Will the Fed take the medicine one of its presidents prescribes for other banks?

The president of the Federal Reserve Bank of Minneapolis, Neel Kashkari, like an old doctor for ailing banks, recently prescribed a stern regimen for those in weakened conditions from big mark-to-market losses on their long-term investments and loans. Speaking at a National Bureau of Economic Research panel this month, Kashkari pointedly asked: 

“What can a bank do that is already facing large mark-to-market losses?” 

An excellent and hard question, for the losses have already happened, economically speaking. Of course, these banks can passively hold on and hope that interest rates will go back down to their historic lows, and hope that depositors will stop demanding higher yields or departing elsewhere. 

Besides hoping, what can they do?

Doctor Kashkari unsympathetically reviewed the possible medicines, all bitter. These, he said, were three: 

1. Try to raise more equity. 
2. Sell the underwater assets. 
3. Cut dividends. 

Considering these options, Kashkari observed that raising equity may not be so easy or attractive, since investors may not be inclined to invest in funding losses. Divesting the underwater assets by definition means selling at a loss, so the unrealized losses become realized losses on the accounting books.  This perhaps would render the bank formally undercapitalized or worse and may frighten large depositors — will they run?

The third option of cutting dividends then appears as the most practical way to conserve some capital, but as Kashkari asked rhetorically, how many bank CEOs are likely to want to cut their dividends? So he proposed new stress tests with high-interest rates, which would lead to restricting the dividends by regulatory order.

Physician, Heal Thyself! 

Kashkari did not mention that the biggest bank in the country, the one he works for, is facing particularly large mark-to-market losses. The $8 trillion Federal Reserve has net mark-to-market loss of $911 billion as of its last report on March 31. This mark-to-market loss is a remarkable 21 times its total capital of $42 billion. Moreover, according to my calculations, the Fed appears to be heading for an operating loss of about $110 billion for the year 2023. 

So it is timely and appropriate to apply “Doctor” Kashkari’s three possible medicines to the Federal Reserve itself.  

1. The Fed is clearly in a position to raise more equity in the face of its losses if it chooses to. All the commercial bank members of the Federal Reserve are required to subscribe to stock in the Federal Reserve according to a formula based on their own capital, but they all have bought only half of their required subscriptions. The Fed has the right to call for the purchase of the other half at its discretion. It could issue that call right now, and double its paid-in capital. But will it?   

2. The Fed could obviously sell some of its underwater investments. But just as for other banks, that would turn unrealized losses into realized losses and make the Fed’s existing accounting losses even bigger. As the leading investor in mortgage-backed and long-term Treasury securities, large sales by the Fed could move market prices downward, increasing its mark-to-market losses on the remaining investments. Although it has produced projections of realizing losses by sales of underwater investments, the Fed, like the banks Kashkari discussed, chooses not to sell. 

3. How about dividends then? The Fed is paying rich dividends of 6 percent to small banks and the 10-year Treasury yield to large banks while it is running an estimated annual loss of about $110 billion, has a $911 billion mark to market loss, and properly accounted for per my calculations, has negative capital of $38 billion, which is getting more negative each week. It is borrowing money to pay its dividends. And what would a high interest rate stress test applied to the Fed’s massive interest rate risk show? Should the Fed take Kashkari’s dividend medicine and restrict or skip its dividends in light of its huge losses? Revising Kashkari’s rhetorical question, how many Federal Reserve presidents and governors want to do that, including the president of the Federal Reserve Bank of Minneapolis? 

As that president explained, when you already have large economic losses, none of the options are appetizing. 

Alex J. Pollock is a senior fellow at the Mises Institute, the author of “Finance and Philosophy—Why We’re Always Surprised,” and co-author of “Surprised Again!  The Covid Crisis and the New Market Bubble.”