Accounting tweak could save Fed from losses

WASHINGTON Fri Jan 21, 2011 3:47pm EST

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WASHINGTON (Reuters) - Concerns that the Federal Reserve could suffer losses on its massive bond holdings may have driven the central bank to adopt a little-noticed accounting change with huge implications: it makes insolvency much less likely.

The significant shift was tucked quietly into the Fed's weekly report on its balance sheet and phrased in such technical terms that it was not even reported by financial media when originally announced on January 6.

But the new rules have slowly begun to catch the attention of market analysts. Many are at once surprised that the Fed can set its own guidelines, and also relieved that the remote but dangerous possibility that the world's most powerful central bank might need to ask the U.S. Treasury or its member banks for money is now more likely to be averted.

"Could the Fed go broke? The answer to this question was 'Yes,' but is now 'No,'" said Raymond Stone, managing director at Stone & McCarthy in Princeton, New Jersey. "An accounting methodology change at the central bank will allow the Fed to incur losses, even substantial losses, without eroding its capital."

The change essentially allows the Fed to denote losses by the various regional reserve banks that make up the Fed system as a liability to the Treasury rather than a hit to its capital. It would then simply direct future profits from Fed operations toward that liability.

This enhances transparency by providing clearer, more frequent, snapshots of the central bank's finances, analysts say. The bonus: the number can now turn negative without affecting the central bank's underlying financial condition.

"Any future losses the Fed may incur will now show up as a negative liability as opposed to a reduction in Fed capital, thereby making a negative capital situation technically impossible," said Brian Smedley, a rates strategist at Bank of America-Merrill Lynch and a former New York Fed staffer.

"The timing of the change is not coincidental, as politicians and market participants alike have expressed concerns since the announcement (of a second round of asset buys) about the possibility of Fed 'insolvency' in a scenario where interest rates rise significantly," Smedley and his colleague Priya Misra wrote in a research note.

STALE RISK

In response to the worst financial crisis and recession since the Great Depression, the U.S. central bank pulled out all the stops on monetary policy. It not only slashed interest rates effectively to zero, but also committed to buy some $2.3 trillion in Treasury and mortgage securities in order to keep long-term borrowing costs down.

For weeks now, worries had been percolating among investors about the possibility that the central bank might run into trouble when it eventually decides to unwind some of those extraordinary measures. For more, see: [ID:nN1080075]

In particular, analysts feared the Fed might be forced to sell either its Treasury or mortgage-backed securities at a steep loss in a rising interest rate environment, or end up having to pay a higher interest rate on bank reserves than it receives on the securities it holds.

Fed Chairman Ben Bernanke, asked about the possibility in congressional testimony earlier this month, said even the most extreme circumstances would not have very large implications.

"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.

However, the Fed has tended to assume that interest rates would be rising sharply only if the economy were recovering very rapidly. Fed policymakers seem to be ignoring the possibility that the country could face a bout of so-called stagflation -- a period of high inflation with depressed economic activity like that seen during the 1970s.

That would be truly damaging to the Fed's holdings because it would almost certainly have to sell assets at a loss.

Lou Crandall, chief economist at research firm Wrightson ICAP, points out that the nearly $1 trillion in dollars circulating through the global financial system represent a form of interest-free borrowing for the Fed, giving it a large cushion against possible losses.

Still, if the crisis has taught economists anything, it is that, in highly leveraged financial markets, risks seen as extreme can often materialize more quickly than forecasters can adjust their models.

The Fed's accounting change does help it dodge a scenario that could be highly damaging to its reputation and credibility, even if a "paper insolvency" would have few immediate implications for the central bank's operations.

Compared with the prospect of going broke, being accused of accounting shenanigans is a luxury. In that sense, the Fed's decision to alter its own accounting rules appears prudent.

If only businesses and households had the same privilege.

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