It’s Not Just the Obama Administration That is Flouting the Law, So is The Fed—Part One

Eccles building cc

This is what the Fed would prefer you not know.

By now everyone knows that the Obama administration is deliberating choosing to disregard some laws, most notably Obamacare and immigration statutes, among others. By contrast, the Fed’s extra-legal moves have gone almost completely unreported by the press.

For example, the Fed recently issued its annual report. Some news stories focused on the big unrealized loss ($53 billion) in its securities portfolio, but none noted the illegal way in which the Fed created this loss.

One story described Republican critics of the unrealized loss as “unsophisticated,… primitive,… [ holding] childlike beliefs about monetary policy.” Don’t they know that the Fed contributed $79 billion to the Treasury last year, a sum larger than the unrealized loss and a big help for the federal deficit?

Let’s dig a little deeper here. How exactly did the Fed generate that payment for the Treasury? First, it created money out of thin air. Second, it used the new money to buy bonds from Wall Street, the same bonds that Wall Street had earlier bought from the government. So in effect, the government bought its own bonds with new money it had created. In effect, the government had borrowed from itself, but in a way that was intentionally hard to follow.

It is not just nonsensical for the government to borrow from itself. It is also illegal. But when it is done in this indirect way, using Wall Street as an intermediary, it is technically legal. Since this sleight of hand is considered legal, this is not what we mean when we say the Fed has been operating illegally. We have to dig a bit deeper still.

As most people know, the Fed has been buying trillions of dollars worth of bonds with newly created money since the Crash of 2008, and also buying riskier bonds. As noted by leading Fed analyst John Hussman, the Fed violated Section 14(B) of the Federal Reserve Act when it bought $1.5 trillion of Fannie Mae and Freddie Mac mortgage bonds not explicitly guaranteed by the US government.

Holding risky bonds means that the Fed can incur a loss on their sale. That is why it has reported $53 billion in unrealized losses at the present time. Moreover these losses can multiply depending on what happens to interest rates and other factors.

Why should we care? For one thing, the Fed illegally issued a note to its Statistical Release H 4.1 on January 6, 2011 stating that any of its losses would henceforth be a liability of the Treasury, that is, a liability of the taxpayers. So, if the Fed gets in trouble running its giant hedge fund-like operations, taxpayers will be expected to bail it out.

Who gave the Fed a right to offload its losses on taxpayers? The Treasury may have agreed, but it is blatantly illegal without approval from Congress. And even if approved by Congress, it is arguably unconstitutional, because Congress cannot delegate its right and obligation to commit taxpayers’ money.

It has been alleged that this is all worrying about nothing. If the Fed doesn’t ever sell any of the securities it currently holds, it will never realize any losses, and the taxpayers will never be on the hook. The Fed has already said that it does not plan to sell its mortgages.

But it’s not that simple. Some of the bonds were bought at a premium. This bit of financial jargon means that when the bond is completely paid off, there will still be a loss on the books. Technically this means that the Fed has added to our national debt without authorization. Meanwhile there is a much more serious problem.

If the Fed wants to raise interest rates, it must sell securities. Just to raise interest rates to a bare 2%, still low by historical standards, would require the sale of between one and two trillions dollars of securities. A Fed that cannot sell without bankrupting itself or presenting a huge bill to the taxpayers has painted itself into a corner. It has limited its flexibility to raise interest rates even if consumer price inflation is accelerating.

Part Two of this article will discuss additional games the Fed is currently playing, both legal and illegal.