Saturday, January 26, 2013

To the Fed – Defer This!


The Federal Reserve makes a ton of money on its $3T horde of government bonds. In 2012 the Fed earned a tidy $90B by borrowing short and lending long. That income number is the difference between interest income and expense. The P/L does not reflect the fact that the Fed as a huge unrealized gain in its portfolio (The Fed takes capital gains and losses only when securities are sold). According to a recent Fed report, the Fed is sitting on unrealized gains that are in the neighborhood of $200B.


This chart shows how big the Fed’s contributions to Treasury have been over the past few years. The Fed’s net income has cut 10% off of the annual deficit.



The question that hangs in the air is what happens if interest rates were allowed to “normalize”. Fortunately, there is an answer to this question. The source of this information is interesting, it comes from the Federal Reserve.


Screen Shot 2013-01-26 at 11.54.28 AM


This is a technical report and covers many “what ifs”. One critical variable is what will the Fed do in 2013. That has been answered, the Fed has done QE#4 and will grow its balance sheet at the rate of $85B per month. This result is reflected in the red-dotted lines in the following charts.


First a look at the interest rate assumptions that drive the results at the Fed:






On the assumption that those rates will be the reality,  this is what would happen to the Fed’s income statement:




Note that in all cases, the years of $80b Fed gains are over. Note also that if interest rates do rise, the annual return to Treasury quickly falls to zero, and actually goes negative (loss).

The Fed’s balance sheet would get crushed (on a mark-to-market basis). The $200B of unrealized gains would fall to an unrealized loss of $300B. A half-trillion dollar swing in just a few years.




Let’s say it plays out like this. What does it mean if the Fed has annual losses, and a big hole in its assets? The answer is, “Not much”.


- The annual remittances to Treasury would fall to zero, That would, by itself, add to the deficit. The magnitude of the change (-$80b) would not be that big an issue.


-If the Fed takes an annual loss, an accounting “asset” is immediately created equal to the loss. The asset would be in the form of a future claim on remittances to Treasury. This is an accounting gimmick.


If the Fed had a $50B loss in year #1, a $50B Deferred Asset is created. If in year #2 the Fed has a$50B profit, the money is first used to reduce the Deferred Asset. If you believe that the Fed will earn a profit over time to offset current losses, then the Fed can never be consider insolvent.


This is the Fed’s explanation of the magical accounting:


The deferred asset is subsequently realized as a reduction of future remittances to the Treasury. Thus, it is an asset in the sense that it embodies a future economic benefit that will be realized as a reduction of future cash outflows.


The Fed goes on to defend this (flaky) logic with:


This accounting treatment is consistent with U.S. GAAP and is similar to the way that private companies report deferred loss carry forwards as an asset.


Well, that is “sort of” correct. This situation can arise with a private sector company. Tax loss carry forwards are an asset. But they are an asset that analysts look askance at –  for obvious reasons.

The Fed is not just the Central Bank. It is a regulator for the nation’s biggest banks. If one of those banks tried to use a $100B tax loss carry forward as an asset, the Fed would put the screws to them. For example:


-The Basel II capital requirements specifically exclude Deferred Taxes as a qualified asset. (So how can the Fed treat it as equity?)


-The Fed has restricted Citi from stock buy-backs and dividends because the bank has $50B in Deferred Tax assets on its books. (Good for the goose, but not the gander?…)


Note: This is an odd report to be coming from the Fed. What to make of it?

I put it on the growing list of “things” that are suggesting that the Fed is pondering a change in direction. If there are any ‘tea leaves’ in the analysis, they would read that QE is going to be ending pretty soon.

The Fed is aware of the risks it is taking. The report quantifies the risks in an orderly, but scary way. The fact that this report exists, confirms to me that some Fed members are increasingly uncomfortable with those risks.











  1. Hello Bruce,

    I would like to ask you a few questions. What is this growing list of “things” that are suggesting that the Fed is pondering a change in direction? I must admit that I am hard pressed to imagine what immediate circumstances are apt to arise such The Fed can even begin to contemplate leaving The Hotel California. After all, who is going to take up the slack in the absence of The Fed buying up the lion’s share of new sovereign debt issuance? If you say Japan, I would say that Japan’s self destruct button has already been set, and that the timer is set to detonate in approximately two years. In short, relying on the Empire of the Setting Sun doesn’t make it off the runway as a plan. If you have a different understanding regarding the nature of The Fed’s activity these days than one that involves their activities as being about making up the yearly shortfall in Uncle Sam’s budget deficit, I would like to hear it. Of course, at its inception, QE was about recapping TBTF banks, but the mission has evolved. The major buyers of U.S. debt have stopped buying and they aren’t going to start up again. Please advise.

