Fed Loses $1.3T, Will It Go Bankrupt?

It is well known that the Federal Reserve is the central bank of the United States, determining the country's monetary policy. We often hear about interest rate hikes, cuts, and balance sheet expansion and contraction, all of which are carried out by the Federal Reserve. Due to the special status of the US dollar, the Federal Reserve is also referred to as the world's central bank, which shows the influence of this institution on the US and global economies.

Recently, media reports have indicated that the Federal Reserve has suffered substantial losses, with a deficit of $120.4 billion as of November 22, equivalent to approximately 860 billion yuan. According to Wall Street analysts, the Federal Reserve's future net losses could peak at a maximum of $200 billion, or 1.4 trillion yuan. Why does the Federal Reserve lose money, and could it go bankrupt as a result? This article will reveal the answers to these two questions.

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Actual Losses and Unrealized Losses

The losses of the Federal Reserve can be divided into two types: actual losses and unrealized losses. Let's discuss each one separately.

First, let's talk about actual losses. Since its establishment, the Federal Reserve has rarely lost money. Some say that the Federal Reserve is a private institution, which has some truth but is not entirely correct. For a purely private institution, any profits would definitely go into their own pockets. The Federal Reserve is different; it hands over its profits to the US Treasury, similar to how the People's Bank of China remits profits to the finance, so from this perspective alone, the Federal Reserve is not a true private institution.

Income greater than expenses is profit, and income less than expenses is a loss. It is clear that recently the Federal Reserve's income has been less than its expenses.

The Federal Reserve's income mainly comes from interest earned on held securities. For example, the Federal Reserve holds a large amount of US bonds and Mortgage-Backed Securities (MBS). According to the Federal Reserve's recent balance sheet, out of its total assets of $7.8 trillion, $4.8 trillion are Treasury bonds and $2.46 trillion are MBS.

US Treasury bonds and MBS are tools for the Federal Reserve to make money, and these two interest-bearing assets bring in interest income for the Federal Reserve. It should be noted that the vast majority of the bonds held by the Federal Reserve are medium to long-term bonds, with interest rates that were set years ago. At that time, the United States had not raised interest rates and maintained an extremely low-interest rate environment, so the interest income brought to the Federal Reserve was not much.

On the other hand, US commercial banks deposit money with the Federal Reserve as reserves, and the Federal Reserve has to pay interest to commercial banks. Since March 2022, the Federal Reserve has raised the federal funds rate multiple times, leading to a rapid increase in financing costs across the United States. The reserve interest rate at the Federal Reserve has also risen, leading to increased interest expenses.

With interest income remaining at a low level and interest expenses continuing to rise significantly, it is no surprise that the Federal Reserve is spending more than it is taking in. This is an actual loss, where the cash inflow is less than the cash outflow.The mere actual losses would not lead to the Federal Reserve suffering losses of $120 billion or even up to $200 billion, after all, how much interest is there? The real culprit behind the huge losses is actually the paper losses.

As mentioned earlier, the Federal Reserve holds a large amount of U.S. Treasury bonds and Mortgage-Backed Securities (MBS), the value of these assets fluctuates with market prices. What does this mean?

I wonder if anyone remembers the recent Silicon Valley Bank bankruptcy incident that caused quite a stir? Silicon Valley Bank faced a run and fell into a cash flow crisis, and the culprit that triggered the run was the huge losses disclosed in its financial report, which is similar to the Federal Reserve.

Silicon Valley Bank had previously purchased a large amount of U.S. Treasury bonds, and the Federal Reserve's interest rate hikes led to a continuous rise in the yields of U.S. Treasury bonds. The characteristic of bonds is that the higher the yield, the lower the transaction price. If bonds bought at a high price see their value decrease, doesn't that result in paper losses?

For example, if you bought a U.S. Treasury bond for $90 two years ago, and after the U.S. raised interest rates, the yield on U.S. Treasury bonds quickly rose, causing the price of the bond to drop from $90 to $60, the buyer would incur a paper loss of $30.

Silicon Valley Bank essentially died from the paper losses triggered by the decline in the market price of the U.S. Treasury bonds it held. The Federal Reserve holds an even larger amount of U.S. Treasury bonds, and compared to Silicon Valley Bank, the paper losses are obviously more severe.

Let's put up a chart of the yield trend of 10-year U.S. Treasury bonds for everyone to feel for themselves. The price of U.S. Treasury bonds is inversely proportional to the yield, so the price trend chart is actually the opposite.

Why is it called a paper loss? Because as long as the Federal Reserve does not sell the U.S. Treasury bonds, there will be no loss, which is a bit like stocks; no matter how much the stock price falls, as long as it is not sold, it is not considered an actual loss.

Of course, there are differences between bonds and stocks, the former can really avoid losses. As long as you hold the U.S. Treasury bonds to maturity, the U.S. Treasury will pay cash according to the face value, and the face value of a U.S. Treasury bond is $100. After maturity, for each U.S. Treasury bond held, you can account for $100 in cash, and the annual interest will naturally not be less.

Will the Federal Reserve "cripple" itself?Based on the analysis above, it can be seen that both actual losses and paper losses are related to interest rate hikes. The Federal Reserve is the one that decides to raise interest rates, which results in its own losses. Isn't that quite magical? Will the Federal Reserve's deficit grow larger and larger, eventually making itself "crippled"?

I'm afraid not, for three reasons.

Firstly, paper losses are not fatal to the Federal Reserve.

Paper losses can be fatal to commercial banks but not to the Federal Reserve. The reason is simple: when people see commercial banks losing money, they worry about not being able to withdraw their deposits, so they all rush to the banks to cash out. No matter how large the bank is, it cannot withstand a run.

The Federal Reserve is different; it does not have to face cash withdrawal requests, so even if the paper losses are severe, there will be no run, and paper losses will not turn into actual losses.

Secondly, the interest rate hike is already in its later stages, and interest expenses will decrease.

Since the interest rate hike in July, the Federal Reserve has maintained the federal funds rate unchanged several times, and next year the Federal Reserve may even start to lower interest rates. The cost of financing will gradually decrease in the future, reducing the pressure on the Federal Reserve's interest payments, and actual losses will gradually be offset.

In fact, in most years, the Federal Reserve not only does not lose money but also makes a lot of money and hands it over to the U.S. Treasury. In the past decade, the Federal Reserve has handed over nearly $1 trillion in profits to the U.S. government.

Thirdly, the Federal Reserve is the issuer of the U.S. dollar.

This is the most important point and also the power that the Federal Reserve can use as a last resort. The Federal Reserve is the central bank of the United States, undertaking the function of issuing currency. Have you ever seen an institution that "prints money" go bankrupt due to lack of money? This is simply an impossible event.Although the Federal Reserve does not have the arbitrary right to "print money," it can continuously obtain dollars by selling the U.S. Treasury bonds and mortgage-backed securities (MBS) it holds. To take a step back, even if the Federal Reserve runs out of assets, the U.S. government would not allow any accidents to happen to the Federal Reserve. In a sense, the Federal Reserve, the U.S. dollar, and the United States are a trinity. If any part of this trinity encounters a problem, it would plunge the United States into an irretrievable situation. Therefore, the Federal Reserve must operate normally. It is not only bankruptcy that is not allowed, but also any crisis is not permitted to occur.