Tuesday, June 25, 2013

The Fed's accounting magic makes mark to market losses disappear

We are getting a number of questions related to the Federal Reserve experiencing a major loss on its securities holdings due to the sharp correction in bonds over the past couple of weeks. How big is the loss and how will it impact everything from the central bank's capitalization to distribution of income to the US treasury? The answer is that while the mark to market loss on the Fed's $3.2 trillion of securities holdings is massive (here is the full portfolio in detail), it will never be recorded on the bank's financial statements unless the Fed begins to sell the portfolio. Currently it has no plans to do so.

While private institutions in the US usually follow Generally Accepted Accounting Principles (GAAP) for their financial reporting, the Federal Reserve Banks do not. Instead their financials are prepared using the Financial Accounting Manual for Federal Reserve Banks - a set of accounting rules just for the Fed. And when it comes to securities holdings, the method of accounting is "straight-line amortization" rather than "fair value".
FRB: - The primary difference between the accounting principles and practices in the Financial Accounting Manual and GAAP is the presentation of all System Open Market Account securities holdings at amortized cost rather than the fair value presentation required by GAAP. Treasury securities, government-sponsored enterprise (GSE) debt securities, Federal agency and GSE mortgage-backed securities, and investments denominated in foreign currencies comprising the SOMA [System Open Market Account Holdings (the bond holdings)] are recorded at cost on a settlement-date basis rather than the trade-date basis required by GAAP. The cost basis of Treasury securities, GSE debt securities, and foreign government debt instruments is adjusted for amortization of premiums or accretion of discounts on a straight-line basis. Amortized cost more appropriately reflects the Reserve Banks' securities holdings given the System's unique responsibility to conduct monetary policy. Accounting for these securities on a settlement-date basis more appropriately reflects the timing of the transactions' effects on the quantity of reserves in the banking system. Although the application of fair value measurements to the securities holdings may result in values substantially above or below their carrying values, these unrealized changes in value have no direct effect on the quantity of reserves available to the banking system or on the prospects for future Reserve Bank earnings or capital. Both the domestic and foreign components of the SOMA portfolio may involve transactions that result in gains or losses when holdings are sold prior to maturity. Decisions regarding securities and foreign currency transactions, including their purchase and sale, are motivated by monetary policy objectives rather than profit. Accordingly, fair values, earnings, and gains or losses resulting from the sale of such securities and currencies are incidental to the open market operations and do not motivate decisions related to policy or open market activities.
Here is roughly how this works. If the Fed buys a 10-year bond with a 3% coupon at $105, it will record a gain of $3 per year on the coupon and a loss of 50 cents ($5 dollar premium amortized over 10 years) per year. It will therefore pay a dividend of $2.5 per year (less operating expenses) to the US Treasury on this bond. If the Fed buys the same bond at a discount, say at $95, the net income per year would be $3.50 because the $5 discount would be accreted over 10 years.

So if the Fed's bond purchase was originally priced at $105 and is now at $99, the Fed will record $2.5 of income this year rather than the $3 loss it would report under "fair value" accounting ($3 coupon - $6 mark to market loss). Unless the bond is sold (or defaults), the loss will never appear on the financial statements. That's the privilege of being part of the Federal Reserve System.

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