Audit the Fed?

Author: David Kotok, Post Date: February 13, 2015
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Political tidbit #1

A prominent Washington reporter wrote a celebrated article called “The Ten Dumbest Members of Congress.” The senator at the top of her list then held a press conference to deny that he was the dumbest.

Political tidbit #2

The great political cartoonist Al Capp gave the name “Jack S. Phogbound” to the US senator who represented the citizens of Dogpatch. I recall Mammy Yocum (Pansy Hunks) proudly telling her family, “There’s no Jack S. like our Jack S.”

We are writing today in response to email exchanges with notable friends and fishing colleagues who are engaged in a discussion of legislation that calls for an audit of the Federal Reserve (Fed). That is now a serious conversation taking place in Washington DC.

We have a view regarding this call to “audit the Fed.” Some of my fishing buddies will not like it and do not agree.

First, what does this term audit mean? In finance, it means that skilled professionals observe and test an institution’s or an individual’s data to verify its accuracy. Wikipedia finance defines it as “a systematic examination of books, accounts, documents and vouchers of a business to ascertain how far the financial statements present a true and fair view of the concern. It also ensures that the books of accounts are properly maintained by the concern as required by law.”

The financial community is very familiar with audits. We have them regularly. We receive and rely on certifications of accuracy from auditors. So an audit of the Fed would be a verification of its holdings.

The Fed comprises 12 regional banks. It is the regional banks that hold the assets of the Fed. They deploy them and implement policy actions. It is the regional Fed banks that are involved with other commercial banks in their regions. It is the regional banks that engage in the process of clearing payments. Each of those regional banks reports its financial condition weekly. Those reports are released on Thursday afternoons after 4:00 PM. They are publicly available and are articulated in sufficient detail as to allow any inquiry that is reasonable to be fulfilled with information readily obtainable in those reports.

The call to “audit the Fed” would suggest that there is misinformation in those reports. “Audit the Fed” would imply that when the Fed says it holds Treasury notes, bills, or bonds, federally backed mortgage securities, deposit reserves of the banking system, or excess reserves of the banking system, and engages in repurchase operations or reverse repurchase operations, that in fact those holdings and transactions are somehow incomplete or fraudulent.

“Audit the Fed” would also say that the representations of the Fed concerning its balance sheet are not accurate. That notion is absurd. When it comes to accounting issues, the Fed is already “audited,” just like any arm of the federal government. In fact, the Fed is an arm of the government with 100 years of history and is a creature created by act of Congress.

Now, there is another issue being used to conjure hyperbole and deception. The Fed is being attacked with regard to its capital structure. The antagonists say that the Fed is nearly broke, that it is leveraged 80 times its equity capital, and that if it were a private institution it would be insolvent. The fact is that the Fed is not a private banking institution; it is backed by the United States. My colleague Bob Eisenbeis had a long career within the Fed. He notes that, “As the central bank, the Fed has implicit capital representing the backing of the US government and the US Treasury. That’s the reason book capital isn’t relevant. It’s the implicit guarantee (actually, explicit guarantee) since US currency carries the logo “United States of America” and is legal tender.”

The would-be auditors of the Fed keep alleging that the central bank’s leverage constitutes a risk. They are guilty of purveying misinformation.

The Fed operates with no capital or only an insignificant amount. It is a central bank that does not need capital. It could operate with zero or negative capital. It could operate with a leverage ratio of 100:1, 200:1, or even 1,000:1. The Fed has an unlimited capacity to make payments. There is no issue of solvency with the central bank of the United States.

Cumberland Advisors calculates the Federal Reserve’s equity capital ratio and regularly posts the data on its website. A link to the “CUMB-E Index” data can be found in the middle-right section of our home page (www.cumber.com). The direct link is http://www.cumber.com/pdf/duration.pdf. We use this to help us determine market sensitivities as the Fed makes policy changes. We do not use it to determine risk of the Fed failing to make a payment. We view the Fed as riskless in the same way we view the US Treasury obligation as riskless.

The CUMB-E calculation includes an evaluation of the gold certificates held by the Fed at $42 per ounce. Many people ignore the gold certificates. A few people actually mark the certificates to the market and recalculate their value, on the assumption that the Treasury could revalue the market at any time. Were that to happen today, the equity ratio of the Fed would immediately change from the very low fraction of 1% to approximately 4%. So the detractors of the Fed who claim that the Fed is functioning without capital ignore the possibility of that revaluation happening at any time. The $42 dollar price could be changed by an act of the very Congress that is debating an audit of the Fed and criticizing its capital. The $42 figure came into existence when President Nixon closed the gold window at the demise of the Bretton Woods currency regime and changed the official conversion of the US dollar from $35 to $42. Nixon then stopped exchanging America’s gold for dollars. The $42 has been the legal valuation ever since.

That was in the 1970s. It was the time when Sen. William Lloyd Scott, R-VA, topped Nina Totenberg’s list of the 10 dumbest members of Congress, whereupon Scott held a press conference to refute the charge that he was the dumbest.

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