There have been a lot of red faces in the asset management industry of late, with Tiger Global alone burning nearly $18 billion in 2022. But you know who. Really stinks at investing? central banks
Take the Federal Reserve, for example. Chairman Jay Powell had the Fed swallow nearly all the bonds on call ($4.5 trillion worth) at the start of the pandemic, while rates were already near record lows. There was only one way for the returns to go. What was I thinking?
Unsurprisingly, the Fed’s portfolio has sucked. The Fed’s latest financial update, in September 2022, reveals paper losses of nearly $1.3 trillion for the first three quarters of that year. Since then, 10-year Treasury yields have gone from around 3.5% to 4.25% and back again, suggesting losses may be similar today.
And that’s just the Fed’s market losses on its portfolio, the SOMA (system open market account).
The Fed’s net income, primarily, the difference between what the Fed earns on its bond portfolio and what it pays out to commercial banks in its reserves at the Fed, has also turned deep red. The US central bank is now losing about $1 billion a week.
In 2023, the Fed is likely to post its first annual operating loss since 1915.
However, the Fed is not alone. All the major central banks have hemorrhaged huge losses in market value over the last year. The Swiss National Bank has paper losses of $143 billion. The hole in the Bank of England exceeds 200,000 million dollars. At the Bank of Canada, it’s $26 billion. Some estimate the ECB’s loss at about $800 billion.
Most are also trading at a loss. And as the governor of the Dutch National Bank explained in a letter to his Ministry of Finance, losses are especially acute when credit quality is high:
“All central banks that implement purchase programmes, both in the euro area and outside it, face these negative consequences. . . The losses are greatest for national central banks that have bought bonds from governments that enjoy relatively high credit ratings. . . After all, government bonds from these countries have the lowest interest rates and are therefore more likely to incur losses when financing costs rise.”
In normal times, most central banks remit their profits to their finance ministries. Amid the losses, many have already stopped paying those dividends. Thus, Daniel Gros of the Center for European Policy Studies argues that it is now clear that QE was “a colossal mistake” that “carried serious fiscal risks, which are now materializing as interest rates rise.” That’s right?
Those fiscal risks are twofold. First is balance sheet risk: the bonds held by central banks have plummeted in value. The second is an income statement problem: central banks are taking operating losses. In both cases it is reasonable to wonder about the risks that these losses entail for the taxpayer.
But, upon closer inspection, it seems. . . none of that matters?
Let’s take the issue of balance. As the Fed itself points out, since the securities in SOMA are held to maturity, it doesn’t matter if they are underwater when they are marked to market:
“ . . . As interest rates rise during a period of normalization of the monetary policy stance, the market value of the portfolio is likely to decline, possibly resulting in unrealized losses on the SOMA portfolio. However, even if these unrealized losses are large, they will only affect income if and when assets are sold from the portfolio.
The Fed reports losses at mark-to-market for the sake of transparency, but in practice uses amortized cost accounting (not the GAAP accounting used by corporations).
The Fed records bond prices at the level at which they were bought, plus or minus their pull-to-par, typically very small for the investment-grade bonds SOMA is filled with. The Federal Reserve rarely sells bonds before maturity; You don’t face margin calls and you reduce your balance sheet by letting securities mature, not by selling them. Those huge market losses? They never really notice.
But what about that massive (fiscal) sucking sound of negative net income from the Fed? As the Brookings nerds have written, there are three reasons why the Fed’s recent losses are not a net burden to the taxpayer (FTAV emphasis below):
“First, even if QE leads to Fed losses in some periods, it is likely to increase Fed gains in other periods as well. Therefore, the losses in a given year may simply offset a portion of the gains in other years.leaving the overall effect on Fed revenues positive.
Second, the Fed does QE to put downward pressure on long-term interest rates. Therefore, if the policy is effective, QE will reduce the interest that the Treasury pays on its long-term debt. So even if the Fed makes losses over time on its holdings, there may not be a net loss to the Treasury and therefore to the taxpayer.
