In a May 13 guest commentary, Alex Pollock pointed out some very interesting information on the astounding market value losses reported by the Swiss National Bank due to the legal requirement that the bank mark to market euro-denominated assets purchased as part of its efforts to maintain a currency peg between the Swiss franc and the euro. Pegging an exchange rate always ends up hurting the central bank and its taxpayers. It isn’t whether, but rather when and how much. The result is that wealth is transferred from taxpayers to speculators and investors positioned on the other side of the peg.
What is noteworthy about Mr. Pollock’s discussion is the unusual fact that the Swiss National Bank is required to report the market value of its assets and effects on its capital position, whereas the Federal Reserve books its asset purchases at cost, thereby deferring recognition of changes in the value of those assets. In short, the Fed pursues book-value accounting while the SNB reports market values. This means, of course, that comparing the market value of the SNB equity with the book value of the Fed’s capital is comparing apples and oranges.
Does it matter and should it matter how a central bank reports? Given the composition of the Fed’s balance sheet, which we have written about on a number of occasions (and we actually report weekly on the duration of the Fed’s capital), it might matter from an accounting and policy perspective when the Fed begins to normalize short term rates. The Fed’s present balance sheet has an estimated duration of just slightly under 5 (our computations). This is substantially above its historical level in the 2 range before the financial crisis, but below its peak early in the financial crisis. The increase in the duration of its assets, combined with a duration of its capital on the order of .27, means that only a small increase in interest rates, which surely will come as the Fed begins to normalize policy, will cause the Fed to become economically insolvent.
Some would argue that this doesn’t matter. After all, the Fed is ultimately an agency of the government, and as long as the country and Treasury are solvent, which they clearly are, with ample accumulated wealth, economic insolvency is a technical accounting issue but not substantive. In this respect, it is not appropriate to compare central bank accounting to private-sector accounting or measures of solvency.
Mr. Pollock goes on to suggest that in contrast to the SNB recognition of market value losses, the Fed has unilaterally changed its accounting standards so that losses would be “hidden in an intangible asset account.” But this somewhat mischaracterizes what the Fed has done. First, from a technical perspective, any booked losses would be recognized (and publicly visible weekly) in a so-called deferred asset account. Second, the Fed did not unilaterally change its accounting but rather struck a deal with Treasury, so that instead of recognizing losses from the sale of assets by writing down its book capital, it could book those losses in a deferred asset account. This change was effective January 1, 2011; and we detailed the accounting change in a January 27, 2011, commentary (http://www.cumber.com/commentary.aspx?file=012711.asp).
Our explanation of the accounting change is worth repeating here, despite its technical nature.
[The Fed stated in its Jan.6, 2011, H.4.1 release that] (e)ffective January 1, 2011, as a result of the accounting policy change, on a daily basis each Federal Reserve Bank will adjust the balance in its surplus account to equate surplus with capital paid-in and, in addition, will adjust its liability for the distribution of residual earnings to the U. S. Treasury. Previously these adjustments were made only at year-end. Adjusting the surplus account balance and the liability for the distribution of residual earnings to the U. S. Treasury is consistent with the existing requirement for daily accrual of many other items that appear in the Board’s H.4.1 statistical release. The liability for the distribution of residual earnings to the Treasury will be reported as “Interest on Federal Reserve notes due to the US Treasury” on table 10 [now table 6). Previously, the amount necessary to equate surplus with capital paid-in and the amount of the liability for the distribution of residual earnings to the US Treasury were included in “Other capital accounts” in table 9 and in “Other capital” in table 10.
First let us clear up one possible source of confusion. Since Federal Reserve notes are obviously non-interest bearing, why would the Federal Reserve account for the remittance to the US Treasury as “Interest on Federal Reserve Notes due to the US Treasury”? The answer is rooted in the fact that the Federal Reserve is required to collateralize its issuance of Federal Reserve notes with US Treasury debt. The funds being remitted are the interest on that collateral, plus interest on its other debt holdings that may qualify.
As for the change itself, it appears innocuous and amounts to a simple change in accounting and possible timing of remittances, as distinct from a significant change in practice, but the real import of the change is buried in footnote 15 of supplemental table number 10 (now table no. 6) of that same report.” The footnote states:
- Represents the estimated weekly remittances to the US Treasury as interest on Federal Reserve Notes or, in those cases where the Reserve Bank’s net earnings are not sufficient to equate surplus to capital paid-in, the deferred asset for interest on Federal Reserve notes. The amount of any deferred asset, which is presented as a negative amount in this line, represents the amount of the Federal Reserve Bank’s earnings that must be retained before remittances to the US Treasury resume [emphasis added]. The amounts on this line are calculated in accordance with Board of Governors policy, which requires the Federal Reserve Banks to remit residual earnings to the US Treasury as interest on Federal Reserve notes after providing for the costs of operations, payment of dividends, and the amount necessary to equate surplus with capital paid-in.
The change is clearly an accounting trick so that the Fed can avoid the possibility of having to explicitly write down the value of its capital. This could happen if the Fed sold assets and the losses exceeded the earnings on its portfolio, so that Treasury remittances would go to zero. But the losses are not hidden, nor would it be difficult to ascertain that the Fed’s book value was zero. All one would have to do is to compare the size of the deferred asset account, which would be separately reported, with the reported book capital. What would be hidden, however, would be the market value of the unsold assets in the Fed’s portfolio. But even this would not present an insurmountable obstacle for anyone truly interested in undertaking the research, since the New York Fed reports weekly the maturity date, CUSIP, coupon, and par value of each security in the System Open Market Account Portfolio (http://www.newyorkfed.org/markets/soma/sysopen_accholdings.html), where the assets in question are held. The assets include T-bills, T-notes and bonds, fixed-rate notes, TIPS, and agency securities. Not only are the current holdings reported, but one can download the weekly history of the holdings from 2003 to the present.
To conclude, while one might prefer a different reporting method, the key issue is whether it matters how markets might respond should a central bank report that it has negative net worth. There is one important distinction between the Fed and the Swiss National Bank that Mr. Pollock notes, and that is that at least some SNB shares are publicly traded, which could support the case for mark to market. However, there are several other central banks whose shares are publicly traded including the central banks of Belgium, Japan, South Africa and Greece, and like most banks, they don’t mark assets to market.
We believe that, aside from some public embarrassment, the financial condition of a nation’s central bank must be seen in the context of how that condition arose and whether the sovereign is solvent. In the Fed’s case, it would be clear that all we would be looking at is an accounting event and not a substantive economic event. Having said that, the question is whether the possibility of significant losses from asset sales will lead the Fed to opt for other ways to reduce the size of its portfolio.
Images: Flickr (licence/attribution)
About The Author
Dr. Robert A. Eisenbeis serves as Cumberland Advisors’ Chief Monetary Economist. In this capacity, he advises Cumberland’s asset managers on developments in US financial markets, the domestic economy and their implications for investment and trading strategies.
Dr. Eisenbeis was formerly Executive Vice-President and Director of Research at the Federal Reserve Bank of Atlanta, where he advised the bank’s president on monetary policy for FOMC deliberations and was in charge of basic research and policy analysis. Prior to that, he was the Wachovia Professor of Banking at the Kenan-Flagler School of Business at the University of North Carolina at Chapel Hill. He has also held senior positions at the Federal Reserve Board and FDIC.
He is currently a member of the Shadow Financial Regulatory Committee and Financial Economist Roundtable and a fellow member of both the National Association of Business Economics and Wharton Financial Institutions Center. He holds a Ph.D. and M.S. degree from the University of Wisconsin and a B.S. degree from Brown University.