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The US Fed's $82bn QE "Profit"

Can you spot the patsy in the US Federal Reserve's apparent "profit" from printing money...?

THE U.S. FEDERAL RESERVE just reported a record $81.7 billion in profit for 2010, writes Martin Hutchinson, contributing editor to the Money Morning email.

If that money was turned over to taxpayers directly, there's no doubt it would have some "stimulus" benefit. A check worth $270 for every man, women and child in the United States ain't chicken-feed. The pretax earnings of Goldman Sachs Group Inc. never got above the $12 billion mark.

But since that money actually just "disappears" into the coffers of the US Treasury, it does very little good for anybody. And it's worth taking a closer look at the Fed's reported profits – especially since we taxpayers will be called upon to bail out the central bank, once the inevitable losses arrive.

First, this "profit" isn't what it seems. And you should be worried – very worried – about what's to come.

The $82 billion the Fed reported as profit for last year was up from $48 billion in 2009 – a 71% gain that would have made any investment banker proud – especially since 2010 was a down year for that particular business.

However, the US central bank does possess one capability that private-sector investment banks lack (or rather, an ability which investment banks believed they possessed until the credit-default-swap crisis of a few years ago): The Fed can expend its balance sheet as much as it likes.

The profit increase was largely due to the Fed's balance-sheet expansion through several quantitative easing programs, and through the purchases of US Treasury bonds and federal "agency bonds".

The earnings gain also owed a lot to central-bank interest-rate policies: Financing yourself cheaply (or, for much of the Fed balance sheet, at zero) in the short-term market and buying Treasuries or housing bonds has been a profitable game for the banking system for the last two years. That's why few small business loans are being made – the banks can make money with much less effort in this silly game.

Of course, the profitability of the borrow-short/invest-long game depends on the Fed keeping short-term rates below long-term rates. But that makes it a pretty safe bet for the nation's central bank, since it's the Fed itself that controls short-term interest rates.

There is, however, one enormous snag. Unlike every other financial institution in the country, the Fed does not have to "mark to market" its portfolio. That means that the Treasuries it bought when interest rates were lower (for most of last year) will have hidden losses.

In short, that "$81.7 billion profit" is overstated – by at least a few billion Dollars. And the real excitement will come when rising inflation forces the Fed to raise interest rates, since it will do two bad things to Fed profits.

  • The interest-rate boost will eliminate the gapping profit the Fed makes by borrowing short-term and lending long-term. (Some of the Fed's balance sheet is funded by issuing Dollar bills, which are effectively "free money," but these days much moreof it is loans from the banking system, on which it will have to pay interest once it pushes up interest rates.)
  • The rate increase will cause long-term rates themselves to rise – which will give the Fed a hideous unrealized loss on its balance sheet after all its Treasuries and federal agency securities go down in price. The First Pennsylvania Bank went bust in 1980 through borrowing short-term and investing in long-term Treasuries; eventually erosion of capital becomes very real.

US Federal Reserve chairman Ben S. Bernanke believes that he can avoid this problem by reversing quantitative easing before he puts up interest rates, thereby cleaning up the Fed's balance sheet at little cost.

But there's a problem here – a $1.6 trillion problem called the federal budget deficit.

The Fed has been funding 70% of this through its "QE2" (part two of "Quantitative Easing) program. If it even lets QE2 expire at the end of June, the Treasury will suddenly find it much more difficult to sell bonds (particularly as Japan – the second-largest holder of US debt behind China – won't be buying many, having its own problems).

The bottom line: Interest rates will go up, anyway.

Needless to say, with the Treasury selling $1.6 trillion of bonds annually into a difficult market, and inflation at least creeping up, the odds that the Fed will sell all – or even most – of its $2.6 trillion balance sheet in a short space of time are a big fat zero.

Thus, when interest rates rise, the Fed will be stuck with its gigantic pool of assets and will start recording losses that are almost as gigantic.

The central bank will probably still manage to show a profit for 2011 (by some funny accounting, if by no other way), but 2012 is a lost cause.

And when those losses occur, I'll give you one guess as to who will have to cover them.

I'll even give you a hint: It won't be Fed Chair Bernanke or US Treasury Secretary Timothy F. Geithner. It will be someone much closer to home. Your home...

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Now a contributing editor to both the Money Map Report and Money Morning, the much-respected free daily advisory service, Martin Hutchinson is an investment banker with more than 25 years’ experience. A graduate of Cambridge and Harvard universities, he moved from working on Wall Street and in the City, as well as in Spain and South Korea, to helping the governments of Bulgaria, Croatia and Macedonia establish their Treasury bond markets in the late '90s. Business and Economics Editor at United Press International from 2000-4, and a BreakingViews editor since 2006, Hutchinson is also author of the closely-followed Bear's Lair column at the Prudent Bear website.

See full archive of Martin Hutchinson.

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