MAY 31, 2011, 6:45 P.M. ET.
The Fed Has Trapped Itself on Rates
Thanks to borrowing short and lending long, the central bank could end up losing big money
By GEORGE MELLOAN
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Markets have been nervous for months about the Federal Reserve's inflationary monetary policy. Main Street is nervous too, as food and fuel prices rise. The recent drop in commodity prices was a correction, but the long-term prospect is for a further pocketbook pinch at the gas pump and checkout counter.
So why doesn't the Fed change course? One possibility is that it feels obliged to help the Treasury cope with the vast deficits generated by the Reid-Pelosi Congress. Another is that raising interest rates to curb inflation could create discomfort for the Federal Reserve itself, given the disordered state of its balance sheet.
The Fed has been committing an ancient sin that has tripped up many a banker: borrowing short and lending long. Although this is a common practice—for example, issuing one-year CDs to depositors to buy 30-year mortgages—it involves an inherent vulnerability. The bank makes its money on the differential between the low interest rate on short-term borrowing and the higher rate it gets on long-term lending. But if its long-term portfolio suddenly loses value, the bank is subject to a large loss that eats into its capital and jeopardizes its ability to continue attracting short-term investment. Banks go broke that way.
Last year, the Fed launched a second round of quantitative easing, QE2, in which it set about to buy $600 billion in Treasury bonds and notes as a form of economic stimulation. As the current sluggishness of the economy makes evident, there hasn't been much stimulus. But the Fed has helped the U.S. Treasury finance a massive federal $1.6 trillion deficit and refinance the maturing portion of the $14 trillion national debt.
The Fed has not bought up Treasury bonds and notes with newly created money. Instead, it has been getting its $600 billion by borrowing from the vast excess reserves owned by the private banks. These are deposits with the Fed in excess of those required by law. They expanded enormously post-2008, when the Fed was creating new money to replace the liquidity the banks had lost in the market crash.
The Fed is borrowing the money cheaply, at only a quarter of a percent interest rate. The Treasurys it buys yield over 3%. Meanwhile, the Fed can claim that it also is "immobilizing" reserves that, if loaned into the economy, could be inflationary. Sounds pretty clever, doesn't it?
It sounds even more clever when you look at last year's robust earnings of the 12 Federal Reserve banks. For 2010, they posted combined earnings of $81.7 billion, about $6 billion shy of the earnings of the entire commercial and savings bank industry. By law, the U.S. Treasury got most of this bonanza, $79.3 billion, with some $1.4 billion going into dividends to member banks and less than $1 billion to expand Reserve bank capital. It looked like nothing short of a heroic performance by the much-criticized Fed.
But the Fed is running a big interest-rate risk. Over the past few years, the Fed has borrowed about $1 trillion in excess reserves from member banks. The banks can call in those loans to the Fed on demand, which is about as short-term as you can get. Should the economy pick up and banks need that money to make private loans, the Fed would have to offer a higher rate to try to hold those reserves. But when interest rates go up, the value of bonds goes down—and so too would the market value of the Fed's $2 trillion-plus portfolio of Treasurys and mortgage-backed securities.
Writing in Forbes.com on May 6, William F. Ford (a former Atlanta Fed president) and Walker F. Todd (who did stints with both the Cleveland and New York Feds as a lawyer and economist) note that a one percentage point rise in long-term interest rates would lower the market value of the Fed's current bond portfolio by $100 billion. That would more than wipe out the $81.7 billion in earnings the Fed reported for 2010.
The reserve banks' skimpy capital base could be wiped out. Federal Reserve banks don't adhere to the asset-to-capital requirements imposed on private banks. And according to Messrs. Ford and Todd, the New York Fed has an "astounding" 98-1 leverage ratio—worse than Fannie Mae in its heyday.
Of course this is all theoretical, given that the Fed isn't obliged to acknowledge a loss on its portfolio until it sells securities and actually realizes the loss. But it does explain why the Fed is uncomfortable with any development that would cause the cost of long-term credit to rise and the value of existing portfolios to fall. It shows no inclination to raise its near-zero interest rate target, whatever critics say.
The QE2 process is due to end this month, not with a shout but a whimper. It didn't stimulate much, and given the dollar's weakness, markets seem to have been savvy about the risks of what the Fed was up to.
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Mr. Melloan, a former columnist and deputy editor of the Journal editorial page, is author of "The Great Money Binge: Spending Our Way to Socialism" (Simon & Schuster, 2009).
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