Federal Reserve passes its own stress test

Mar 24, 2014

FORTUNE -- The Federal Reserve says it's fit enough to weather economic stress as well.

Last week, the Fed released the results of its annual stress test of the nation's largest banks. Nearly all of the banks came out with a clean bill of health. Monday, the Fed got its turn on its own examination table.

The diagnosis: The Fed is just fine.

The Fed's internal examination came in the form of a paper from three economists at the San Francisco Fed. The paper looks at the Fed's portfolio and how it would do if interest rates were to rise. The portfolio has ballooned to over $4 trillion in the last few years, from $800 million before the financial crisis, as the central bank has bought bonds in an effort to hold down interest rates. Last year, interest from that portfolio allowed the Fed to book nearly $80 billion in profits.

MORE: Money manager: The Fed is killing the recovery

Regulators, the Fed included, have become increasingly worried about what rising interest rates would do to banks. And for the first time this year, the Fed included as part of its stress test a scenario where the economy enters a recession and encounters a rise in interest rates. When rates rise, debt prices fall. So higher interest rates would cause the loans and bonds banks hold to decrease in value. The same thing could happen to the Fed, which could cause profits at the Fed to plunge. (In the stress test, the Fed found that the banks could manage the losses.)

The Fed, of course, doesn't have to worry about being bailed out or not. The government is already on the hook for all its losses, and gets to keep its gains. But what the Fed does have to worry about is that if it were to start losing taxpayer money, that, on top of the claims that its policies are ineffective, might force the central bank to reluctantly shift course.

One thing the Fed has going for it is that it doesn't have to ever sell the bonds it owns. It could hold them until they are paid back. So even if the bonds it owns fall in value, the Fed doesn't actually have to record a loss, as long as it doesn't sell and the bond is eventually paid back. And all the bonds that the Fed holds are either from the Treasury or are mortgage bonds backed by Fannie Mae or Freddie Mac, meaning the government is on the hook for them anyway.

A stronger economy or rising inflation, though, could cause the Fed to raise interest rates. That could leave the Fed upside down. If short-term interest rates were to rise to 4% -- which is where some Fed members think they should be in a normal economic environment -- and the Fed was holding $3 trillion of bonds that were, on average, yielding 2.5%, that would translate to an annual loss of $45 billion.

MORE: It's too early for the Fed to raise rates

But don't worry. The three economists at the San Fran Fed -- Jens Christensen, Jose A. Lopez, and Glenn D. Rudebusch -- say that's not going to happen. They ran a bunch of models and determined that there was only a 10% chance the Fed would ever lose money on its portfolio. The Fed's profits will probably drop, but not below $20 billion by 2020.

If the Fed ever did end up upside down, Christiansen says it could sell some bonds it bought well before the financial crisis, when long-term rates were in the 7% range, and book a profit. Prices on those bonds have gone up a lot. "The group of people at the New York Fed who manage the portfolio could get a whole bunch of capital gains whenever they want it," says Christensen.

Remember, the Fed itself decides when to raise interest rates. That may give the impression that this question of whether the Fed makes money, or whether it can survive economic stress, seem like a rigged game. And perhaps it should. It's their test after all.

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