Fed New Accounting Change Means its Impossible for the Fed to go Bankrupt!

Fed New Accounting Change Means its Impossible for theFed to go Bankrupt!

Politics / Central BanksFeb 21, 2011 - 08:11 AM
By: Robert_Murphy


Back in early January, the FederalReserve made an obscure announcement in its weekly report. It appeared to be aninconsequential accounting change in the treatment of earnings, and was sold asa step toward greater transparency.
The change was buried in such jargonthat it took weeks for the financial bloggers to fully digest what had happened— the new move made it effectively impossible for the Fed to go bankrupt! Inthis article I'll explain the rule change and speculate on the Fed's motives.

YouCall This Transparency?

On January 6, in the opening of itsweekly H.4.1 release — which details changes to the Fed's holdings from theprior week — the Fed announced thefollowing:

The Board's H.4.1 statisticalrelease, "Factors Affecting Reserve Balances of Depository Institutionsand Condition Statement of Federal Reserve Banks," has been modified toreflect an accounting policy change that will result in a more transparentpresentation of each Federal Reserve Bank's capital accounts and distributionof residual earnings to the U.S. Treasury. Although the accounting policychange does not affect the amount of residual earnings that the Federal ReserveBanks distribute to the U.S. Treasury, it may affect the timing of thedistributions. Consistent with long-standing policy of the Board of Governors,the residual earnings of each Federal Reserve Bank, after providing for thecosts of operations, payment of dividends, and the amount necessary to equatesurplus with capital paid-in, are distributed weekly to the U.S. Treasury. Thedistribution of residual earnings to the U.S. Treasury is made in accordancewith the Board of Governor's authority to levy an interest charge on theFederal Reserve Banks based on the amount of each Federal Reserve Bank'soutstanding Federal Reserve notes.

Effective January 1, 2011, as aresult of the accounting policy change, on a daily basis each Federal ReserveBank will adjust the balance in its surplus account to equate surplus withcapital paid-in and, in addition, will adjust its liability for thedistribution of residual earnings to the U.S. Treasury. Previously theseadjustments were made only at year-end. Adjusting the surplus account balanceand the liability for the distribution of residual earnings to the U.S.Treasury is consistent with the existing requirement for daily accrual of manyother items that appear in the Board's H.4.1 statistical release. The liabilityfor the distribution of residual earnings to the U.S. Treasury will be reportedas "Interest on Federal Reserve notes due to U.S. Treasury" on table10. Previously, the amount necessary to equate surplus with capital paid-in andthe amount of the liability for the distribution of residual earnings to theU.S. Treasury were included in "Other capital accounts" in table 9and in "Other capital" in table 10.


If the reader had the stamina to gothrough the entire statement above, he or she can understand why nobody thoughtmuch of it, at the time of the release. The Fed seemed to be saying that therule change was no big deal, was perfectly consistent with the treatment givento other items, and that, if anything, it was a move promoting greatertransparency of the Fed's operations.
It was not until later in the monththat skeptical financial bloggers realized the implications of the rule change:the Fed was now impervious to bankruptcy, as a matter of accounting.

BernankeWanted to Focus on the Positive …

Here's a summary of the newsituation from an investment website:

Here is how Bank of America's PriyaMisra explains this curious, and most certainly politically-motivateddevelopment: "The Fed remits most of its net earnings on a weekly basis.Prior to this accounting change, any unremitted earnings due to the Treasurywould accrue in the 'Other capital' account, but will now be shown in aseparate liability line item called 'Interest on Federal Reserve notes due tothe Treasury.' As a result, any future losses the Fed may incur will now showup as a negative liability (negative interest due to Treasury) as opposed to areduction in Fed capital, thereby making a negative capital situationtechnically impossible regardless of the size of the Fed's balance sheet or howthe FOMC chooses to tighten policy." (emphasis in original)

Well now, that's rather a differentflavor from the Fed's original statement, isn't it? To see how the two areconsistent, let's look again at the critical passages from the Fed's announcement:

[E]ach Federal Reserve Bank willadjust the balance in its surplus account to equate surplus with capitalpaid-in and, in addition, will adjust its liability for the distribution ofresidual earnings to the U.S. Treasury. … The liability for the distribution ofresidual earnings to the U.S. Treasury will be reported as "Interest onFederal Reserve notes due to U.S. Treasury" on table 10. Previously, theamount necessary to equate surplus with capital paid-in and the amount of theliability for the distribution of residual earnings to the U.S. Treasury wereincluded in "Other capital accounts" in table 9 and in "Othercapital" in table 10.

The trick is that the Fed led thereader to assume that "the balance in its surplus account" would bepositive. In other words, the Fed was dealing with the standard case where itsassets grow over time (because of interest earnings on its bonds, etc.). Thatwould lead the left-hand side of the balance sheet (i.e., the"Assets") to grow, and so something on the right-hand side of thebalance sheet (i.e., "Liabilities and Capital") would need to grow bythe same amount.

