Is the Federal Reserve insolvent?
No, it isn’t, but it probably will be.
On Wednesday, July 15, 2015 the Fed had total assets of about $4.493 trillion. Its liabilities were $4.435 trillion. That leaves only $58 billion in equity or only 1.3 percent of assets. It only takes a small reduction in assets to wipe out equity and cause insolvency.
The unrealized loss of the Fed’s assets at the end of 2013 was $53 billion, which is frighteningly close to the total amount of equity of $55 billion. This rebounded as interest rates declined. At the end of 2014, the Fed’s assets had unrealized gains of $174 billion, which is more than three times the equity.
Normally, these unrealized losses and gains would be accounted for, using Generally Accepted Accounting Principles (GAAP), as most businesses use. However, the Fed occasionally deviates from GAAP. The Fed values the bonds on its balance sheets at amortized historical cost (in other words, what you paid for it, not what the current market price is). Under normal accounting rules, you value assets at current market value, and not at its historical price. The Fed doing this can cause their finances to appear unrealistic. This does not accurately reflect the Fed’s financial condition, which is a problem, because the Fed is supposed to be transparent.
When the Fed raises interest rates the value of its bond portfolio will fall. This could easily wipe out its equity, since, as you remember, their equity is highly volatile, and highly dependent on interest rates; it can swing dramatically with the changes in interest rates ($55 billion in 2013 to $174 billion in 2014). Since the Fed can create its own accounting rules, when interest rates do rise, it will probably create some deferred asset to show that its equity is positive.
Since the Fed is a central bank and not a for profit business, it’s not a big deal if the Fed became insolvent. The Fed can create money out of thin air, so there will never be a liquidity problem at the Fed. Its purpose is monetary policy, which deals with the nation’s inflation and employment. Insolvency does not have to interfere with these objectives. The only immediate effect insolvency would have is reduced remittances to the Treasury. As remittances go down, fiscal policy becomes more difficult, and congresses job becomes harder. The Fed becoming insolvent would send out small ripples, but it wouldn’t be a dramatic and immediately catastrophic event.
So could the Fed become insolvent? Absolutely. But it really isn’t something you need to lose a lot of sleep over.
Sources: Federal Reserve Annual Report 2013, 2014, 2015