Federal Reserve Bond Sales?
by Michael S. Rozeff
by Michael S. Rozeff
Rumor has it that the Federal Reserve is considering selling bonds. The legality is in question. Leaving that aside, why would the Fed do such a thing? If it did, how would such a thing work? What would be its effects?
The Fed can issue non-interest bearing debt now. This is the Federal Reserve notes that we use as a medium of exchange. When the Fed buys things like Treasury bills, commercial paper, junk bonds, stocks, or many other securities, it pays by creating reserves for banks that can be cashed out, if desired, as Federal Reserve notes. The Fed has created a ton of potentially inflationary reserves lately. It is paying interest on these reserves in order to "sterilize" them, that is, prevent them from being cashed out and from being used to make an excessive amount of new loans. It's trying to save the banking system without causing inflation. It appears that the proposal to issue interest-bearing debt is a variation on this scheme.
The basic scheme that is now in place is that the Fed wishes to support security markets that are under pressure. It buys mortgage obligations, for example. The sellers deposit their checks. The Fed clears them by crediting the reserve account of the member banks making the deposits. Ordinarily, as the bank lends, the multiplicative effect of fractional-reserve banking kicks in. The money supply rises. At present, the Fed is trying to short-circuit that process by paying interest on the reserves. Their success at this manipulation will end when the banks start making loans that pay interest higher than what the Fed is offering. At that point the Fed will have to sell loans so as to drain reserves from the system, if it wishes to stem inflation. The Fed will be reluctant to do this. It has fewer Treasury bills than it used to. Its loans are too illiquid to sell. The Fed must overcome this problem or risk much higher inflation.
Enter the new scheme. The Fed issues interest-bearing debt. Whoever buys this, whether an investor or a bank, they pay with a check. When it clears, some bank's reserves decline. This absorbs reserves and/or cash from the system. The banks, for example, use their reserves to buy the Fed's debt. It carries a higher interest rate than what the Fed pays on the short-term reserve accounts. This deters the banking system from using all those reserves in an inflationary manner. In short, the Fed is re-financing the liability side of its balance sheet. It is converting short-term debt (bank reserves) into long-term debt (its own bonds.) By funding its troubled assets with long-term debt, the Fed signals that it intends to hold these assets for a long time. It is now thinking about funding these long-term assets with long-term debt. The banking system is being induced to convert short-term liquid reserves into long-term Federal Reserve bonds.
The big picture here is something like this. The banking system has a lot of lousy loans on its books. It didn't mark them all down or fully because that would reveal that many banks are insolvent. They would need to be re-organized. The insolvent banks didn't want this done. The Fed rode to the rescue by exchanging its good securities for bad loans from the banks — some of them, not all. Meanwhile, bad loans began to crop up elsewhere in the system. The Fed took on some of those too. In the process, it has created far too high a level of bank reserves, a level that is highly inflationary if put to work making new loans. By issuing long-term debt, the Fed would complete the process it began. The banks would now have as assets the better securities the Fed loaned them plus they would have Federal Reserve bonds.
As for the Fed, its balance sheet would now carry as assets many troubled loans that the banks once held. On the liability side, the Fed would have issued its own bonds. Its financial leverage would have increased dramatically even as its asset quality decreased dramatically. Some of the shakiness of the banking system would be transported into shakiness of the Fed as a bank. This would not resolve all the problems because the total amount of shaky debt in the system, in the U.S. and worldwide, is so great that the Fed can absorb only a small fraction of it.
An interesting thing to wonder about is the risk of the Fed's bonds. The riskiness of liabilities derives from the riskiness of assets. Since the Fed has taken on numerous questionable loans (and refuses to be transparent about those loans), its assets have risen in risk as compared to when it held mainly Treasury bills. If the cash flows of the Fed's bonds are to be serviced by the cash flows of these assets, then those bonds will not be risk-free. But the Fed has the power to buy any security it wants to. It can buy its own bonds in the market and support the price (although this raises bank reserves and defeats the purpose of the bonds). It can make them risk-free, although this is unlikely.
