Reuters Spells Out What Could Go Wrong for the Fed, Leaves Out the Biggest Elephant in the Room

It is an amusing read. In their article titled "Could the U.S. central bank go broke?", Reuters' Pedro da Costa and Ann Saphir wonder aloud if it is ever possible for the Federal Reserve to go broke and if so, how.

Their short answer is no, it is not possible because the Fed can simply print money. Nonetheless, they go ahead and list the problematic assets on the Fed's balance sheet, and completely missing the biggest problem.

From Reuters:

(Reuters) - The U.S. Federal Reserve's journey to the outer limits of monetary policy is raising concerns about how hard it will be to withdraw trillions of dollars in stimulus from the banking system when the time is right.

While that day seems distant now, some economists and market analysts have even begun pondering the unthinkable: could the vaunted Fed, the world's most powerful central bank, become insolvent?

According to the two writers, there are two potential problems with the Fed's balance sheet.

Problem No.1: Treasuries ($1.024 trillion)

The Fed now holds just over $1 trillion in Treasuries, Chari noted, and if inflation rose by a couple of percentage points, it would dent the value of those holdings by about 10 percent, leaving the Fed with a $100 billion loss.

Problem No.2: Maiden Lane ($66 billion)

The Fed is also vulnerable to losses through its so-called Maiden Lane portfolios, a collection of investments it acquired when it brokered J.P. Morgan Chase's takeover of a floundering Bear Stearns and bailed out failed insurer AIG.

But they also quite a reassuring message from Ben:

Asked about the issue of potential losses during congressional testimony on Friday, Fed Chairman Ben Bernanke suggested the risks were minimal. If liabilities on the Fed's balance sheet were to exceed its assets, it would only be so because of rising interest rates in the context of a thriving economy, he suggested.

"Under a scenario in which short-term interest rates rise very significantly, it's possible that there might come a period where we don't remit anything to the Treasury for a couple of years. That would be I think a worst-case scenario," Bernanke said.

OK, Ben says the worst-case scenario is that the Treasury will miss interest payments from the Fed. Big deal, right?

So what is Reuters (intentionally) missing?

Problem No.3: Agency bonds and mortgage-backed securities ($1.139 trillion)

The Fed has $147 billion agency bonds and $992 billion mortgage-backed securities guaranteed by Fannie Mae, Freddie Mac, Ginnie Mae (i.e. guaranteed by the US taxpayers). These securities are entered at the face value. In case of MBS, the current face value is the remaining principal balance on the underlying mortgages.

If Reuters thinks US Treasuries getting as much as 10% haircut due to an expanding (aka bubble) economy in the future is bad for the Fed, what about these mortgage bonds which, if marked to market now, would give an immediate significant haircut?

The biggest problem, even bigger than the agency bonds and MBS that the Fed holds, may be the uncertainty over its future. What if Congress finally decides to change the charter of the Fed so that the Fed cannot print at will any more? Or what if Congress allows competing currencies, as Ron Paul has proposed? Or what if the states assert their right to use gold and silver as currencies, like Virginia may be doing?

Then the very premise of the article that the Fed will not go bankrupt because it can print its way out of it would go down the toilet.

Tweet