Here’s a multiple-choice question I’ll be placing on an upcoming quiz in my monetary economics class:
The Federal Reserve is like which of the following:
- A failed 1980s Savings & Loan
- 2023 failure Silicon Valley Bank
- 2001 mega bankruptcy Enron
Answer: All of the above.
The Fed compares to S&Ls because it’s banking backwards: borrow high, lend low. Old time S&L bankers lived by the “3-6-3” rule: pay 3% interest on short terms deposits, lend at 6% on 30 year mortgages, and be on the golf course by 3 pm. This business model worked well with low, stable inflation, which kept interest rates steady. S&Ls began losing money when inflation—and the Fed’s belated response to it—pushed short-term interest rates up well above 6% (remember Paul Volcker?), but a large portion of their loan books was locked-in at those 6% mortgages. A multitude of regulatory blunders led to compounding losses of $175 billion by the time the dust settled on the S&L crisis.
The Fed compares to Silicon Valley Bank because it “invested” in highly interest rate sensitive assets (US Treasuries) which saw a massive decline in market value as interest rates began to rise. As finance students know, “bond prices are inversely related to interest rates.” When interest rates rise, existing bonds, with relatively low “coupons” (annual interest payments) become less attractive to own in comparison with new bonds, issued at the new, higher coupon rates. Investors unload those older bonds, forcing their prices (capital value) down until their risk-adjusted yields match the new, higher rates. SVB invested very heavily in a seemingly “safe” portfolio of Treasury bonds, but their managers apparently never took a basic bank management class, in which they could have learned about interest rate sensitivity, asset-liability management, portfolio diversification, and risk hedging tools like options and swaps. When rising interest rates, combined with its bond-heavy investment book, revealed looming capital losses in early 2023, SVBs depositors began to run on the bank, which forced SVB to fire-sale its devalued bonds, perpetuating even more losses. The bank was liquidated by the FDIC in March 2023 at a loss to the insurance fund of about $20 billion.
The Fed compares to Enron because its financial reporting uses “non-standard” (non-GAAP) accounting to hide losses on its income statement. Enron’s accounting trickery—abetted by auditor Arthur Anderson— was sophisticated and multifaceted, but among their biggest tricks were overstating prospective future income streams and using “off-balance sheet” entities to mask the company’s true debt levels. Enron’s financial chicanery, combined with an audacious rent-seeking grift by way of regulatory arbitrage, made its earnings growth appear unbelievably strong, and made its stock one of the biggest flyers of the dot-com era. The exposure of Enron’s fraud in late 2001 led to the largest bankruptcy in US history to that date.
To be fair, the Federal Reserve is neither a commercial bank, nor a for-profit corporation subject to GAAP, so my comparisons are in one sense purely academic. However, these parallels are fascinating and reveal some troubling aspects of our current monetary and fiscal situation.
To understand how the Fed pulled off this bad-finance trifecta—negative yield spread, capital losses on interest-sensitive “safe” assets, and massive accounting fraud—we need to review some recent history and track how the Fed’s monetary policy operating procedures have changed in response to major events.
Here’s a thumbnail sketch of how the Fed used to operate, pre-2008 (I don’t necessarily endorse any of this, but this is how it was generally presented in textbooks):
When the Fed wants to “stimulate” the economy, it looks to cut interest rates. The Fed reduces interest rates by way of “open market purchases” of Treasury securities. The Fed creates new money (in the form of bank reserves) and uses it to fund these purchases of T-bills from banks. Banks swap T-bills for cash, which positions them to increase their lending. The increased supply of “loanable funds,” if large enough, can push interest rates down—at least in the short run. This can cause inflation to heat up, as the increased bank lending leads to more bank deposits and a larger measured money supply. Moreover, lower interest rates combined with Fed purchases of T-bills enables greater deficit spending by Congress. This can really have an inflationary kick, as we witnessed with Covid stimulus checks puts spendable funds directly in the hands of consumers. To cool down inflationary pressures, the Fed raises interest rates to put a damper on bank lending, and hence business and consumer spending. The mechanism here involved “open market sales” of Treasury securities. The Fed would sell T-bills to banks (at attractive prices) and this would draw bank reserves out of the banking system, as banks hand over reserves to the Fed in payment for their newly acquired T-bills. The Fed would then “extinguish” those bank reserves, and with fewer reserves on hand, bank lending would taper off, leading to smaller rates of growth in the money supply and overall spending, ostensibly putting downward pressure on inflation.
Because the Fed decided to undertake “quantitative easing” in their response to the Great Financial Crisis of 2008, we’ve arrived at a situation where good old “open market operations” are no longer feasible. In its bid to suppress long-term interest rates and boost total spending, the Fed purchased an absolutely huge amount of Treasury and mortgage-backed securities, something on the order of $8 trillion cumulatively through 2022. The relatively small open market operations that the Fed used to rely on to manipulate interest rates and lending are no longer adequate to the task.
To effect a noticeable interest rate hike, for instance, the Fed would have to transact multi-trillion dollar open market sales. Dumping this volume of T-bills on the market all at once would risk massive market disruptions and potentially wild interest rate swings. Treasury prices would plummet (and their yields spike), negatively impacting not only the US government’s ongoing funding operations, but the balance sheets of all manner of businesses which hold significant amounts of Treasuries. Thus today, rather than sell securities in a potentially disruptive fashion, the Fed has found a new mechanism to move short term interest rates around: the so-called “floor mechanism” with the policy tool known as interest on reserve balances (IORB). The way it works is very simple: the Fed pays banks interest on the reserves they keep on deposit with the Fed. This sets a reliable price floor on market interest rates, as banks will refuse to lend to commercial clients at any rate below what the Fed will reliably pay them to just sit on reserves with zero credit risk. So nowadays, when the Fed needs to fight inflation, it simply ups this IORB rate, raising banks’ opportunity cost of lending and thereby pushing all market interest rates upward.
