Fed sees avoiding unprecedented losses by holding mortgage bonds

October 28, 2013 10:22 AM

The Federal Reserve can avoid unprecedented losses by never selling mortgage-backed securities from its record $3.84 trillion balance sheet, according to updated estimates by Fed economists in Washington.

The Fed every month is purchasing $85 billion in Treasuries and mortgage-backed securities in a program aimed at fueling economic growth and combating unemployment, which was 7.2% in September.

If interest rates quickly rise, the value of its holdings may plunge, prompting losses that may jeopardize its annual remittance to the U.S. Treasury. The central bank turned over a profit of $88.4 billion last year.

Chairman Ben S. Bernanke in June announced the Fed was abandoning a plan to eventually sell mortgage debt as part of efforts to reduce the balance sheet. The central bank instead plans to let the securities mature. The Fed, which funds its operations with interest income from its bond holdings, currently holds $1.4 trillion in mortgage bonds.

Under the new strategy, “annual remittances to the Treasury remain elevated by historical standards through 2015, but then decline,” Seth Carpenter, a senior associate director in the Fed Board’s Division of Monetary Affairs, said in a paper written with four other Fed economists.

“The trough in remittances is $17 billion in 2018, a level that is not much lower than the $25 billion average remittances in the decade prior to the financial crisis,” the economists said in a paper posted on the central bank’s website.

Six Years

The estimates from Carpenter are part of a revision of a paper, published in January, saying the Fed was on course to incur unprecedented losses and may be unable to remit a profit to the Treasury for as long as six years.

The prospect that the Fed wouldn’t provide remittances prompted concern among Republican lawmakers.

Central bank losses are “a legitimate concern and something we will be watching,” Representative John Campbell, a Republican from California, said in an interview in February. A certified public accountant, Campbell leads a monetary policy subcommittee on the House Financial Services Committee.

Though profits are more stable than in earlier estimates, the central bank’s balance sheet wouldn’t return to normal for the foreseeable future, according to the Fed economists. Even by 2025, almost two decades after the housing bubble that precipitated the financial crisis began to burst, the Fed would still own $407 billion in mortgage bonds.

Policy Grip

Four economists, including Frederic Mishkin, a former Fed governor and co-author with Bernanke, said in a paper presented in New York on Feb. 22 that the central bank’s grip on policy may weaken if losses coincide with high U.S. budget deficits and an inability of Congress and the White House to put fiscal policy on a sustainable path.

“This mix could induce a bias toward slower exit or easier policy, and be seen as the first step toward fiscal dominance,” the economists said in the paper, presented at the U.S Monetary Policy Forum, referring to fiscal influence on monetary policy. “It could thereby be the cause of longer-term inflation expectations and raise the risk of inflation overall.”

The new Fed estimates assume interest rates slowly return to normal, with the benchmark interest rate rising to 4% by 2018 from just above zero today, and the yield on the 10-year Treasury note slowly rising to about 5% from 2.51%.

Under a higher-interest rate scenario, the Fed would suffer losses and be unable to make a remittance to Treasury from 2017 to 2019, according to Carpenter and co-authors Jane Ihrig, Elizabeth Klee, Daniel Quinn and Alexander Boote.


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