Many people have taken notice of changes slipped into the Fed's balance sheet reporting rules that will allegedly shield the Fed from devastating losses. Please consider Accounting Tweak Could Save Fed From Losses.

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 Jan. 6.

"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.

"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.

Two Distinct Issues

Going forward, there are two key issues here (not counting losses with TARP), and none of the articles circulating properly explains either them, or when the real damage occurred.

1. Losses on Treasures as Interest Rates Rise
2. Losses on Fannie Mae and Freddie Mac Assets

Losses on Treasures as Interest Rates Rise

It is a simple statement of fact that there will be no losses on treasuries if the Fed hold the treasuries to term, which I believe is their intent. Note that the Fed concentrates purchases in the 3-7 year range, making it a relatively easy matter to hold those securities to term.

Moreover, if the economic recovery does not satisfy the Fed it can simply enter a program whereby it replaces expiring treasuries with new purchases. Should the Fed embark upon such a plan, it will offer an excuse that it is not expanding its balance sheet further.

I do not agree at all with the Fed's balance sheet expansion, I simply point out the risk of losses on treasuries is a theoretical issue, not a practical one.

Losses on Fannie Mae and Freddie Mac Assets

The accounting rule change will also allow the Fed to hide losses on MBS garbage on its balance sheet. Those toxic assets have a much longer duration. Can the Fed get rid of them for no losses?

The answer is yes, but it has nothing to do with accounting rule changes. The damage was done in late 2009 by Congress.

Timothy Geithner Meets Vladimir Lenin

Please consider John Hussman's January 4, 2010 article Timothy Geithner Meets Vladimir Lenin

"The best way to destroy the capitalist system is to debauch the currency."

Vladimir Lenin, leader of the 1917 Russian Revolution

Last week, while Congress and the nation were preoccupied with the holidays, the Treasury made a Christmas eve announcement that it would be providing Fannie Mae and Freddie Mac unlimited financial support for the next three years.

Put simply, in a single, coordinated stroke, the Treasury and the Federal Reserve have encroached on spending powers that are enumerated for the Congress alone. Under the Housing and Economic Recovery Act of 2008 (HERA), the Treasury has no such open-ended authority. Indeed, the applicable portion of the Act explicitly limits the total amount of mortgage principal (not losses, but total principal) as follows:

"LIMITATION ON AGGREGATE INSURANCE AUTHORITY. -- The aggregate original principal obligation of all mortgages insured under this section may not exceed $300,000,000,000."

That's $300 billion of original principal. If there is some loophole by which the Treasury's action is legal, it's clear that it was no part of Congressional intent, and certainly not broad public support. Taxpayers are now being obligated by the Treasury and the Fed to make good on a potentially much larger volume of bad mortgage loans, made by reckless lenders, guaranteed by Fannie Mae and Freddie Mac in return for a pittance (called a "G-fee"), and packaged into securities which are now largely owned by the Federal Reserve, which has acquired them through outright purchases (not traditional repurchase agreements).

As I wrote several weeks ago, "The Federal Reserve has expanded the U.S. monetary base by more than 150% since the beginning of the recession. That is not a typo. The monetary base has soared from $800 billion to over $2 trillion. Much of this has been accomplished through outright purchases of mortgage-backed securities (not repurchases) and an equivalent creation of base money. Unless these securities can be sold back out into private hands for the same value that was paid to acquire them, the Fed will have effectively forced the U.S. government to make its implicit guarantee of these agency securities explicit, without the authorization of Congress. To the extent that the underlying mortgages default, the U.S. government will be forced to issue additional Treasuries to retire the mortgage backed securities now held by the Fed. Alternatively, if the U.S. does not explicitly bail out Fannie Mae and Freddie Mac to the full extent, the Fed will have created money, with no recourse, and without the equivalent backing of assets or securities on its books. In short, the Fed is now engaging in unlegislated, back-door fiscal policy."

The Treasury's action last week completes this circle. It provides a surprise pledge of public resources to make these mortgage loans whole, and an unlegislated commitment to make the "implicit" backing of Fannie Mae and Freddie Mac explicit. All without debate, and without the force of public will. Even as the homeowners underlying these mortgages lose their property to foreclosure.

Accounting Rule Change Footnotes

From that perspective, and it's a proper one, these accounting rule changes are nothing but a tiny historical footnote on damage long ago done by Congress ceding power, knowingly or unknowingly to the Fed.

Fed Uncertainty Principle Yet Again

Clever readers will note this as a part of my Fed Uncertainty Principle.

Uncertainty Principle Corollary Number Two:

The government/quasi-government body most responsible for creating this mess (the Fed), will attempt a big power grab, purportedly to fix whatever problems it creates. The bigger the mess it creates, the more power it will attempt to grab. Over time this leads to dangerously concentrated power into the hands of those who have already proven they do not know what they are doing.

That was written April 3, 2008, long before the Fed started usurping powers the constitution grants Congress.

Taxpayers are now on the hook for these losses, and the accounting rule change is a mere reflection of that fact.