Federal Reserve Chairman Ben S. Bernanke’s efforts to rescue the economy could result in more than a half trillion dollars of paper losses on the central bank’s books if interest rates rise abruptly from recent levels.
That sum is the difference between the value of securities in the Fed’s portfolio on Dec. 31 and what they may fetch in three years, according to data compiled by MSCI Inc. of New York for Bloomberg News. MSCI applied scenarios devised by the Fed itself for stress-testing the nation’s 19 largest banks.
MSCI sees the market value of Fed holdings shrinking by $547 billion over three years under an adverse scenario that includes an economic contraction and rising inflation. MSCI puts the Fed’s mark-to-market loss at less than half that, or $216 billion, if the economy performs in line with consensus forecasts of gradually rising growth, inflation and interest rates.
The article goes on to state that these are "potential" losses and MTM, making the point that The Fed has no obligation to sell (and in fact Bernanke said today they won't, more or less.)
That would be true if he had the luxury of sitting on the portfolio.
What if he has to sell?
Here's the problem -- look at the Fed balance sheet.
Note a few things. First, The Fed has zero in bills. Bills are short-term instruments that are mostly-insensitive to interest rates. In the extreme case you can wait the 4 (or 13, or 26, etc) weeks for them to roll off, so there is no, or nearly-no, interest-rate risk in holding them.
However, The Fed doesn't have any more of them. They're all gone, having been "twisted" away.
Everything else is interest-rate sensitive, which is where that above analysis comes from. The longer the duration the greater the mark-to-market move of a bond you're holding when interest rates change.
Now here's the kicker: At present The Fed is preventing the "printed" currency they're using to execute QE from entering the economy, causing immediate and serious inflationary pressures, from leaving The Fed. They are doing this by paying interest on these "excess reserves."
But as the name implies, the reserves are excess of requirements -- that is, the banks cannot be required to leave them on deposit at The Fed. They do so because the interest rate The Fed pays them (out of its operating income) is greater than the risk-adjusted return they believe they could earn in the economy as a whole. Remember, back in the early days of the crisis Bernanke argued for having this power to pay interest on excess reserves for this exact reason.
Nobody ever asked him the following question: What happens when you have a scadload of excess reserves on deposit, no short-term bills on your balance sheet at all, you've bought a crap-ton of long-term paper at historically low rates and rates go up?
Suddenly from the banks' point of view it becomes more lucrative to withdraw those reserves and put them into the economy. But if that happens inflation spikes dramatically and interest rates go up further in response!
To prevent this The Fed would have to pay a higher rate on those excess reserves so as to maintain the preference to leave them on deposit.
From where does it get the money to do so when it is trying to unwind the portfolio -- that is, sell in the market and withdraw excess liquidity?
This is a positive feedback situation. If The Fed sells securities to get the funds to pay the reserves with it crystallizes a mark-to-market loss into a real, honest-to-god cash operating loss and those sales will at the same time depress prices, causing rates to go higher and the mark-to-market loss on the remaining securities to increase!
If The Fed doesn't sell the securities then it has no funds with which to pay the excess reserve interest and the banks will withdraw those funds, causing inflation which will also drive rates higher and increase the mark-to-market loss.
The only way The Fed gets away with this is if we are Japan -- stuck in an economic environment in which there is no meaningful growth and no meaningful inflation, and therefore no reason for the banks to want to withdraw those funds nor do rates rise.
Now remember folks, one of Bernanke's key claims early on is that he "knew" how to avoid the Japanese problem coming here to America when the crisis hit, and that he would avoid it.
Good luck Bernanke -- you're in a trap of your own design, you fool -- exactly as I and a few others warned of years ago.
Where We Are, Where We're Heading (2013) - The annual 2013 Ticker
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