Audit The Fed

Finance

  • Author David Reavill
  • Published May 22, 2023
  • Word count 1,456

Would it surprise you to know that one of the largest institutions in this country does not adhere to Generally Accepted Accounting Standards? Would you be even more surprised to learn that this institution is the chief regulator of the major banks in the country?

I know it sounds crazy, but the institution we're discussing is the Federal Reserve, our country's Central Banker. A situation where a tradition has been allowed to stand without bringing the Fed's financial reports up to current standards. (I'm giving the Fed the benefit of the doubt, I'll let those of you of a more cynical persuasion decipher their motivation.) It's a real case of the: "King has no clothes."

Accounting Standards are the bedrock upon which our entire Financial System is based. Take away those standards, and the chances of deception and deceit increase dramatically. In recent history, we've had several examples of the dangers of a lack of objective Accounting Reports.

Examples of firms that have "cooked the books" include the Great Asian Financial Crisis of the 1990s, where various countries in Asia failed to provide the framework of objective accounting. Or Enron here in the United States, which created one of our history's most significant accounting frauds. Or, most recently, the apparent corruption of Samuel Bankman-Fried and the FTX Crypto Exchange.

In each case, proper Audits would have revealed corruption and deceit. And if rigorously administered would have prevented the significant loss of capital and investments.

As any accountant will attest, an audit needs to consist of two parts, at least, the Balance Sheet, a delineation of what a company or entity owns and owes, and an Income Statement, the register of income and expense. With those two schedules, Balance Sheet, and Income Statement, an excellent picture is pained of that organization.

Two other schedules are often included in a complete Financial Report, and those are: 1. A schedule of changes in Equity (ownership) and 2. a Cash Flow Report, a detailed record of the use and distribution of funds.

However, today, we're looking at just the first two sections of a Financial Report, the Income Statement (sometimes called a Profit and Loss Statement) and the Balance Sheet. These are the two most fundamental parts of the Financial Statement; no Financial Statement is complete without those two sections.

The "Audited" part comes in when a disinterested third party, almost always an accountant, reviews the Financial Report and issues a statement indicating either that a. the Financial Statement accurately reflects the entity's financial position or b. It does not accurately reflect their financial position. And yes, I have sometimes seen Financial Reports where the Auditor says that the Report does not accurately represent the underlying financial situation. It's rare, but it does happen.

So, with that background, let's look at the Financial Reporting done by the Federal Reserve.

Every Thursday afternoon, the Federal Reserve provides: "The Federal Reserve Balance Sheet: Factors Affecting Reserve Balances," Report H.4.1. As we already know, this Report is not a Financial Statement. Although it's considered the "Fed's Balance Sheet," at least on Wall Street, there is at least an implication that there may be assets outside "Reserve Balances." We don't know that there are, and I won't quibble here. But there is no Income Statement. And without an Income Statement, this Report doesn't meet even a minimum qualification to be a Financial Statement.

The Federal Reserve does not provide the source or use of funds, the Income Statement. It never has, and unless you and I demand it, I suspect it never will.

Instead of providing a real Financial Report, the Fed uses a clever ploy. This H.4.1 Report is just a report on "Factors Affecting Reserve Balances." Thereby the Fed portrays itself as a mere custodian of Bank Reserves. As if they a holding these assets for the benefit of someone else, in this case, the nation's commercial banks. While that's true in a minimal sense, we need to recognize that the Fed owns these assets. And as the owner, the Fed is entitled to receive any interest or dividend paid by these various Bills, Notes, Bonds, and Agencies.

Now comes the part where it gets exciting: follow the money. The Fed went on a buying spree in response to the Great Financial Crisis of 2008—the most significant in history. Because since 2008, the amount of Fed assets has exploded. By regulation, the Fed can only purchase US Government backed Bills, Noes, and Bonds. As a result of the crisis and the Fed's need for additional assets, the Fed was also permitted to purchase Mortgage Backed Securities like those issued by Fannie Mae and Freddie Mac.

Before the 2008 Crisis, the Fed owned less than a Trillion of these assets. By 2020, just three years ago, they expanded that to 4 Trillion in assets. Then, after the Covid Pandemic and the issuance of Stimulus Payments, the Fed now owns 8 Trillion in assets.

What just happened?

Here is a recap of the Fed and US Treasury's Strategy through these two Financial crises. Some major Banks, including Citibank, were on the brink of failure during the first financial crisis of 2008. These banks needed cash, and they needed money immediately. Without a bailout, they might cause the entire system to crash. The Administration agreed to bail out the Banks by issuing new Treasury Bonds. Bonds that the Federal Reserve would purchase, and thereby put cash into the system. This complex transaction is called "Monetizing the Debt." It's where the country's Monetary Authority (the Fed) purchases the nation's bonds. And just like that, the Fed's Balance Sheet jumped from less than $1 Trillion to over $4 trillion.

But we still need to finish. Next came to Covid-19 Pandemic. This time the financial crisis was more widespread. Although the banks were not affected this time (interest rates were still low, spreads still high). Many corporations and private individuals, however, were severely impacted. The Biden Administration decided to use the same strategy as used in 2008. Just send checks to everyone and again monetize that debt. In other words, have the Federal Reserve buy more Bonds. Again instantly, the Fed's Balance Sheet doubled from $4 Trillion to nearly $9 trillion.

Before we begin to feel sorry for the Fed, having to buy all that debt, let's keep a few things in mind. While the Fed has expended a tremendous amount, it was not money they earned flipping hamburgers at McDonald's. Remember, the Fed is the nation's Monetary Authority. The Federal Reserve notes in our Wallets all come from the Fed. If the Fed needs cash, it just prints it. To purchase all those Treasuries, the Fed just created the funds. The money base was expanded by $9 Trillion to buy those bonds and notes. That's how our nation's debt is monetized.

That brings us to that missing Income Statement, which the Fed refuses to disclose. All of those Treasuries pay interest. Each Bond, Note, and T Bill, along with all the Agencies, pay interest. If you own a Treasury Bond, as you know, you, too, receive an interest payment. Today the Federal Reserve earns interest on nearly $8 Trillion. While we can't see how much their actual interest income is, we can make an educated guess and at least get a "ballpark" estimate of their income.

As you know, interest rates are rising. Treasuries with one year or less maturity have yields greater than 5%. At the same time, maturities over more than a year have yields of roughly 4%. So, all the Treasuries that the Fed is now purchasing have 4% to 5% yields. But remember, some of the Treasuries the Fed bought back in 2008 may have only had yields of a fraction.

Let's assume that if we add up the income from all the old Treasuries (low yield) and all the newly purchased Treasuries (high yield), together produce a 1% yield. At a 1% yield on their Treasury Portfolio (including mortgage-backed securities), the Fed would receive $80 Billion per year. It's a guess, but we're likely in the ballpark.

To put that number in perspective, only two companies in American History: Apple Computer and Berkshire Hathaway, have ever had that kind of net income for a year. But the Federal Reserve earns that kind of money yearly from just its incredible portfolio of US Treasuries. That's not including the additional income the Fed may make from fees, charges, and other ancillary services.

Finally, remember that the Fed's income is directly tied to the interest they receive on their portfolio of US Treasuries. The higher interest rates go, the higher the Fed's income. Potentially today, with these higher interest rates, the Fed's income could be 3 or 4 times higher than that $80 billion of our guesstimate.

And, oh yes, who sets those interest rates? Why that's right...the Federal Reserve.

David Reavill, author, iconoclast, and outdoors enthusiast. www.valueside.com

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