Third, the The more favorable financial conditions caused by QE help boost production and employment. — in fact, that is the goal of conducting QE when the Fed’s short-term policy rate is constrained by its lower bound. But higher production and employment increase tax revenue and reduce government spending on safety net programs. Therefore, the net effect of QE on the budget may be positive even if the Fed is in loss for a while.”
In other words, while it’s fun to imagine central banks as big dumb bond funds, they’re not. And it’s foolish to look at the losses now in isolation from the gains they made in other years.
The data confirms it. Even looking only at the profits the Fed remits to the Treasury, and ignoring the broader macroeconomic benefits, the Fed has racked up operating losses of $24 billion since August 2022, but earned the Treasury $869 billion in the previous decade. .
Obviously, it’s not a good idea for the Fed to approach Congress for funds, most of which goes to pay commercial banks interest on their reserves. Creative accounting also makes this kind of problem non-existent.
In times like these, when the Federal Reserve is taking losses, it simply turns them into a “deferred asset,” a kind of IOU to the government. From the Financial Accounting Manual for the Federal Reserve Banks:
If the profits of a Reserve Bank are not sufficient to defray the costs of operation, the payment of dividends and the maintenance of the surplus in an amount equal to the portion assigned to the Bank of the aggregate surplus limitation, remittances would be suspended to the Treasure. A deferred asset is recorded in this account, and this debit balance represents the amount of net earnings that the Reserve Bank will need to realize before remittances to the Treasury resume.
That’s not to say there isn’t a tax angle here. Although this note does not take into account the calculation of the federal deficit, the government will have to find new revenue to replace the old remittances from the Federal Reserve.
But as Federal Reserve revenue moves into the red, the payments don’t change direction: The central bank won’t receive payments from the Treasury, it will cover its operating losses through increases in reserves (also known as “printing of money”). The inflationary impact of all this money printing is sterilized, since the “deferred asset” needs to be extinguished by future income. The Fed forecasts that this will happen in 2026.
There are two things to keep in mind at this stage. First, not all central banks operate this way. In the UK, for example, the BoE’s losses on its Asset Purchase Facility (APF) are compensated by the Treasury, and payments are a two-way street: the direction of the flows depends whether the APF is operating at a profit or a loss. . As of November 2022, the UK Treasury had sent £11bn to the central bank to cover losses from the facility.
Second, there are theoretical scenarios in which this creative accounting gets out of control. Looking again at the Federal Reserve, one could imagine inflated losses and deferred assets metastasized to such an extent that the Federal Reserve has to flood the system with reserves. That could push the central bank into a vicious cycle of ever-higher interest payments to depositing banks. This would affect, at the very least, their ability to conduct monetary policy.
However, for an institution that is typically leveraged with loads of free money ($2 trillion of currency in circulation and rising), it’s an incredibly unlikely peril. As Robert Hall and Ricardo Reis argued in 2015: “The risks to financial stability are real in theory, but remote in practice.”
We conclude that central banks with inappropriate dividend rules may face the risk of a reserve explosion, and that this can happen under a variety of scenarios. But we also conclude that the risks of this happening to the Fed and the ECB are remote and that losses can be managed by a temporary reserve buildup that is reversed long before the next major adverse shock occurs.
So the market value of the SOMA doesn’t matter, since everything is held until maturity. And, absent the need to remit funds to the Treasury, the Fed’s operating income losses don’t matter either.
As an investor, the Federal Reserve is essentially a closed-end fund operating on leverage so cheap it would make a hedge fund manager weep with envy. These structural advantages make it often very profitable. But because the Fed also has a broader mission, and a monk’s disregard for profit, it will sometimes suffer heavy losses.
In the Fed’s own language:
While the Fed’s balance sheet expansion in response to the pandemic may have increased the risk of Fed net income temporarily turning negative in a rising interest rate environment, the Fed’s mandate is not to make a profit. nor avoid losses.
In other words, the Fed’s mission is to maximize employment and safeguard price stability. If that means the central bank buying up a truckload of bonds just before a generational sell-off, losing around a trillion in the process, so be it.