Slick accounting at the Federal Reserve could prove disastrous

“Mr. Chairman, on exhibit two, panel four, ‘deferred asset.’ This is kind of a nice term, ‘deferred asset.’ As far as I know, the committee has never used the deferred asset. It strikes me as a possible political firefight to bring that into play. All of the scenarios here, other than option one, if I’m reading this correctly, would bring the deferred asset into play, with possible repercussions, I think, for the Federal Reserve.”

This was James Bullard, president of the Federal Reserve Bank of St. Louis, speaking at the September 2012 meeting of the Federal Open Market Committee, according to the minutes. Said a staff member in reply, “It has never been the case that we have had, for the Federal Reserve System as a whole, a deferred asset.” But they knew that they might have one going forward. Earlier in the meeting, the staff had reported that all the options considered to reduce the Fed’s bond portfolio would cause the “creation of a deferred asset,” perhaps even a “substantial deferred asset.”

{mosads}What in the world were they talking about? In this context, what did this, as Bullard ironically said, “nice” term mean? In fact, they were discussing how, if they ever tried to reduce their huge portfolio of long-term Treasuries and mortgage-backed securities, they were liable to take big losses. They were pondering the effect which the losses arising from any attempt to normalize their balance sheet would have on their financial condition.

What the Fed meant by “deferred asset” in clear language is the “net losses we would take.” What would be deferred is the recognition of the losses in retained earnings. The losses under consideration might occur by selling some of the Fed’s vast investment in long-term securities for less than it paid for them. Could this happen? Of course. Buy at the top for $100 and sell later for $95 means a loss of $5 for anybody.

Already in 2012, the Federal Open Market Committee was struggling with the clear possibility that such losses could be very large, indeed much larger than the Fed’s net worth. Thus, such losses had the potential to render the central bank insolvent on a balance sheet basis, as well as making it it so that the Fed would be sending no money to the Treasury to reduce the budget deficit, perhaps for several years.

In one scenario presented to the Federal Open Market Committee at that 2012 meeting, the “deferred asset” would get to about $175 billion. At the time of the meeting, the Fed’s net worth was only $55 billion, so its leaders were contemplating the possibility of losing up to three times its capital. This was happening while running a long-term securities portfolio of $2.6 trillion.

If negative net worth did arrive, the Fed could still print any money needed to pay its bills, but the balance sheet wouldn’t look so good. And might not publishing a balance sheet with negative net worth mean a “possible political firefight” in Bullard’s phrase? What might Congress say or do? The Fed didn’t want to find out. So it invented having a “deferred asset,” if necessary, rather than reporting a negative net worth.

In short, this “deferred asset” would be an imaginary asset. It would be booked in this fashion to avoid recognizing the effect of net losses on capital. In accounting terms, it would be a big debit looking for someplace to go. The proper destination of the debit for everybody in the world, including the Fed, is to retained earnings, where it would reduce capital, or even make it negative. But the Fed does not choose to allow this, and the central bank defines its own accounting rules.

So the Fed would send the debit to an accounting “deferred asset” instead, which hides the loss and overstates capital. Harshly described, for ordinary banks, this would be called accounting fraud. So more than five years ago, the Fed understood very well the big losses that might result from its massive “quantitative easing” investments, and how such losses might dwarf the Fed’s capital. It knew it could prevent showing a negative net worth by a slick accounting move. Hence the extensive discussion of the “deferred asset,” which does indeed sound a lot better in the minutes than “negative capital.”

Since then, the Fed’s portfolio is much bigger, up to $4.2 trillion, so the potential losses are much bigger now, while the Fed’s capital is much smaller, down to $39 billion because the Congress expropriated a lot of its retained earnings. Interest rates have gone up. Selling down the Fed’s portfolio could now cause an even bigger negative net worth, or “deferred asset.” As we know, the Fed has concluded not to make any sales, only move extremely slowly toward balance sheet normalization by holding all its long-term portfolio to maturity.

Should the Federal Reserve, in the circumstances of 2012 or now, reveal the projected losses from any portfolio sales and resulting “deferred asset” to the public? Should it discuss candidly with its boss, the Congress, how big the losses and negative net worth might turn out to be? Or should it just prepare the accounting gimmick for use, if necessary, worry in private, put on a good face in public, and hope for the best? What would you do, thoughtful reader, in their place?

Alex J. Pollock is a distinguished senior fellow at the R Street Institute in Washington, D.C. He was a resident scholar at the American Enterprise Institute from 2004 to 2015, after serving as president and chief executive officer of the Federal Home Loan Bank of Chicago from 1991 to 2004.