Bonds have to be paid off. They have priority. The Fed's currency, which is non-interest bearing, has lower priority. The risk of the Fed's assets will then load on the remaining liabilities and equity, which are mainly currency outstanding and the Fed's capital. Of these, the currency is at least 20 times the capital. The currency bears most of the risk. What does this mean? Suppose the Fed buys junk bonds that yield 20 percent. If they pay off, the Fed's gamble pays off and the currency's cover is maintained. If they do not pay off, then the Fed has to pay off its bonds by selling good assets in order to pay the interest on those bonds. In that case, the currency's value declines.
Who will buy such bonds? Will they be issued to the public? Would they be offered to banks only? The Fed will have to reveal what its holdings are and have them audited if it is even to sell its bonds to the public. Who will put money into a blind investment trust not knowing what it holds?
Whoever buys them helps to bring down bank reserves. This is a dis-inflationary policy. These bonds could be offered to the public. In that case, what would the indenture provisions be? Bond indentures are lengthy documents with stringent provisions that tie the hands of the borrowers. It is unlikely that the Fed wants to endure such restrictions. It is more likely that it would restrict purchases to banks and minimize indenture restrictions. It might even find ways to force or pressure banks to take them. The market for them might be restricted or non-existent. The goal would be to shore up banks while preventing a monetary explosion.
The Fed aims to preserve the financial system in its current form. Given its unstable performance and the human misery and travail caused by that system, and given its injustice, this is a highly dubious objective. Nonetheless, that is its aim. To accomplish it by issuing bonds may possibly stave off for a time the inflationary consequences of the Fed's balance sheet explosion by refunding bank reserves into long-term debt. However, at the same time, it loads a higher risk of currency failure onto the Federal Reserve notes that are our medium of exchange.
All along, the Fed's purchases of and exchanges for risky loans have been betting against the markets. That accompanied the shoring up of bank balance sheets. This policy is suggestive of a government that bets against the market in trying to maintain the price of an overvalued currency. Governments usually lose these bets. The Fed does not consist of a team of experienced speculators, and even if it did, successful speculators do not speculate the way that the Fed is. No one who is rational and using his own money would bet as the Fed is. Perhaps a hedge fund manager using other people's money might make such bets. Some have, and they have had their breakfast, lunch, and dinner handed to them. Sooner or later, the Fed is going to lose big, if it has not already lost, on its loan bets. At least, that is the usual outcome. The Fed has made huge currency swaps with other central banks. What if one or more of these banks defaults? The Fed will be left holding a worthless foreign currency. (Well, even more worthless than now.)
As the Fed loses its bets, or if it does, then we can expect currency depreciation. The risk of that is present. It does not disappear if the Fed funds its assets with Federal Reserve bonds instead of bank reserves. However, if the Fed sells its own bonds, it defuses some of the inflationary potential present in a fractional-reserve system due to the Fed's past actions that have inflated bank reserves so steeply.
Now we must consider another feature of this scenario, which, unlike the one discussed above, is inflationary. Suppose that the Fed issues bonds and manages to sterilize bank reserves. It then decides that it has more room to expand its balance sheet even further! It goes through another round of vastly increasing bank reserves while buying up troubled securities. The currency depreciation possibility mounts up still further! The Fed then requires another round of bond issuance. And if the Fed, for political reasons, buys up mortgages from Fannie and Freddie and overpays for them as it expands its balance sheet, then this causes a direct depreciation of the currency (the dollar).
The Fed then, while still a central bank, becomes also a troubled-loan mutual fund. It becomes a kind of junk bond fund. The value of the currency and of the bonds it issues will move up and down with the value of the loans that it holds. Since the bonds have priority as to interest payments, the currency becomes a junior and levered paper that has much greater risk than at present. The country's currency becomes even more unstable than at present.
December 16, 2008
Michael S. Rozeff [send him mail] is a retired Professor of Finance living in East Amherst, New York.
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