Rates Up Fed Down

Phil Kernen

THE FEDERAL RESERVE has been the biggest buyer of Treasury and mortgage-backed bonds for the past decade. In that time, it expanded its balance sheet from about $800 million to more than $8 trillion.

As long as inflation remained low, its bond purchases helped produce a slowly growing economy by keeping interest rates and unemployment low. Now that inflation is at its highest level in 40 years, the Federal Reserve is starting to raise interest rates in response. One result: The financial condition of the Federal Reserve itself could get ugly.

The System Open Market Account, or SOMA, is used by the Federal Reserve for all its open market operations, including purchasing and selling domestic securities and foreign currency. Every bond it purchases goes into SOMA.

Unlike public and many private businesses, including the banks it regulates, the Federal Reserve does not follow Generally Accepted Accounting Principles (GAAP). Instead, the Fed follows its own rules that allow it to defer any unrealized gains or losses until it sells the securities it holds.

As the SOMA’s balance sheet grew and interest rates fluctuated, the value of those bonds moved up and down. After 2008, interest rates generally followed a downward trend that had started in the 1980s. The unrealized gain in SOMA bonds reached $400 billion in 2020.

But two short periods of rising rates, in 2013 and 2018, led to net unrealized losses of approximately $60 billion. Still, the Fed closed out 2021 with an unrealized gain of $128 billion.

Analysts blamed the Great Financial Crisis of 2007-09 on increased leverage in the financial sector, as well as the inability of financial firms to weather the plunge in the value of the mortgage-backed securities on their books. In truth, financial companies have almost always been more highly leveraged than other sectors of the economy.

During the 2007 crisis, leverage at investment banks like Bear Stearns and Lehman Brothers reached around 30-to-1, meaning one dollar of equity supported $30 of borrowed money. With 30-to-1 leverage, a relatively small 4% loss could wipe out these firms’ capital—and it did.

In an ironic twist, to save the banking system, the Fed purchased these and other firms’ ill-liquid assets with borrowed money. Following four rounds of bond buying, the Federal Reserve has an $8.5 trillion bond portfolio. Its portfolio is supported by a capital balance of $48 billion—or a leverage ratio of 177-to-1.

The Fed’s SOMA holdings are mostly fixed-coupon Treasury notes and mortgage-backed securities. Just as with any bond, rising interest rates cause these bonds to lose value.

In the first six months of 2022, the Federal Reserve raised interest rates by 1.5 percentage points. As a result, its $8.5 trillion bond portfolio fell roughly 10%, suffering—by my estimate—an unrealized loss of $850 billion.

This represents a loss equal to 17 times the Fed’s capital. Arguably, the Fed is technically insolvent. Following the accounting rules used by the Fed, however, these unrealized losses will only appear on supplemental disclosures. The Fed will never post them to its balance sheet.

As the unrealized losses grow more significant, however, some problems will arise. The first problem is political, as members of Congress realize that the Federal Reserve is sitting on assets that are worth billions less than their purchase price.

The second problem is more practical. The Fed doesn’t want to sell any of the bonds in its portfolio, preferring to reduce its balance sheet by allowing bonds to mature and then not reinvesting the proceeds.

Yet the odds are growing that simply raising short-term rates will not be enough to arrest inflation to the desired degree. Shrinking the SOMA account balance will be required, because selling the Fed’s bond holdings should depress bond prices and hence push up longer-term interest rates, helping to slow the economy and damp down inflationary pressures. Problem is, that would force the Fed to realize losses, which would exacerbate its first problem—owning a portfolio worth less than its cost.

The third problem affects the Fed’s operational flexibility. The Fed adopted its accounting standards to manage its unique organizational status. But suppose it has to start selling off assets. It wouldn’t be able to ignore the resulting losses for long. That could limit the availability and usefulness of its ability to buy and sell bonds, a key monetary tool.

The final problem is cash flow. Since 2007-09, a growing balance sheet has left the Federal Reserve increasingly profitable on a cash flow basis. The Federal Reserve receives interest income on its $8.5 trillion bond portfolio. It also pays interest on much of its liabilities, primarily $5.6 trillion in reverse repurchase agreements and bank reserves. The rest of its liabilities is the cash in the economy.

The Federal Reserve remits its profits back to the U.S. Treasury. They amounted to more than $107 billion for 2021. The interest earned on its bond portfolio is relatively low and fixed. By contrast, the interest expense on its liabilities floats and increases each time it raises short-term interest rates. The more the Fed raises interest rates, the more interest it has to pay out—and the less profitable it becomes.

My analysis suggests that, after the Federal Reserve’s latest increase in the federal funds rate to 2.25% to 2.5%, it will begin paying out more in interest than it’s earning on its bond portfolio. Moreover, following recent inflation reports, it’s increasingly likely rates will need to move at least to 4%, and possibly higher, to get inflation back under control.

Too much leverage always has consequences, and the costs are becoming apparent for the Fed. The income boost the Federal Reserve gives the U.S. Treasury is likely over for now.

How can the Fed minimize its operational losses? Some ideas include cutting the interest paid on its liabilities, raising reserve requirements for banks—on which the Fed pays zero interest—or reducing the balance sheet faster by selling bonds and realizing losses. None of these options is perfect, and all have downsides.

In an extreme event, the fund flows from the Fed to the U.S. Treasury could reverse. Though it’s improbable, imagine Fed Chair Jerome Powell going hat-in-hand to Treasury Secretary Janet Yellen and Congress asking for a couple hundred billion to rescue his balance sheet. The bottom line: Many observers see the Federal Reserve as all-powerful. But in years ahead, the Fed may not be able to throw around its weight the way it used to—and that could have major consequences for the economy.

Phil Kernen, CFA, is a portfolio manager and partner with Mitchell Capital, a financial planning and investment management firm in Leawood, Kansas. When he’s not working, Phil enjoys spending time with his family and friends, reading, hiking and riding his bike. You can connect with Phil via LinkedIn. Check out his earlier articles.

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