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Fed official: Our bond-buying is potentially toxic

January 18, 2013: 8:25 AM ET

If interest rates were to suddenly rise to their historic levels, the Federal Reserve's investment portfolio could be doomed.

By Rob Curran

federal reserveFORTUNE -- Federal Reserve critics have long warned that quantitative easing may result in a dangerously bloated balance sheet at the central bank, but it's never been clear why the Fed's internal finances should matter to you and me.

Now Dallas Federal Reserve President Richard Fisher is arguing that the health of the Fed's balance sheet could affect the health of the federal government and even the Fed's statutory role.

Under three rounds of quantitative easing and several other market-support programs, the Fed has purchased a whopping $2 trillion in Treasurys and mortgage bonds since the financial crisis struck in 2008. At that time, the central bank carried $900 billion of bonds and securities on its balance sheet. Those bonds had accrued over the years during "open market operations," which is the buying and selling the Fed does when carrying out its policy changes. According to a filing last week, the Fed paid a record $88.9 billion into government coffers in interest payments from its portfolio in 2012, most of it from interest on mortgage bonds, securities that it's still buying.

As Fisher quipped at a December speech in Gainesville, Texas: "You are looking at one of the few public servants who actually brings the deficit down."

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Fisher, a sun-tanned, sparkle-toothed California transplant, is a happy hawk. His son Miles Fisher is an actor who has appeared on Mad Men, something that the senior Fisher said impressed one of his Chinese hosts more than his own title during a recent visit East. Fisher's two favorite subjects are the fiscal virtues of his adopted state and the fiscal sins of the legislature in Washington D.C., for which he ran as a Democratic senate candidate in 1994. (He also pillories California's finances in an anecdote that imagines California Governor Jerry Brown spending millions on environmental impact studies after an early-morning confrontation with a coyote; Texas Governor Rick Perry famously shot a coyote on a morning jog. "Cost of bullet: 25 cents. Cost to taxpayer: zero.")

Fisher, who does not currently hold a vote on the Federal Reserve's Open Market Committee, has long argued that further bond buying is pointless in the absence of Congress balancing the budget. He insists that quantitative easing is not achieving its stated goal of bringing down the unemployment rate. Other critics, such as bond investor Jeffrey Gundlach, echo his claims that quantitative-easing has run up against the law of diminishing returns.

Fisher goes further, saying that the quantitative-easing is not only futile, but potentially toxic.

"The question is how far are we willing to go and how large a balance-sheet will we be able to leverage before we run the risk not only of (hurting) the financial well-being of the Fed but also" that of the country, said Fisher, during a question-and-answers session after his speech at the Gainesville Chamber of Commerce.

Basically, if the Fed holds its mortgage and Treasury bonds as yields rise, it will have to mark its portfolio down to market. To stay solvent after a certain level, the Fed would have to stop remitting cash to the Treasury. In 2010, the Congressional Budget Office warned that the federal government could become dependent on the increased remittances generated by the Fed's balance sheet.

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"The chances are great that the Federal Reserve will remit slightly more than the amounts CBO expects," CBO analysts wrote. "But there is also a small chance that it will remit much less -- or even nothing -- if serious problems reemerge in the financial markets or the economy greatly weakens again."

Fisher's economists at the Dallas Fed looked at 50 years of charts going back to 1962 and found that the yield on the 10-year was above 6% for more than half that period. They wondered what would happen to the Fed's balance sheet if the 10-year yield returned to that historical norm.

"Might this lead to us having to defer remittances to the Treasury, or worse?" Fisher said. "And will Congress remember we remitted all that money, made all that money for taxpayer? I worry that if we were to get in that situation then we might have more efforts to politically interfere with our independence."

With the yield on the 10-year currently still under 2%, Fisher's concerns may seem a long way from fruition. In fast-moving modern markets, however, the gap between fears and their realization has narrowed.

There are many scenarios under which U.S. rates could rise rapidly: a failure to resolve the budget crisis, a surge in inflation after an uptick in global growth, or a Wizard of Oz-style loss of faith in central banks' magic.

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"Market participants just assume printing works, period. For now." said Lorenzo Di Mattia, manager of hedge fund Sibilla Global Fund, in an e-mail. "When that perception changes it'll be devastating. Timing? 90% chances that happens in the next 5 years, but less than 10% chances it happens this year, I'd say."

Fisher's concerns were obviously aired at the last Fed meeting in December. Some traders were surprised by the eagerness of bankers to discuss the "exit strategy" from quantitative easing.

"There is a debate within the FOMC on the Fed's balance sheet," said Quincy Krosby, investment strategist at Prudential Financial, pointing to the Fed's December minutes. "And it's not just a debate of the hawks versus the doves, it's very much a debate on how much can the Fed take on, and what kind of dislocation will there be when the Fed begins to exit."

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