Is the old Gillian Tett back? The one-time Financial Times capital market editor has taken to writing less frequently (understandable now that she has head the US operation) and less intrepidly (much of her commentary was prescient, particularly on my pet topic, collateralized debt obligations).
But her latest piece sounds a wee warning, and it’s one we’ve commented on as well, namely, that central banks are vulnerable to losses, and just like the banks they mind, may need a rescue by taxpayers if the err badly enough.
Her object lesson is the Swiss National Bank. Unlike most central banks, the SNB is quite transparent, and publishes periodic statements of the value of its assets on a mark to market basis. The usually conservative SNB made a uncharacteristically aggressive move last year, intervening in currency markets in an effort to suppress the value of its levitating franc.
Even though the locals applauded the move, the central bank was outgunned by currency traders and threw in the towel mid year. As the swissie continued to rise, the bank showed losses at the end of 2010 of SFr 21 billion. The only saving grace was that the gains on the bank’s hefty gold positions exceeded the damage. But that does not reassure its shareholders, who have become accustomed to annual payments out of bank “profits”, and are concerned that the profits this year will be too meager for them to enjoy their customary level of income.
The critical part of Tett’s article:
The losses at the SNB have come to light partly because it is relatively transparent – and currency swings can be monitored more easily than, say, price moves on bonds. But the SNB is not the only central bank that has recently taken bold gambits. The European Central Bank, for example, holds an (ever-swelling) pile of periphery eurozone bonds; the Fed’s balance sheet has more than doubled in size, to $2,500bn, as it has gobbled up mortgage-backed bonds and Treasuries; and the Bank of England also holds a large pile of gilts and mortgage assets.
Thus far – unlike at the SNB – those experiments have not generated visible losses. A cynic might argue that is because there is less transparency. However, in reality, other central banks have also been canny – or lucky – too. The Fed, for example, acquired its mortgage assets at seemingly low prices, which creates a cushion. Last year the Bank of England saw unexpected gains on its gilt holdings and the ECB has recently enjoyed rising quantities of interest income from its peripheral bonds.
But this happy picture may not last indefinitely. In the coming years, the price of Treasuries or gilts could plunge; some peripheral eurozone bonds could even default, creating losses. If that ever occurred, some central bankers think that any pain could still be offset. The Fed, for example, currently receives so much “income” from seigniorage that it may have considerable room for manoeuvre. But, there again, the Fed already faces virulent domestic political criticism; and at the ECB there is no clear agreement about who would indemnify it in event of losses. It is not impossible to imagine a scenario, then, where losses might stir up a row; particularly if political groups already had an axe to grind – as in Switzerland.
I believe Tett has underestimated the magnitude of the potential problem. First, the Fed’s program of mortgage-backed securities and other bond purchases have high odds of losses. The big risk is not credit losses but interest rate losses. The Fed bought bonds when yields were at rock bottom levels. The game plan is to unwind positions when interest rates are higher, to sop up liquidity. HIgher interest rates mean lower bond prices. If the Fed succeeds in getting the economy back to a normal level of inflation (which is one of its aims, it means it will suffer losses on anything other than very short dated paper.
Now as some readers have noticed, the Fed has also institutionalized an accounting dodge so that it will not have to admit to balance sheet losses. Commentators appear to have missed that this finesse does nothing to solve the underlying reality. The Fed can “print” its way out of balance sheet losses only to the extent that it is not constrained by inflation. If it does run into inflationary constraints, it would need an explicit bailout, irrespective of the accounting treatment. As former central banker Willem Buiter wrote in 2009:
….it is possible that, should the private securities default, the central bank will suffer a capital loss so large that the central bank is incapable of maintaining its solvency on its own without creating central bank money in such quantities that its price stability mandate is at risk. Without a firm guarantee up front that the Federal government will fully re-capitalise the Fed for losses suffered as a result of the Fed’s exposure to private credit risk, the Fed will have to go cap-in-hand to the US Treasury to beg for resources. Even if it gets the resources, there is likely to be a price tag attached – that is, a commitment to pursue the monetary policy desired by the US Treasury, not the monetary policy deemed most appropriate by the Fed.
Notice that the Fed has quietly established an accounting finesse to circumvent this outcome. Normally, the Fed remits funds to the Treasury annually. The notion is that any Fed position losses (due to credit losses or adverse interest rate movements) would be credited against income earned on Fed assets. If that number still was negative, it would have a credit at the Treasury. In the next profitable year, the Fed would simply retain some of the income it would normally forward to the Treasury to recapitalize the loss. This is what we call “extend and pretend” when private sector banks use flattering accounting to mask balance sheet holes and hope they can earn their way out of trouble.
Now some readers will contend the Fed is highly unlikely to need to revert to this mechanism, much the less to run into an actual negative balance. I’m still troubled. The officialdom has become positively self congratulatory about its conduct during the crisis (even though Geithner is getting the limelight at the moment, the media fawning is unseemly). It not only bailed out the official banking system, but it also rescued the shadow banking system. The Fed and other central banks have made it clear that they will not let either major institutions or markets they deem to be significant fail (note that pure retail markets, like auction rate securities, don’t count).
And the dirty secret of the ongoing Eurozone mess is that its banking system has not been cleaned up, and many countries (England, Germany, Switzerland, the Netherlands, for starters) have banking sectors so large relative to the size of their economies that their central banks cannot effectively backstop them. That should mean that the first order of business ought to be to constrain credit growth to increase the safety and stability of the system. But that’s a no-no. We’ve had various financial reform efforts that leave the system still significantly unfettered, when the size and danger it poses says it should be shackled. And the other mechanism for reducing risk, which is to increase capital in the banking system, is being approached in such a cautious and half hearted manner so as to assure it will fall well short of what is needed (witness the attenuated timetable for implementing Basel III).
The Fed unfortunately appears to believe its PR. It seems to think that financial reform measures like living wills and special resolution will work, when they have two fatal flaws: nation based bankruptcy regimes and the unwillingness of counterparties to have positions frozen while a firm is unwound. But the financial firms understand this little scheme won’t work even if the regulators have persuaded themselves that it will.
The failure to change incentives of executives and producers, or restrain risk taking in a significant way, means the industry has been merely inconvenienced after having had cdentral banks demonstrate that they will pull out all stops to save major players. This simply encourages the financial services industry to engage in a large scale martingale betting strategy. Per Wikipedia:
The simplest of these strategies was designed for a game in which the gambler wins his stake if a coin comes up heads and loses it if the coin comes up tails. The strategy had the gambler double his bet after every loss, so that the first win would recover all previous losses plus win a profit equal to the original stake. Since a gambler with infinite wealth will, almost surely, eventually flip heads, the Martingale betting strategy was seen as a sure thing by those who advocated it. Of course, none of the gamblers in fact possessed infinite wealth, and the exponential growth of the bets would eventually bankrupt those who chose to use the Martingale.
The industry nearly blew itself up, was rescued, and in short order was paying itself even higher bonuses than before the crisis. That means it has every reason to go back to piling on risk. The Fed’s accounting finesse means it has slipped one of the mechanisms, having to deal with the consequences of a loss, that might constrain its behavior and hence make it think more carefully about its balance sheet operations. Incentives matter as much for central bankers as they do for banks themselves, and the one at work for the Fed are poor indeed.