Sunday, January 23, 2011 3:53 PM

Timothy Geithner Meets Vladimir Lenin Stage II; Accounting Rule Changes at the Fed will Mask Losses

Many people have taken notice of changes slipped into the Fed's balance sheet reporting rules that will allegedly shield the Fed from devastating losses. Please consider Accounting Tweak Could Save Fed From Losses. http://www.cnbc.com/id/41198789

Concerns that the Federal Reserve could suffer losses on its massive bond holdings may have driven the central bank to adopt a little-noticed accounting change with huge implications: it makes insolvency much less likely.

The significant shift was tucked quietly into the Fed's weekly report on its balance sheet and phrased in such technical terms that it was not even reported by financial media when originally announced on Jan. 6.

"Could the Fed go broke? The answer to this question was 'Yes,' but is now 'No,'" said Raymond Stone, managing director at Stone & McCarthy in Princeton, New Jersey. "An accounting methodology change at the central bank will allow the Fed to incur losses, even substantial losses, without eroding its capital."

The change essentially allows the Fed to denote losses by the various regional reserve banks that make up the Fed system as a liability to the Treasury rather than a hit to its capital. It would then simply direct future profits from Fed operations toward that liability.

"Any future losses the Fed may incur will now show up as a negative liability as opposed to a reduction in Fed capital, thereby making a negative capital situation technically impossible," said Brian Smedley, a rates strategist at Bank of America-Merrill Lynch and a former New York Fed staffer.

"The timing of the change is not coincidental, as politicians and market participants alike have expressed concerns since the announcement (of a second round of asset buys) about the possibility of Fed 'insolvency' in a scenario where interest rates rise significantly," Smedley and his colleague Priya Misra wrote in a research note.

Two Distinct Issues

Going forward, there are two key issues here (not counting losses with TARP), and none of the articles circulating properly explains either them, or when the real damage occurred.

1. Losses on Treasures as Interest Rates Rise
2. Losses on Fannie Mae and Freddie Mac Assets


Losses on Treasures as Interest Rates Rise

It is a simple statement of fact that there will be no losses on treasuries if the Fed hold the treasuries to term, which I believe is their intent. Note that the Fed concentrates purchases in the 3-7 year range, making it a relatively easy matter to hold those securities to term.

Moreover, if the economic recovery does not satisfy the Fed it can simply enter a program whereby it replaces expiring treasuries with new purchases. Should the Fed embark upon such a plan, it will offer an excuse that it is not expanding its balance sheet further.

I do not agree at all with the Fed's balance sheet expansion, I simply point out the risk of losses on treasuries is a theoretical issue, not a practical one.

Losses on Fannie Mae and Freddie Mac Assets

The accounting rule change will also allow the Fed to hide losses on MBS garbage on its balance sheet. Those toxic assets have a much longer duration. Can the Fed get rid of them for no losses?

The answer is yes, but it has nothing to do with accounting rule changes. The damage was done in late 2009 by Congress.

Timothy Geithner Meets Vladimir Lenin

Please consider John Hussman's January 4, 2010 article Timothy Geithner Meets Vladimir Lenin http://www.hussmanfunds.com/wmc/wmc100104.htm

“The best way to destroy the capitalist system is to debauch the currency.â€