However a significant problem has inevitably emerged, given the combination of QE, IORB, and inflation. QE meant that the Fed issued trillions of dollars in new reserves, a large chunk of which banks have opted to just sit on, rather than lend. IORB, especially after the recent rate-hiking cycle, has meant banks earn a tidy return by not lending this large chunk of reserves. Inflation means the Fed has to raise interest rates (and IORB), which means even more easy, passive income for banks via their un-lent reserve balances.
So here’s where it gets weird, sad, and fraudulent: we have arrived at a situation where the Federal Reserve is paying more money for the deposits it holds (via IORB) than it earns on its portfolio of investments in Treasurys and MBS that it acquired through all that QE. In other words, the Fed has gone full 1980s S&L: borrow high, lend (invest) low. This also means the Fed has turned over a new leaf: for the first time ever, America’s central bank is losing money. In its 2023 operating year, the Fed system amassed total operating losses of $114 billion—this in addition to unrealized capital losses on its Treasury/MBS portfolio that began with rate hikes in 2022. However, if you look at the Fed’s consolidated income statement for 2023, you’ll see “comprehensive income” (net income) reported at a positive $1.5 billion. Did the Fed have non-operating income to offset the fact that it paid $281 billion in interest, but only earned $175 billion on its bond portfolio? Nope. The Fed indeed lost money outright, S&L style. But in a move that would impress the most creative accountants, the Fed simply engaged in “non-standard accounting practices” to hide that loss on its income statement. In truly Enron-esque style, the Fed listed the loss as, get this, a “deferred asset,” and magically waved it away. Here’s the fine print from the Fed’s 2023 financial statements:
The Reserve Banks remitted excess earnings to the Treasury on a weekly basis during most of 2022 and periodically during 2023. In the fall of 2022, the Reserve Banks first suspended weekly remittances to the Treasury because earnings shifted from excess to less than the costs of operations, payment of dividends, and reservation of surplus. The Reserve Banks’ deferred asset represents the net accumulation of costs in excess of earnings, and is reported as “Deferred asset – remittances to the Treasury” in the Combined Statements of Condition. The deferred asset represents the amount of net excess earnings the Reserve Banks will need to realize in the future before remittances to the Treasury resume. No impairment existed as of December 31, 2023, as net excess earnings of the Reserve Banks in future periods are expected to exceed the balance of the deferred asset.
In other words, the Fed admits it lost money last year, but it will definitely earn that money back later, and therefore it can just kick that loss down the road, repackage it as a “deferred asset” and add it back on the income statement. It’s recorded as a negative, but it’s subtracted: a negative plus a negative equals a positive. If only Kenneth Lay had lived to see it!
The irony of Fed losses is rich. The Fed was created as a “lender of last resort” for the US financial system. It’s job was to centralize the reserves of the entire financial system (then: gold; now: Fed-issued base money) and be ready, willing, and able to lend freely to member banks during times of financial crisis. The Fed acquired the reserves it held largely by regulatory mandate for member banks to keep a certain amount of money on deposit—”required reserves.” Thus, the Fed would force banks to deposit money with it at zero interest, and in turn the Fed would lend that reserve, as needed, to banks at a positive interest rate. While the Fed was not seeking to earn constant profits on its reserve fund, it at least covered its operating expenses and acted as a bank normally does: “borrow low, lend high”—albeit with a limited, crisis-oriented lending role.
Today, things are bass-ackwards for the Fed: it is borrowing high and lending low. It’s so backwards that the Fed is losing hundreds of billions of dollars annually. If this were a Fortune 500 company, stock values would have tanked, bankruptcy proceedings would be ongoing, lawsuits would be flying, executives and auditors would be facing jail time.
The difference with the Federal Reserve, of course, is that it’s a government-chartered central bank with a monopoly on issuing base money, so none of this matters, at least legally speaking. Unlike the badly-managed and/or fraudulent corporations I compared it to, the Fed won’t go out of business. The Fed can endlessly create new money to paper over its problems and continue operating as if everything’s hunky-dory. And in a sense, everything is fine for the Fed, at least for now. The Fed is special, it’s a central bank, it’s the government. It can excuse itself from standard accounting practices and it doesn’t have to turn a profit. Maybe you’re okay with that, but let me leave you with a deeper note of worry.
It appears we have arrived at a moment in time where the solution to any and every potential problem is to print more money. After all, printing money—via QE to “stimulate” the moribund US economy—is what got the Fed into this situation of needing to create a price floor on short-term interest rates (the IORB mechanism). Printing money to finance massive government deficits and stimulus checks is what triggered the biggest inflation in 40 years. And now, to raise rates and cool the inflation it created, the Fed finds itself… printing more money. But this time, on account of the new floor mechanism and IORB, the Fed finds itself in a position where it must pay out more interest (on reserves) than it’s earning (on its Treasury and mortgage bonds). The Fed has painted itself into a corner where the solution to every scenario involves just printing money. Unless drastic steps are taken to either reduce bank reserves and/or slash interest rates, the Fed seems to be stuck with the losses and the money printing. This does not bode well for the future of the US economy.
Perhaps I’ll add a follow-up question on that upcoming quiz:
The Federal Reserve is most likely to enact which policy in the near- to medium-term future:
- Print money to “stimulate” the economy via QE
- Print money to “fight inflation” via IORB-induced rate hikes
- Print money to finance $2 trillion US government deficits
