The notes to the Fed’s Financial Statements read like a disclaimer at the end of an Rx drug commercial. However, a financial statement review would not be complete without a look at the fine print. The question is: How bad is it?
Never mind the $16 billion dollar loss that was capitalized, let’s start with the $1.2 trillion dollar loss that never happened, as Page 43 explains:
Under the column: Change in cumulative unrealized gains is the total of $1,208,223 (in millions), or $1.2 trillion, in a loss position.
It’s quite tiny but Footnote 3 above refers to the $1.2 trillion loss, as follows:
Because SOMA securities are recorded at amortized cost, the change in the cumulative unrealized gains (losses) is not reported in the Combined Statements of Operations.
This loss represents the decline in fair market value of the Fed’s US Treasuries and Mortgage-Backed Securities (debt) holdings. As a result of the increasing rates, the value of the Fed’s assets has declined dramatically. Consequently, if the Fed wanted to sell these assets today, no one would pay as much as the Fed initially paid for them, in fact they’d pay about $1.2 trillion less.
Of course, it would be next to impossible for the Fed to actually sell its entire $8 trillion portfolio since the pool of buyers is fairly small, so prospective buyers would demand a much lower price in return. This helps explain their Quantitative Tightening (QT) strategy. The Fed must slowly shrink its balance sheet by around $80 billion or so a month, as we’ve seen it do this year, in order to mitigate losses; and so, the mystery of QT is nothing more than the Fed buying time before a system failure occurs.
Since the assets are not written down to market, they remain at cost, so no loss appears on the financial statements. To be fair, so long as nothing catastrophic happens, the Fed will probably not realize the $1.2 trillion loss… conversely, it could always get worse!
The other section deserving of consideration is on Page 24, where the deferred asset (capitalized loss) of $16 billion is explained. It reads:
On a weekly basis, if earnings become less than the costs of operations, payment of dividends, and reservation of an amount necessary to maintain the aggregate surplus limitation, the Reserve Banks suspend weekly remittances to the Treasury and record a deferred asset.
The interest, administrative, and dividend costs were discussed in the review of the Statement of Operations a few days ago.
Page 24 note continues:
A deferred asset represents the shortfall in earnings from the most recent point that remittances to the Treasury were suspended. The deferred asset is the amount of net excess earnings the Reserve Banks will need to realize in the future before remittances to the Treasury resume.
As of Thursday’s release, their deferred asset stood at $50 billion.
With interest rates this high it becomes difficult to imagine when the Fed will start to have positive income and remit money to the Treasury again. It’s almost as if the Fed only makes money when it expands its balance sheet, meaning the only way out of this is to inflate the money supply. Readers will recognize that this is precisely what the Fed has been doing and until they’re stopped, expansion of the balance sheet will continue to be its long run monetary policy.
To answer the initial question: How bad is it?
The notes reveal that all is not well with the Fed, and these heavy losses can be squarely attributed to its own policy. A profitable Fed may be even more dangerous than an unprofitable Fed. Like the money supply, there is no upper limit on how much profit the Fed could make by simply flooding the world with trillions of additional dollars to buy every bond and possibly stock in sight. When the Fed eventually pursues the road to profitability via Quantitative Easing, it will come with devastating consequences.