Prior to the announcement, theimmediate move would be to mark up an increase on the "Assets" sidewith a corresponding credit to the "Capital" (or "ShareholderEquity") items on the right-hand side. But now, the Fed is saying thatwhen its assets appreciate, it won't credit the capital accounts. Instead, itwill make the right-hand side of the balance sheet go up by entering a newliability, titled (paraphrasing) "Earnings We Need to Send to theTreasury."

(To understand the big picture, keepin mind that after the Fed pays its bills, any excess earnings are remitted tothe Treasury. As I argued in this piece, that mechanismmeans that Uncle Sam effectively pays no interest on those bonds held by theFederal Reserve.)
So far, so good. It seems as if theFed is simply eliminating one of the steps in the accounting. Before, the Fedwould earn income on its assets, would then recognize that jump in its holdingsby marking up its capital, and then would transfer some of that increment incapital over to the Treasury.
But now — so one would think, fromreading the Fed announcement — the Fed is just directly relating assetincreases into payments that it owes the Treasury. So those earnings don't"flow through" the capital portion of the balance sheet (on theright-hand side) anymore. No big deal, right?

DenialIs Normal after a Traumatic Loss

Ah, but as Bank of America's Misrapointed out, the real fun happens when the Fed suffers losses on its assets. Innormal accounting, when the market value of a company's assets goes down, thefirm marks down its "Assets" (left-hand side of the balance sheet)and correspondingly marks down its "Capital" by the same amount(right-hand side of the balance sheet).

The danger is that if a firm losestoo much, then it might wipe out all of its capital. At that point, the firmwould be insolvent, because its remaining "Assets" would be smallerthan its "Liabilities." Remember the basic accounting truism:

Assets = Liabilities + Capital (orEquity)

If the company suffers such largelosses that its "Capital" (or "Equity") becomes negative,that is simply another way of saying that the company owes people more money(i.e., its liabilities) than it has in assets. That is the definition of insolvency,and unless the situation is rectified the firm will eventually default on itsobligations and go bankrupt.

Fortunately, from the Fed'sviewpoint, this tragic outcome is no longer possible for the US central bank.No matter how big the hit to its assets, the Fed will never be insolvent froman accounting standpoint. Even if the Fed's bond portfolio lost $1 trillion inan afternoon, the Fed would be fine: It would mark down its "Assets"by $1 trillion, and under its "Liabilities" it would list "negative$1 trillion owed to the Treasury." Thus the left- and right-hand sides ofthe balance sheet would still balance, and "Assets" would stillexceed "Liabilities."
Over time, if the Fed continued toearn interest income from its holdings, the Treasury would "work off"its debt to the Fed. For example, if the Fed's excess earnings — which wouldnormally be remitted as a payment to the Treasury — were $10 billion in thenext quarter, then the Fed's books would show that its liability to the Treasuryhad increased to "negative $990 billion." (Note that when negativenumbers get bigger, they move toward zero.)

NothingCan Stop the Ben Bernank

When QE2 was the hot item, analystswere openly wondering whether the Fed could become insolvent. After all,"the Bernank" was loading up its balance sheet with bonds at a timewhen interest rates were at historic lows. If and when interest rates were tospike, the bonds held by the Fed would suffer a large decrease in market value.In principle, if the spike were high enough, the Fed could wipe out all itscapital and become insolvent.
Or at least, the Fed could have doneso before the January rule change. As I wrote in November, there is no technicalhindrance to Bernanke's money-printing operation, even from insolvency. TheFed's "liabilities" consist in Federal Reserve Notes (and bankreserves, which are legally equivalent). If a person gives Bernanke a $100bill, he "owes" them five $20 bills, or ten $10 bills, etc.

Even so, before the January rulechange, it would have been very awkward for the Fed to become insolvent. Thefinancial community would have seen just how nihilistic fiat-money centralbanking really is.

But never fear, that awkwardpossibility has been eliminated. It is now mathematically impossible for theFed to become insolvent, through the magic of "negative liabilities."There is nothing to hinder Bernanke's inflationary spree now, except publicbacklash against rising prices.

Conclusion

The Fed's rule change, couched inobscure language, is very ominous. It suggests that Fed officials know just howvulnerable they are, and that large interest rate hikes may be much closer thanthey have led us to believe.

http://www.marketoracle.co.uk/Article26444.html

You didn't think they would add two trillion dollars to their balance sheet without a no-risk guarantee, did you? To infinity and beyond!

I personally don't believe anything the FED says vis-a-vis balance sheet, currency in circulation, monetary aggregates and asset purchases. Why would I believe an entity that has destroyed the dollar and the American economy just to profit the banks? This is end game for the fiat scam. The FED can play games and cook the books to create the appearance of solvency - so be it. But in the real world of honest accounting and one-plus-one=two the FED is bankrupt and corrupt. I short the dollar and go long gold, silver and hard assets and wait patiently for the final accounting to reset the world back to reality and sanity. I wait patiently because it is just a matter of time.

What is absolutely absurd to me is that this particular nuanced and parsed "rule change" is to prevent an already bankrupt FR from declaring future bankruptcy.

Someone got a big payout type bonus for slipping that one into the "suggestion box"...