 it has racked up a remarkable $44 billion of cumulative operating losses. That exceeds its capital of $42 billion, so the capital of the Federal Reserve System has gone negative to the tune of $2 billion—just in time for April Fools’ Day.

This event would certainly have surprised generations of Fed chairmen, governors, and, we’d have thought, newspapermen. The Fed’s capital will keep getting more negative in April and for some long time to come, at least if interest rates stay at anything like their current level. The Fed in the first quarter of 2023 reported losses running at the rate of $8.7 billion a month.

On an annual basis that would be a loss of over $100 billion. Recalling the famous line of Everett Dirksen—about how a billion here and a billion there starts to add up to real money—we are talking about serious losses. These are cash, operating losses. The mark to market of the assets in Fed’s balance sheet also caused an unrealized loss of $1.1 trillion as of September 30.

To see the negative capital from the Fed’s weekly “H.4.1” report, one does have to do a bit of the simple arithmetic of the first paragraph. The Fed’s balance sheet claims its capital is $42 billion, but in violation of the most obvious accounting principle (from which it conveniently excepts itself), the Fed does not subtract its operating losses from its capital as negative retained earnings.

Instead, it accumulates the losses as an opaque negative liability, which balance is found in Section 6 of the report under the title “Earnings remittances due to the U.S. Treasury.” These are simply negative retained earnings: to get the right answer, you just subtract them from the stated capital.

Although the Fed itself and its defenders say that its negative capital and its losses don’t matter to a central bank, they do mean the Fed has become a fiscal drag on the American Treasury, a current cost to the taxpayers instead of a contributor of profits to it, as, just for the record, it was for more than a century.

The situation is certainly unbecoming for what is supposedly the world’s greatest central bank. Did the Fed intend to lose this much money and drive its capital negative? I think that the answer is no. Yet the Fed seems never to have explained to Congress how big a big money-loser and fiscal drag it would become.

The unprecedented $44 billion in operating losses so far, and their unavoidable continuation, are a feature of the post-1971 age of Nixonian fiat money, where the dollar is undefined in statute and unlinked from gold or silver specie.

This has allowed the Fed to have, in effect, made itself into the financial equivalent of giant 1980s savings and loan. Of the Fed’s $8.7 trillion in assets, there is a risk position of about $5 trillion of long-term fixed rate investments funded by floating rate deposits and borrowings.

Of these investments, $2.6 trillion are mortgage securities made out of 30-year fixed rate mortgages. The result is an extreme interest rate risk, which turned into big losses when interest rates rose. This interest rate risk is similar to that of Silicon Valley Bank.

The Fed knew it was creating the interest rate risk, but seems not to have expected the massive size of the losses which resulted. As an old banker told me long ago, “Risk is the price you never thought you would have to pay.”

Of course, if short term interest rates had stayed near zero, the Fed would now be reporting big profits instead of big losses. Two years ago, in March 2021, the Fed was still rapidly adding to its long term investments and to the magnitude of its risk. At that time, the Fed published projections for 2022.

In what seems unbelievable now, yet was the belief of the Fed then, the 2022 projection for the federal funds rate was 0.1 percent. The highest individual forecast was 0.6 percent. Needless to say, the reality at the end of 2022 was a fed funds rate of 4.5 percent.

That was how much the cost of the Fed’s floating rate liabilities went up and generated losses for it and the Treasury. So much for Fed foresight. This provides yet another instructive lesson in how an interest rate risk position can move against you much more than you thought.

Unfortunately, with such forecasts, and with its years of suppressing interest rates and buying trillions in long term bonds and mortgage securities, the Fed was also the Pied Piper who led the banking system as a whole into a similar risk position.

A recent National Bureau of Economic Research working paper correctly points out that for banks, the interest rate risk arises not only from long term fixed rate securities, but also from fixed rate loans. Taking all of these into account, the paper estimates the current mark to market loss of the banking system at $2 trillion.

All banks together have tangible capital of about $1.8 trillion. So using the broad NBER estimates, it looks like on a mark-to-market basis, we may have a banking system with a tangible capital in the neighborhood of zero, in addition to a central bank with negative capital. What hath the Fed wrought?

The Fed’s Capital Goes Negative

Published in NY Sun.

The Fed’s Capital Goes Negative

The Federal Reserve’s new report of its balance sheet shows that in the approximately six months ended March 29 it has racked up a remarkable $44 billion of cumulative operating losses. That exceeds its capital of $42 billion, so the capital of the Federal Reserve System has gone negative to the tune of $2 billion — just in time for April Fools’ Day.

