Is The Fed Actually Broke? And Does Anyone Care?

When you bring up the topic of the Federal Reserve going broke, most individuals react by saying, “That’s impossible! The Fed can’t go broke. They can just print more money.” That’s a typical reaction, but it displays a misunderstanding of what money is and how the Fed actually works.

Yes, the Fed can print all the money it wants. But money is not an asset for the Fed; it’s a liability.

Take a $20 bill out of your purse or wallet and read it. On a banner across the top it says, “Federal Reserve Note.” A note is a form of debt; in other words, it’s a liability.

That becomes clear when you look at the Fed’s balance sheet (it’s publicly available on the Fed’s website). Assets consist mainly of securities, mostly U.S. Treasury bills and notes, and mortgage-backed securities. Liabilities consist of cash, coin, and reserves deposited by member banks at the Fed.

The Fed’s net worth or capital is simply the net of the assets minus liabilities. That equity account is a small sliver of capital relative to the total assets. In other words, the Fed looks like a highly-leveraged hedge fund.

Printing money can be used to buy more securities, but all that does is leverage the balance sheet even more by piling more assets (securities) and liabilities (money and reserves) on top of the same sliver of capita. But what if it’s worse than that? What if the assets are less than the liabilities, so the Fed has a negative net worth?

That’s the question discussed in this article. A negative net worth is one definition of insolvency, which is a fancy name for broke. In the steady state, this would not happen. The Fed can just sit still, let assets mature at par value, get paid the cash by the issuer at which point the cash just disappears when the Fed receives it. The Fed could gradually deleverage just by doing nothing.

But, what if the Fed balance sheet were marked-to-market like a real hedge fund? Or what if the Fed sold securities at a loss instead of just waiting for them to mature at par value?

The Fed’s accounting method does not mark-to-market, but any analyst can run the numbers anyway just by looking at asset maturities and using current market prices for those assets. If you do this, you find that higher interest rates have resulted in many securities in Fed’s portfolio being worth less than book value.

That’s bond math 101: higher rates = lower prices. Beyond that, the Fed does not want to wait to deleverage. It wants to reduce the balance sheet quickly. That means assets sales, especially the less liquid mortgage-backed securities.

That’s where real operating losses arise because an actual sale below par value results in a loss that must be charged against capital. So, yes, the Fed is probably insolvent on a mark-to-market basis (a method they do not use) and could become insolvent as the result of securities sales below par value (something they are doing).

Does it matter? Probably not. Most people don’t even know what the Federal Reserve is, let alone the inside accounting issues we described here. But in the next panic, it might.

How can the Fed bail out big banks when the Fed itself is insolvent? The issue might not be a legal one so much as a matter of confidence.

Just in case, the Fed does have a hidden asset to offset all of those not-so-hidden losses. The Fed has a gold certificate on its books based on a quantity of gold valued at $42.22 per ounce. If that gold were revalued to the current market price of $1,850 per ounce, another $500 billion would appear out of thin air. That could be added to Fed capital.

The Fed doesn’t like to talk about gold, but maybe the entire monetary system is based on gold after all.

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