Is the Fed going bankrupt? 5/19

a big portfolio of mortgage securities that could be deep under water

Neil Irwin writes,

Back in February 2020, the Fed owned $1.4 trillion in mortgage-backed securities, and the number was falling rapidly. But when the pandemic took hold, the central bank began a new round of bond purchases (known as "quantitative easing"), swelling that number to $2.7 trillion.

OMG. I had not been following this. Let’s say that the mortgage securities have an average interest rate of 3 percent. Then if the market interest rate goes to 6 percent, the Fed will be sitting on a market-value loss of over $1 trillion.

Irwin explains,

If the Fed sells mortgage securities that pay low rates at a time when prevailing rates are much higher, it will incur big financial losses that reduce the funds the central bank returns to the Treasury.

• In that scenario, expect officials to face tough questions from Capitol Hill to explain why they've lost billions of dollars on behalf of the American people.

• Plus, the selling would likely push mortgage rates up further, at a time the housing industry is already starting to groan under the pressure of rising rates. Homebuilders, real estate agents, and other influential industry groups will make their unhappiness known to elected officials.

If the Fed does not sell because it is afraid of realizing losses, that is a version of “extend at pretend.” The losses are still there on a mark-to-market basis. If the Fed were a regulated financial institution, where market-value accounting is required, it would be bankrupt.

If you’re thinking that the Fed cannot go bankrupt because it can print money, your picture of the Fed is simplistic and out of date. The post-2008 Fed works differently.

To understand the circumstances today, review what happened to mortgage lenders the last time interest rates shot up. As of 1970 in the United States, mortgage loans were the assets of bank-like institutions called Savings and Loans (S&Ls). They funded mortgages with deposits that were savings accounts. Savings accounts paid an interest rate that was capped by regulation, known as regulation Q.

When market interest rates started to rise, the value of mortgage assets fell, bankrupting the S&Ls. But regulators did not require market-value accounting, so they did not shut down the S&Ls. Instead, under this “extend and pretend” policy, the regulators waited while the S&Ls started losing deposits. They lost deposits because depositors did not want to keep getting 4 percent on their money when other options were available that paid 8 percent or 10 percent or more.

To make up for losing their deposit base, the S&Ls had to either sell their mortgages or obtain other sources of funds that paid market interest rates. Selling the mortgages at market value would have meant recognizing steep losses, giving regulators no choice but to shut them down. So they found other sources of funds instead. That meant that they were paying more in interest on their liabilities than they were earning on their mortgage assets. They were making losses rather than profits, but they could stay in business and wait for the day when interest rates went down again and they could return to profitability.

That day never came. While they were losing money, the S&Ls took more and more risks, because their shareholders had nothing to lose. Government insurance backed their deposits. After about 15 years, they were finally shut down, with taxpayers taking an enormous hit.

Fast-forward to today, and the Fed is in a similar position to an S&L around 1970. The Fed is not funded with retail deposits that come from the public. Instead, its main liability is reserve balances held by banks. The Fed pays a low rate of interest on these reserves. Banks have been willing to hold reserves at a low interest rate, because market interest rates have been low, meaning that alternatives have not been compelling. That is in the process of changing.

As market interest rates rise, the banks will be less eager to hold reserves that pay a low interest rate. That puts the Fed in a similar position to a 1970s S&L. How can it attract funds?

The Fed’s mortgage portfolio is under water. If it sells mortgage securities, those losses have to be realized right away. If it does not sell mortgage securities, the Fed has to find other sources of funds. For example, it can induce banks to keep reserves by raising the interest rate paid on reserves. If it ends up having to pay 4 percent while earning 3 percent on its mortgage securities portfolio, it will incur losses gradually. Like the S&Ls of yore, it can hope for the day when inflation and interest rates come down. While it extends and pretends, the Fed’s losses are passed along to taxpayers.

Have a nice day.