When I wrote about Bernanke’s ‘Non-Standard’ Policies I forgot ask an important question.
Who is carrying the risk for the Fed’s new policy?
By looking at the normal balance sheet mechanism it is quite simple to determine that the taxpayers are the once who will have to bleed when the Fed’s policy runs into problems.
The Federal Reserve is a private company owned by large commercial banks and has a total capital of some $30 billion. The government has given the Fed certain exclusive rights and obligations in exchange for certain services and a chunk of its profits. The profits for the Fed owners are limited by law to 6% of the paid-in capital. The rest goes to the government and gets spend like any taxdollar.
The Fed gives out dollar notes, i.e. money, and uses these to buy Treasuries. On its balance sheet the notes it has given out are a liability, the treasuries it bought are an asset. At the end of 2006 the Fed had $780 billion of outstanding notes and the same amount of U.S. government securities. Its balance sheet was indeed in balance.
The treasuries the Fed purchased generate interest. For the fed this is net income, i.e. profit. A small part of the profit is payed out to its owners, some of the money goes to expand its reserves and the bulk, some $30 billion in 2006, is payed back to the government.
If the Fed would not generate this profit and give it to the government, the 160 million or so U.S. taxpayers would have to make up the difference. If the Fed makes no profit, each U.S. taxpayer will have to pay an additional $190 per year.
If a regulated bank is in trouble the Fed can lend money to the bank in exchange for treasuries as collateral. To do so increases both sides of the Fed’s balance sheet and increases the amount of money in circulation. It is an inflationary policy as more money is put into circulation and is chasing an unchanged amount of goods.
Bernanke’s new policy to ‘help’ the banks currently in trouble is ‘sterilized’. The Fed does not lend out money, but it lends out treasuries and accepts other interest generating papers as collatoral. The amount on both sides its balance sheet stays unchanged and the policy does not directly generate inflation (An argument can be made that this creates a hidden form of inflation.)
According to the Fed lending rules it now accepts asset backed securities, like mortgage papers, with a ‘haircut’ of 20%, i.e. for 80% of the nominal value of those papers.
If the papers the Fed accepts as collateral for lending out treasuries is worth less than those 80% and the bank it lent treasuries to goes bankrupt, the Fed will make a loss.
That is not a theoretical case. The Fed so far has committed aboul half of the treasuries it held to the scheme. It has prolonged the lending period from overnight to 28 days. It no longer only lends to the commercial banks it regulates, but also to unregulated financial institutions like BearStearns.
Many of the asset backed securities are worth much less than there face value. Nobody really knows exactly how much because there currently is no real market for such papers – which is exactly the reason for the ‘credit crunch’. In a few cases such papers have been sold for only 30% of their face value. The Fed takes such at 80% of face value.
The Fed has given away valuable treasuries for junk and when one of the banks it lent to fails, it will make a loss instead of a profit. Then the government will get less or no money from the Fed and the taxpayer will be asked to come up with more.
The Fed does not carry the risk here, the taxpayers do.
It would be good for them to understand this. That’s probably the reason why the media doesn’t explain this.
