The Wilder View

The Fed can handle it

On April 23, the Fed released its 2008 annual financial statement for the combined Federal Reserve System. I saw two different types of commentary related to the financial statement: those pertaining to the $3.1 billion in losses on the acquisition of Bear Stearns assets, and those highlighting the record $43 billion operating profits (hat tip, Mark Thoma), up $2 billion over the year.

This is my interpretation: the Fed can handle its massive policy measures (i.e., take the losses) going into 2009 and 2010, since the expected risk, size, and income earned on the Fed’s portfolio will increase.


The Fed’s balance sheet is set to surge. On April 29, 2009, the Fed held $2.1 trillion in assets, up $1.2 trillion over the year. The chart to the left illustrates the Fed’s asset holdings then (September 2008), now (April 29, 2009), and a rough approximation of the future (rest of 2009-2010). As illustrated, the assets are expected to grow to over $4 trillion, given that the Fed buys the remaining of its announced asset purchase programs:

  • $1.25 trillion in GSE-backed MBS ($367 billion currently, April 29, 2009, on balance)
  • $200 billion in GSE debt ($66 billion currently on balance)
  • $300 billion in Treasury buybacks ($77 billion acquired to date)
  • $1 trillion in TALF funding ($6 billion currently on balance)

The Fed is adding risk to its portfolio – ABS backed by consumer, student, and small-business loans, CMBS (commercial mortgage-backed securities, RMBS (residential mortgage backed securities). To be sure, the growing slack in the economy guarantees that the Fed will take losses on its massive portfolio going forward. However, as long as the Fed has earned income enough to cover its losses and expenses, and transfer its historical profits to the Treasury, then holding inflation constant, the net explicit cost to taxpayers is negligible.

An example. The Fed earned $43 billion in operating income on its 2008 portfolio that averaged $1.4 trillion in 2008 (you can see the historical date of the Fed’s weekly balance sheet here), of which $39 billion is net income. All else equal, that’s roughly $120 billion in expected net operating income on a portfolio that is over three times as big, $4.3 trillion. Hold the Treasury’s expected earnings from the Fed constant at roughly $30 billion – the Fed transferred $35 billion to the Treasury, which it does every year (see page 5 of the .pdf) – leaves the Fed with about $90 billion of wiggle room for losses.

Losses are going to rise beyond the $3 billion reported in 2008. However, the overly simplistic example that I have presented above illustrates that the Fed will be able to internalize its measures on higher expected earnings.

Originally published at the News N Economics blog and reproduced here with the author’s permission.

Leave a Response