    • Things:

      – The minutes from the last Fed meeting started off the talk of ending QE by the end of the year.

      – Housing has bottomed. In most areas of the country there is a turn-around happening.

      – The US will make/sell 15m cars this year. There is no way the US can have a recession and sell that many cars. Can’t happen!

      – Part of the RE recovery is due to rising rents. Rents are big part of the inflation calculation. This suggests that inflation is going to be increasing.

      – The Stock market is at a 5 year high. There is no need for emergency monetary measures any longer.

      – Bernanke is leaving the Fed at the end of the year. He does not want to leave while there is a big QE program ongoing. He wants to give the new guy a (relatively) clean slate.

      I could go on, but this is a good start on that list of “things”.

      • Bruce-

        Yes the economy is getting better…but solely bc of the fed’s monetary largesse…what happens to housing when mortgage rates rise from 3.5% to 5.5% by 2015 as the fed’s chart shows? That’s a 65% increase in the monthly payment of a house, which will have a significant impact on home prices and most importantly bank balance sheets.

        What happens to the stock market? What happens to auto sales? What happens to industrial data series which have been plunging in December? Has the fed ever raised rates into a sub-50 ISM? What happens to that sector of the economy?

        Lastly, if the fed stops qe under the auspices of an improving economy, who funds the us gov’ts deficit, and at what interest rate, if the us fed won’t?

        The Japanese? They just posted their biggest trade deficit in the country’s history in 2012.

        The Chinese? They bought more gold than ust’s last year.

        The eu? No. They are dealing with their own issues.

        I think all this noise about the fed tightening is year is bc they are looking at asset markets and getting scared to death about the monster they have created. They can’t stop qe bc there is a $1.1T us govt deficit that must get monetized or the ust mkt melts down, followed shortly thereafter by the stk mkt, the housing mkt, the auto mkt and the broader us economy.

        The fed is painted in a corner…IMO we are less than a year away from the day that mr market recognizes that the fed is never going to stop qe in increasing quantities…that is going to be an interesting day to say the least…

        • Auto Sales have been helped by the govt. whom purchased GMAC and turned into ALLY which is now taking super subprime ABS paper…It was the only way to bring car sales near previous levels…
          If you want to find a bubble look into ABS paper for subprime…been writing about it for years at CR…
          520 Ficas and 0% 72 month loans or 84-96 month loans for sub prime….

          its a bubble…in the industry and in the know…

      • “The US will make/sell 15m cars this year. There is no way the US can have a recession and sell that many cars. Can’t happen!”

        how are you so sure?


  2. So the Fed, really truly seriously, thinks that in some 5 years interest rates will be back to 4-5% ? Are they nuts, or what? Such rates would instantly detonate the US & most Western governments’ budgets. The projected sizes of their coming deficits are already in la-la-land, let alone their ability to finance those at 5x higher rates. Who do these Fed guys think they’re kidding?
    Unless perhaps I have completely misunderstood the depth and gravity of the crisis and happy days are almost here again?
    Bruce, what’s your take on those Fed interest rates projections?

    • They were not projections of what will happen. This was a numbers crunch of what would happen if rates were “normalized.

      The rates of 4% for Fed Funds and 5.5% for 10 yr rates is not at all out of line with post WWII averages.

      Could these rates be in our future? I don’t think so, it depends on inflation. At the moment, that looks tame, but things are changing.

  3. Thank you for answering my question regarding the “things.” And, by all means, go on with your list. There’s just one problem with the list so far, Bruce.

    None of the things on your list has anything to do with why the Fed engages in QE.

    They did not initiate or continue QE because of the performance of the stock market, and so it follows that they will not stop QE if and when, for example, The S&P 500 makes nominal highs above pre-crash levels.The TBTF banks have been recapped, and the country may not be in a recession as per your assertion about the meaning of the auto data. But, the real estate market has, at best only stabilized as the result of a lot inventory being removed from the market and a favorable rate environment. Unfortunately there is nothing about prospective economic growth and concomitant employment that should give anyone comfort that real estate, except in some high profile pockets, has shed its fundamental woes.

    But, again, QE isn’t about such things. What it is about is propping up TBTFs And it is about picking up the bond market slack now that major buyers have permanently removed their support. So, again, who is going to take up the slack in the absence of The Fed buying up the lion’s share of new sovereign debt issuance?

    • QE did prop up the TBTFs. But take a look at those banks today. They are at no risk of failure anymore. That was a 2009 problem, now it is 2013.

