As Stimulus Tab Rises for Fed, Observers Worry a Bailout is Next

The Federal Reserve has taken unprecedented steps to stimulate the economic recovery from the Great Recession, but the tab has risen to such tremendous proportions — fast approaching $4 trillion — that some worry the central bank ultimately could require its own taxpayer rescue.

The Fed’s total assets on its balance sheet have more than quadrupled to $3.8 trillion since 2008 amid a massive bond-buying effort. And there are few signs that the growth will stop any time soon.

That could put the finances of the world’s most powerful central bank at risk if historically low interest rates were to rise sharply — something top Fed officials said they do not expect but that critics warn is very possible.

It also could inhibit the ability of central bank officials to respond to future economic and financial crises.

“It’s really pretty cut-and-dried as far as the arithmetic goes: If you buy bonds and interest rates go up, you’re going to take a capital loss on those bonds,” said James D. Hamilton, an economics professor at the University of California-San Diego. “The more they buy, the bigger their balance sheet, the bigger the loss they’re going to face.”

Federal Reserve policymakers wrap up a two-day meeting Wednesday and are expected to continue purchasing $85 billion a month in low-interest-rate Treasury bonds and mortgage-backed securities as part of the Fed’s third and longest such program to stimulate economic growth.

The continuing lackluster recovery from the Great Recession, combined with the economic hit from the partial federal government shutdown this month, have analysts predicting that there’s little chance Fed policymakers will vote to scale back the program until early 2014 at the soonest.

If that’s the case, the Fed’s balance sheet would swell to more than $4 trillion. And as the number gets bigger, the risks also rise.

“The Fed stands to lose a lot of money, and by a lot of money, I mean hundreds of billions of dollars,” said Rep. Mick Mulvaney, R-S.C., who has raised those concerns with Fed Chairman Ben S. Bernanke. “It is not hyperbole to suggest the next big bailout could be of the Federal Reserve.”

But Bernanke said there’s no need to worry and that any losses incurred by the Fed probably would be offset by more than $300 billion in interest the Fed has earned on its expanded holdings in recent years.

“The bottom line is that for any reasonable interest rate path, this is going to end up being a profitable policy for the taxpayer,” Bernanke told lawmakers this summer.

The Great Recession and financial crisis caused so much economic damage that the 100-year-old Fed has had to attempt new ways to try to stimulate economic growth.

Normally, the Fed simply adjusts the short-term interest rates it set for banks to make overnight loans to one another with money they keep at the central bank. A lower interest rate reduces the incentive to park money at the Fed, giving banks an incentive to lend it instead and create economic activity.

But with those interest rates near zero since 2008 and the economy still struggling, the Fed in 2009 began an unconventional approach – buying long-term Treasury bonds and mortgage-backed securities. The idea was to push down long-term rates, such as mortgages, to get the economy moving.

During three rounds of Fed bond-buying, the latest beginning in September 2012, interest rates have tumbled to record lows before rising in recent months as investors feared the Fed was preparing to reduce the program.

But the bond-buying is risky for the Fed. It purchases bonds from banks and pays for them by adding a credit to the bank’s reserves held at the Fed. Banks store their excess reserves at the Fed, which currently pays 0.25 percent in interest.

In effect, the Fed is borrowing money at very low interest rates to buy the bonds, said Marvin Goodfriend, an economics professor at Carnegie Mellon University’s Tepper School of Business.

“In the short term, it’s a money-maker,” he said, noting the long-term bonds the Fed purchased pay about 2.5 percent interest while it has to pay only about 0.25 percent interest on the money it used to buy them.

“The borrowing cost is cheap right now,” Goodfriend said. “Those borrowing costs are going to rise.”

When interest rates begin rising, the Fed will have to pay a higher rate on bank excess reserves. That will eat into the Fed’s bottom line.

At the same time, rising interest rates will reduce the value of the bonds, which make up about 94 percent of the Fed’s assets. As of last Wednesday, the Fed held about $2.1 trillion in Treasury securities and about $1.4 trillion in mortgage-backed securities. Its total assets, which include loans and foreign currency holdings, were $3.8 trillion.

As interest rates rise, the Fed would have to reduce the value of those low-interest-rate bonds to sell them.

“If the Fed were to sell those bonds for a loss, who makes up the loss? The U.S. taxpayer makes up the loss,” said Peter Schiff, chief executive of investment firm Euro Pacific Capital and a leading critic of the Fed’s stimulus policies.