Federal Reserve Report: Central Bank’s Record $82 Billion “Profit” is a Red Flag Warning

Martin Hutchinson:  If the record $81.7 billion in profit that the U.S. Federal Reserve reported for 2010 was turned over to taxpayers directly, there’s no doubt it would have some “stimulus” benefit – after all, a $270 check for every man, women and child in the United States ain’t chicken-feed.

But since that money actually just “disappears” into the coffers of the U.S. Treasury, it does very little good for anybody.

Still, since the pretax earnings of Goldman Sachs Group Inc. (NYSE:GS) never got above the $12 billion mark, it’s worth taking a closer look at the Fed’s reported profits to see just what’s going on – especially since we taxpayers will be called upon to bail out the central bank, once the inevitable losses arrive.

And once you take the time to investigate, you’ll quickly realize two things – this “profit” isn’t what it seems. And you should be worried – very worried – about what’s to come.

Gaming the System?

The $82 billion the Fed reported as profit for last year was up from $48 billion in 2009 – a 71% gain that would have made any investment banker proud – especially since 2010 was a down year for that particular business.

However, the U.S. central bank does possess one capability that private-sector investment banks lack (or, that investment banks believed that they possessed until the credit-default-swap crisis of a few years ago): The Fed can expend its balance sheet as much as it likes.

The profit increase was largely due to the Fed’s balance-sheet expansion through several quantitative easing programs, and through the purchases of U.S. Treasury bonds and federal “agency bonds.”

The earnings gain also owed a lot to central-bank interest-rate policies: Financing yourself cheaply (or, for much of the Fed balance sheet, at zero) in the short-term market and buying Treasuries or housing bonds has been a profitable game for the banking system for the last two years. That’s why few small business loans are being made – the banks can make money with much less effort in this silly game.

Of course, the profitability of the borrow-short/invest-long game depends on the Fed keeping short-term rates below long-term rates. But that makes it a pretty safe bet for the nation’s central bank, since it’s the Fed itself that controls short-term interest rates.

There is, however, one enormous snag. Unlike every other financial institution in the country, the Fed does not have to “mark to market” its portfolio. That means that the Treasuries it bought when interest rates were lower (for most of last year) will have hidden losses.

In short, that “$81.7 billion profit” is overstated – by at least a few billion dollars.

Losses Loom

The real excitement will come when rising inflation forces the Fed to raise interest rates, since it will do two bad things to Fed profits.

First, the interest-rate boost will eliminate the gapping profit the Fed makes by borrowing short-term and lending long-term. (Some of the Fed’s balance sheet is funded by issuing dollar bills, which are effectively “free money,” but these days much moreof it is loans from the banking system, on which it will have to pay interest once it pushes up interest rates.)

Second, the rate increase will cause long-term rates themselves to rise – which will give the Fed a hideous unrealized loss on its balance sheet after all its Treasuries and federal agency securities go down in price. The First Pennsylvania Bank went bust in 1980 through borrowing short-term and investing in long-term Treasuries; eventually erosion of capital becomes very real.

U.S. Federal Reserve Chairman Ben S. Bernanke believes that he can avoid this problem by reversing quantitative easing before he puts up interest rates, thereby cleaning up the Fed’s balance sheet at little cost.

But there’s a problem here – a $1.6 trillion problem called the federal budget deficit.

The Fed has been funding 70% of this through its “QE2” (for “Quantitative Easing – Round 2”) program. If it even lets QE2 expire at the end of June, the Treasury will suddenly find it much more difficult to sell bonds (particularly as Japan – the second-largest holder of U.S. debt behind China – won’t be buying many, having its own problems).

The bottom line: Interest rates will go up, anyway.

Needless to say, with the Treasury selling $1.6 trillion of bonds annually into a difficult market, and inflation at least creeping up, the odds that the Fed will sell all – or even most – of its $2.6 trillion balance sheet in a short space of time are a big fat zero.

Thus, when interest rates rise, the Fed will be stuck with its gigantic pool of assets and will start recording losses that are almost as gigantic.

The central bank will probably still manage to show a profit for 2011 (by some funny accounting, if by no other way), but 2012 is a lost cause.

And when those losses occur, I’ll give you one guess as to who will have to cover them.

I’ll even give you a hint: It won’t be Fed Chair Bernanke or U.S. Treasury Secretary Timothy F. Geithner….

Written By Martin O. Hutchinson From Money Morning

Martin is a Contributing Editor to both the Money Map Report and Money Morning. An investment banker with more than 25 years’ experience, Hutchinson has worked on both Wall Street and Fleet Street and is a leading expert on the international financial markets. At Creditanstalt-Bankverein, Hutchinson was a Senior Vice President in charge of the institution’s derivative operations, one of the most challenging units to run. He also served as a director of Gestion Integral de Negocios, a Spanish private-equity firm, and as an advisor to the Korean conglomerate, Sunkyong Corp. In February 2000, as part of the Financial Services Volunteer Corps, Hutchinson became an advisor to the Republic of Macedonia, working directly with Minister of Finance Nikola Gruevski (now that country’s Prime Minister). The nation had been staggered by the breakup of Yugoslavia – in which 800,000 Macedonians lost their life savings – and then the Kosovo War. Under Hutchinson’s guidance, the country issued 12-year bonds, and created a market for the bonds to trade. The bottom line: Macedonians were able to sell their bonds for cash, and many recouped more than three-quarters of what they’d lost – to the tune of about $1 billion. Hutchinson earned his undergraduate degree in mathematics from Cambridge University, and an MBA from Harvard University. He lives near Washington, D.C.

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