Friday, January 21, 2011

HOT: Fed Hides Major Accounting Change

Reuters has a very hot story out tonight on an accounting change the Fed snuck into a regular weekly report. It will move off the capital part of its balance sheet any losses the Fed may have on paper it purchased from Goldman Sachs, or anybody else for that matter. Here's Reuters via CNBC (My emphasis):
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.

But the new rules have slowly begun to catch the attention of market analysts. Many are at once surprised that the Fed can set its own guidelines, and also relieved that the remote but dangerous possibility that the world's most powerful central bank might need to ask the U.S. Treasury or its member banks for money is now more likely to be averted.
But they are averting asking the Treasury for money in the future by an accounting gimmick that will simply dump the debt off the capital part of the balance sheet, so it won't be reported as a loss, and make it a liability to the Treasury. More from Reuters:
[According to]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.
Bottom line: We all knew the Fed was going to have to do some kind of monkey business to deal with all the junk securities it purchased, here it is: Negative liabilities. Yes, only at your local Fed.