      As far as the bond market, well I think you are missing something. If the Fed stops QE, and rates rise back up a percent or two, then a whole bunch of people would be interested to buy those bonds. I see no problem why the US could not sell a Trillion of bonds a year to the public. Just not at today’s rate structure.

      • I think you spent too much time on Asshole Street. You write “If the Fed stops QE, and rates rise back up a percent or two, then a whole bunch of people would be interested to buy those bonds. I see no problem why the US could not sell a Trillion of bonds a year to the public.” A trillion dollars of bonds? That’s just part of the deficit. What you would need to sell is probably $5 trillion worth of bonds. I think you’re forgetting all the rollovers. If interest rates rise (as you state), this whole corrupt system will implode because all the revenue will go to paying interest.

        And you think you can sell a $ trillion to the public? What public? The public is broke. You have no fucking clue what you’re talking about. QE can NEVER end or it’s game over.

        • Kris says – “The public is broke”. I keep reading people on various blogs making this statement.
          It’s not factual. Sure, some people ARE broke.

          Me, many of my peers and family members? We’re mid 50’s, gainfully employed, little to no debt of any kind and sitting on hundreds of thousands of dry powder. I own some stocks, some bonds, a little bit of metals but have most $ on the sidelines. So, no, plenty of us aren’t broke and will deploy fairly significant bucks for the right opportunity.

          • This is what I’m referring to: http://www.bloomberg.com/news/2012-09-04/food-stamp-use-climbed-to-record-46-7-million-in-june-u-s-says.html

            If you are stupid enough to be holding $US at this particular juncture and in the “hundreds of thousands of dry powder”, you should buy UST bills and get slaughtered.

            “plenty of us aren’t broke and will deploy fairly significant bucks for the right opportunity.” If you’re still sitting on worthless paper you will miss the opportunity.

            • Oh, for crying out loud Kris….what are you 12?
              Because more people are taking handouts means they’re broke?
              Such a simple way to view things.

              Have you considered the thresholds might have been broadened and/or that people have little conscience any more about tapping what is intended for those who truly need it? Read Freakonomics (profound examples of things not being what they seem on the surface).

              Don’t worry about me and my dollars…we are, and will be, just fine. You’ll realize soon enough that some (or plenty) of the financial prognosticators you’re listening to will be wrong. Many of them have been wrong for several years now already.

              • Yes, all those people on food stamps are “sitting on hundreds of thousands of dry powder” and they will be buying this worthless paper. I have lived through very high inflation so don’t sit there and tell me this bullshit. You people in the USSA have never experienced it but it’s coming.

                You keep your paper, I’ll keep my silver.

  4. Re: “I put it on the growing list of “things” that are suggesting that the Fed is pondering a change in direction. If there are any ‘tea leaves’ in the analysis, they would read that QE is going to be ending pretty soon.”

    If the Fed is looking to end QE relatively soon, why would it adopt the ‘Evans Rule’ in December? By doing so, it essentially put QE on autopilot and largely relinquished discretionary control of when QE ends. Unless the unemployment rate falls sharply, the real economy otherwise improves dramatically, or inflation picks up, the Fed can’t end QE without losing credibility. If it had not adopted the Evans Rule, it would have much more flexibility to end QE whenever it wants to. Bruce, how do you reconcile the Evans Rule with your view re: QE ending pretty soon?

    • I can’t.

      But then again, what do you make of the Fed minutes FROM THE SAME MEETING where the discussion of ending QE by the end of the year first came up?

      I think it is possible for the Fed to end QE AND continue with ZIRP. I don’t think this is a violation of the “Evans Rule”. Monetary policy would remain very easy, just no QE.

  5. Conscience of a Conservative says:

    “Deferred asset” sounds like “Fed speak”.
    I guess the balance of my mortgage that isn’t being paid to my bank is an asset and not a liability?

  6. In a way, your mortgage is a Deferred Asset. Two possibilities:

    1) You pay in full and the lender makes a gain. The lender owes taxes on the gain.

    2) You don’t pay and the lender takes a loss.

    If the lender takes a loss, they can offset the loss against other tax liabilities. So the loss is converted into a Deferred Tax Asset that can be use at a later time. That Asset reduces the taxes that are due on those who do pay (#1).

  7. Hi BK, so would you invest in a short bond ETF? If rates are going to normalize…seems like it couldn’t lose.

    • I have said in these missives on many occasions – I NEVER advocate that investors play the short side of bonds.

      Short bonds is the ultimate timing trade. The reason it is so time sensitive is that there is a very large negative carry to be short bonds on a leveraged basis. There is no “Sell and Hold” with this strategy, you will bleed to death.

