Thursday, January 20, 2011

Federal Reserve Makes Own Insolvency Impossible

How, you may ask? It changed the accounting rules (it sets its own accounting rules) so that any loss on the asset side of the balance sheet will be accounted for by creating an entry "interest on Federal Reserve notes due to the Treasury". The Fed will simply put the negative number on this line item to account for a loss on the asset side, instead of taking a hit on the capital, like any other company. If the number is negative, the Fed won't remit interest payments (i.e. profits from the Fed's Treasury holdings) to the Treasury Department.

I thought I saw some big statement when I checked the Fed's then-latest balance sheet in early January, but I skipped it entirely and went to the information I wanted at that time. Note to self: Read anything the Fed has to say.

Someone at Bank of America did, and Zero Hedge reports:

To all who thought that the FASB gives leeway only to banks when fudging their numbers, and boosting their equity capital in ways previously unheard of, we have a surprise. The latest entrant in the "accounting gimmickry" club is none other than the Fed. And since the Fed is not auditable by anyone, it gives itself permission to change and bend the rules in any way it desires. Following on recent speculation that the Fed could in theory have a equity capital deficiency due to its massive asset book, and its tiny equity buffer, both discussed many times previously on Zero Hedge (here and here), the Fed recently announced as part of its January 6 H.4.1 release "an important accounting policy change with the release of its weekly H.4.1 report on January 6 that effectively prevents it from facing a negative capital position even in the event that it incurs substantial losses." Here is how Bank of America's Priya Misra explains this curious, and most certainly politically-motivated development: "The Fed remits most of its net earnings on a weekly basis. Prior to this accounting change, any unremitted earnings due to the Treasury would accrue in the "Other capital" account, but will now be shown in a separate liability line item called "Interest on Federal Reserve notes due to the Treasury.” As a result, any future losses the Fed may incur will now show up as a negative liability (negative interest due to Treasury) as opposed to a reduction in Fed capital, thereby making a negative capital situation technically impossible regardless of the size of the Fed’s balance sheet or how the FOMC chooses to tighten policy." And there you have it: instead of reducing the left side of the balance sheet upon the incurrence of losses, the Fed has decided to fudge the right side. And presto. No more possibility of insolvency ever again. Which only means that the Fed's now ridiculous DV01 of just under $2 billion will in no way prevent the world's biggest hedge fund from taking proactive steps to actually mitigate rate risk, and in fact will likely encourage it to gamble even more with taxpayer capital.

[The article links Bank of America's analysis.]


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