The U.S.’s Least Capitalized Big Bank: The Fed

WSJ.com: Real Time Economics:

Last year the Federal Reserve pushed the nation’s biggest banks to beef up their capital levels to ensure that they could escape a worsening crisis with common equity of at least 4% of their total assets. Today, the Fed put out financial statements on itself and revealed that its own capital level is below that stress-test level.

At the end of 2009 the Fed had $51.3 billion in total capital on $2.3 trillion of assets, for a capital ratio of 2.3%. Is this something to be alarmed about? The answer is yes and no. It’s not, because the Fed makes plenty of profits on the loans it makes to banks and the securities it holds. (Its cost of funds is now close to zero.) In a normal year its profits are around $25 billion. Last year, its net income was a record $53.4 billion, enough to double its capital in a year.

Capital was up from $42.2 billion, or 1.9% of assets, in 2008. The Fed turned 89% of its 2009 profits over to the U.S. Treasury, a rather hefty dividend yield for U.S. taxpayers, thanks in part to the Fed’s controversial role in financial crisis rescues. One bright spot was the performance of its Maiden Lane portfolios which hold assets from the bailouts of American International Group Inc. and Bear Stearns; they recorded gains in 2009 instead of losses in 2008. Ironically, much of the income turned over to the Treasury was generated from Treasury bonds owned by the Fed and government sponsored enterprises controlled by Treasury.

Still there are reasons to be concerned about the Fed’s paper-thin capital position. It has a more risky portfolio than it’s ever had before, including $1.25 trillion in mortgage securities that could lose market value if interest rates rise or if it has to sell them quickly. A 4% loss on that portfolio would equal almost all of its capital.

Of course the Fed can print money itself. (As opposed to a bank, which depends on the backing of depositors and other creditors to fund its operations.) Thus, as a Fed official notes, on condition of anonymity, it would be able to continue operating even if its capital becomes depleted. The official adds that the Fed is in fact expecting to continue its run of big profits. Moreover, the Treasury would stand behind it in a crisis. Still, if its fortunes take a turn for the worse and its capital disappears, it would be a mighty embarrassing turn for the world’s most powerful central bank.