In 2008, the Federal Reserve famously purchased a lot of subprime bank loans that have been described, in the banking industry, as “toxic waste”–in an effort to clean up the balance sheets of large lending institutions.
Since then, the Fed has been an active buyer of Treasury securities and, in its latest (and ongoing) QE3 program, become the single largest buyer of mortgage securities issued by Fannie Mae and Freddie Mac, working hard to drive down their coupon rates.
These dramatic gestures are supposed to help revive the American economy, but what are they costing our nation’s reserve bank? The Reuters news service looked at last year’s audited results and reports a surprise: the Fed’s increasingly complex balance sheet generated $88.9 billion in profits last year. That’s far more than the most profitable U.S. companies, like number one Exxon Mobil ($41 billion); number two Chevron ($27 billion), #3 Apple ($26 billion) or Microsoft ($23billion).
Under Chairman Ben Bernanke, the Fed has gotten in the habit of earning a profit on its operations. In 2011, 2010 and 2009, it took in $77.4 billion, $81.74 billion and $53.42 billion in profits, respectively. The Fed earns money in the same manner as most banks do, profiting from the spread between return on assets and the interest paid on liabilities. The Fed’s liabilities consist mostly of currency in circulation, which pays no interest, and reserves, the cash that commercial banks are required to keep on deposit at the Fed. Since 2008 these reserves have ballooned to $1.6 trillion, on which the central bank pays only 0.25% interest. This difference between 0.25% and the average return of about 3.5% on its bond holdings accounts for the substantial profit the Fed earns from printing money.
Where does this money go?
Does the Fed pay out this largesse to its executives in the form of bonuses, like Goldman Sachs? Fortunately not. The Fed sent $88.4 billion to the U.S. Treasury last year, and gave taxpayers back a comparable percentage of its profits in previous years. The interesting observation is that the most profitable entity in the American economy is run like a nonprofit on behalf of our government.
However, there may be reason to fret about what could happen next. In the past, rising rates meant little for profits, since reserves were smaller and earned no interest. Since 2008, the Fed has paid interest on reserves in order to exercise control over interest rates. In the future, when the Fed must eventually switch to a tighter monetary policy, it will be forced to pay out more interest. To absorb reserves, it may have to sell some bonds for less than purchase price, resulting in capital losses. In theory, the Fed could begin losing money, which is a risk that grows with every Fed bond purchase.
On the other hand, a significant perk of central banking is that it can simply print the money it needs to pay interest. If this results in a loss, the Fed then creates an offsetting “deferred asset” on its balance-sheet, representing future profits it will not need to send to the Treasury. The profit that is lost would be much less than total interest saved, along with higher tax revenue from stronger economic growth and roughly $500 billion of profit that earlier quantitative easing (QE) had generated. Most important of all, these losses would happen only after the economy recovered sufficiently to demand higher interest rates. This situation, after all, would be the proof that QE had worked in the first place.