      If you go to work everyday and trade bonds, by all means trade bonds from the short side. From time-to-time over the next few years big money will be made on the short side. But if you don’t trade bonds for a living, don’t trade em short…..

  8. Yes, Bruce, the TBTFs are recapped. I said that very clearly in the middle of my last post.

    You assert that the U.S. public will pick up the slack. Perhaps, but it will only to take a few percent rise, the same rise you think will attract the necessary buying from the public, to put immense pressure on the government in the form of interest payments. Likewise, that same few percent rise in interest rates will, at the least, put a damper on the fragile real estate market recovery.

    In the meantime, The Fed can not stop taking up the slack until the public comes to the putative rescue. Unless rates are set to catapult higher by a few percentage points, pronto there is no unburdening of Fed support that can be achieved anytime soon. Also, the idea that rates are going to go up by just a few points-two per cent- and remain at a level that amounts to a goldilocks scenario-not too warm and not too cold strikes me as wishful thinking.

    I, too, could go on, but, for now, I’ll refrain.

  9. Bruce — am I reading those Fed interest rate projections correctly? The Fed itself “expects” (baseline projection) the 10y yield to continue rising through 2018ish — starting a few months ago?

    Artificially manipulating interest rates lower than they would be otherwise is the whole point of quantitative easing — according to The Bernank himself (he omits the word “artificial” from his diplo-babble, but…)

    This means the Fed’s baseline projection that QE is going to fail? You can’t say you are pissing away $85 billion per month to keep rates low, and then also say you expect rates to rise anyhow

    So QE is expected to be a failure — in the baseline projection of the Fed itself?

    • Not projections of what will happen. This is only one possible outcome. For what it is worth, I don’t see it happening.

      Even if QE ends, ZIRP will continue. The Fed will still have the ability to peg the short end. That will keep a lid on the long end.

      • “Even if QE ends, ZIRP will continue” How exactly?

        “The Fed will still have the ability to peg the short end. That will keep a lid on the long end.” This makes no sense. WHO will buy the bonds if QE ends? You?

        • Kris, sorry if I was not clear.

          Peg the short end = The Fed will keep the Federal Funds rate at less than 1%.

          There is (and always will be) something called a yield curve. That curve is based on what the short end is yielding. The curve has ranged from 0-4% over short rates. You have to trust me on this one. If short money is 1%, 10-year money can’t be over 6%.

          You ask WHO would buy US bonds. I don’t think you understand how this works. The market for government bonds is enormous. The biggest market in the world. There is no problem for the US to place an additional Trillion a year for the next few years without QE.

          It just means that rates would have no move up a bit.

          Anyway, why are you so cranky? It’ just a blog about the Fed. Nothing to get excited about.

  10. This paper has been the fed game plan…it’s been spot on so far…thus inflation is very near….

    The basic idea of the paper is to create money and buy assets to avoid the devaluation of the financial assets, including stocks. According to Eggertsson’ (or FRBNY?) model, the amount of money creation may reach up to 400%(!) of the GDP… but it can be reduced “just” to 70% by the use of non-traditional monetary tools (buying private assets such as stocks, commercial bonds and foreign exchange). And this is exactly what FED is doing for the last four years… and, according to Eggertsson, it still can print and buy much more – if needed

    “Cutting taxes and dropping money from helicopters are only two examples. The government can also increase debt by printing money (or issuing nominal bonds) and buying private assets, such as stocks, or foreign exchange. In a Markov equilibrium, these operations increase prices and output because they change the inflation incentive of the government by increasing government debt (money + bonds). Hence, when the short-term nominal interest rate is zero, open market operations in real assets and/or foreign exchange increase prices through the same mechanism as deficit spending in a Markov equilibrium.

    (p.318, JMCBpaper.pdf)An advantage of buying private assets, as opposed to cutting taxes, is that it does not worsen the net fiscal position of the government. It only changes the inflation incentive of the government…
    (p.20, wp0364.pdf)…government always eliminates any outstanding debt when the nominal rate is positive. The logic behind is simple: nominal debt creates inflation expectations…
    To increase inflation expectations the government buys real assets in period 0 by printing money (or bonds)… In period 1 the government reverses this transaction by selling the bulk of real assets. The nominal debt issued in period 0 effectively commits it to higher inflation in period 1″

  11. I wonder if the IRS will accept “deferred assets” in lieu of cash this April? Seems like a variation on the trillion dollar coin scam, but then I am not suing Geithner’s special version of TurboTax

    If the IRS will not accept bogus assets, can I get my debt ceiling extended to infinity?