This event would certainly have surprised generations of Fed chairmen, governors, and, we’d have thought, newspapermen. The Fed’s capital will keep getting more negative in April and for some long time to come, at least if interest rates stay at anything like their current level.  The Fed in the first quarter of 2023 reported losses running at the rate of $8.7 billion a month.  

On an annual basis that would be a loss of over $100 billion. Recalling the famous line of Everett Dirksen — about how a billion here and a billion there starts to add up to real money —  we are talking about serious losses. These are cash, operating losses. The mark to market of the assets in Fed’s balance sheet also caused an unrealized loss of $1.1 trillion as of September 30.  

To see the negative capital from the Fed’s weekly “H.4.1” report, one does have to do a bit of the simple arithmetic of the first paragraph. The Fed’s balance sheet claims its capital is $42 billion, but in violation of the most obvious accounting principle (from which it conveniently excepts itself), the Fed does not subtract its operating losses from its capital as negative retained earnings.

Instead, it accumulates the losses as an opaque negative liability, which balance is found in Section 6 of the report under the title “Earnings remittances due to the U.S. Treasury.” These are simply negative retained earnings: to get the right answer, you just subtract them from the stated capital.

Although the Fed itself and its defenders say that its negative capital and its losses don’t matter to a central bank, they do mean the Fed has become a fiscal drag on the American Treasury, a current cost to the taxpayers instead of a contributor of profits to it, as, just for the record, it was for more than a century.

The situation is certainly unbecoming for what is supposedly the world’s greatest central bank. Did the Fed intend to lose this much money and drive its capital negative?  I think that the answer is no. Yet the Fed seems never to have explained to Congress how big a big money-loser and fiscal drag it would become.  

The unprecedented $44 billion in operating losses so far, and their unavoidable continuation, are a feature of the post-1971 age of Nixonian fiat money, where the dollar is undefined in statute and unlinked from gold or silver specie. 

This has allowed the Fed to have, in effect, made itself into the financial equivalent of giant 1980s savings and loan. Of the Fed’s $8.7 trillion in assets, there is a risk position of about $5 trillion of long-term fixed rate investments funded by floating rate deposits and borrowings.

Of these investments, $2.6 trillion are mortgage securities made out of 30-year fixed rate mortgages.  The result is an extreme interest rate risk, which turned into big losses when interest rates rose. This interest rate risk is similar to that of Silicon Valley Bank.  

The Fed knew it was creating the interest rate risk, but seems not to have expected the massive size of the losses which resulted. As an old banker told me long ago, “Risk is the price you never thought you would have to pay.”  

Of course, if short term interest rates had stayed near zero, the Fed would now be reporting big profits instead of big losses.  Two years ago, in March 2021, the Fed was still rapidly adding to its long term investments and to the magnitude of its risk. At that time, the Fed published projections for 2022.

In what seems unbelievable now, yet was the belief of the Fed then, the 2022 projection for the federal funds rate was 0.1 percent. The highest individual forecast was 0.6 percent.  Needless to say, the reality at the end of 2022 was a fed funds rate of 4.5 percent. 

That was how much the cost of the Fed’s floating rate liabilities went up and generated losses for it and the Treasury.  So much for Fed foresight. This provides yet another instructive lesson in how an interest rate risk position can move against you much more than you thought.

Unfortunately, with such forecasts, and with its years of suppressing interest rates and buying trillions in long term bonds and mortgage securities, the Fed was also the Pied Piper who led the banking system as a whole into a similar risk position.  

A recent National Bureau of Economic Research working paper correctly points out that for banks, the interest rate risk arises not only from long term fixed rate securities, but also from fixed rate loans.  Taking all of these into account, the paper estimates the current mark to market loss of the banking system at $2 trillion.  

All banks together have tangible capital of about $1.8 trillion.  So using the broad NBER estimates, it looks like on a mark-to-market basis, we may have a banking system with a tangible capital in the neighborhood of zero, in addition to a central bank with negative capital. What hath the Fed wrought?

Yes, taxpayers fund the Fed's losses

Published in the Washington Examiner.

Let us start with why the Fed is losing money. Paul H. Kupiec and Alex J. Pollock over at the Wall Street Journal explain in detail, but in short, the Fed purchased Treasurys and mortgage-backed securities — trillions of dollars' worth, in fact — back when they inexplicably held interest rates near zero, despite persistent economic growth. The purchase of these bonds put more money into the economy. They now pay the Fed a low interest rate, meaning they are comparatively worth less than new Treasurys that pay higher rates.