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Could the U.S. central bank go broke?

While that day seems distant now, some economists and market analysts have even begun pondering the unthinkable: could the vaunted Fed, the world’s most powerful central bank, become insolvent?

Almost by definition, the answer is no.

As the monetary authority, the central bank is the master of the printing press. It can literally conjure up money at will, and arguably did exactly that when it bought about $2 trillion of mortgage-backed securities and U.S. Treasuries to push down borrowing costs and boost the economy.

The Fed’s unorthodox steps helped it generate record profits in 2010, allowing it to send $78.4 billion to the U.S. Treasury Department. But its swollen balance sheet leaves the central bank unusually exposed to possible credit losses that could create a major headache at a time of increasing political encroachment on the Fed’s independence.

Asked about the issue of potential losses during congressional testimony on Friday, Fed Chairman Ben Bernanke suggested the risks were minimal. If liabilities on the Fed’s balance sheet were to exceed its assets, it would only be so because of rising interest rates in the context of a thriving economy, he suggested.

“Under a scenario in which short-term interest rates rise very significantly, it’s possible that there might come a period where we don’t remit anything to the Treasury for a couple of years. That would be I think a worst-case scenario,” Bernanke said. Customarily, the Fed submits surplus profits from its operations back to the Treasury’s coffers.

But the Fed’s newfangled policy steps and the potential for credit losses raises, for some experts, the prospect that the Treasury may actually be forced to “recapitalize” the Fed — economist-speak for what others might call a bail-out.

That would be a strange role reversal given the Fed’s efforts to ease monetary policy by buying the Treasury’s debt, and it could raise a political firestorm from lawmakers who believed all along the Fed was putting taxpayer money at risk.

A PAUPER ON PAPER

Varadarajan Chari, an economics professor at the University of Minnesota and a consultant to the Minneapolis Fed, says that at some point during its exit from easy monetary policies, the Fed actually may go broke — at least on paper.

“The most obvious exit strategy is, when inflation starts to pick up, to stop and reverse asset purchases,” he said. “That’s likely to include requiring the Fed in an accounting sense to see a significant accounting loss.”

The Fed now holds just over $1 trillion in Treasuries, Chari noted, and if inflation rose by a couple of percentage points, it would dent the value of those holdings by about 10 percent, leaving the Fed with a $100 billion loss.

“I’m sure it will have some negative political fallout,” Chari said. “But not economic consequences. Their ability to print money means it (insolvency) doesn’t mean anything.”

Many economists argue that the potential cost to the taxpayer from the Fed’s policies is far smaller than the threat of a prolonged period of economic stagnation that would result from a less proactive approach.

With the U.S. unemployment rate at 9.4 percent and only tentative signs that businesses are beefing up hiring, Fed officials, including Chairman Bernanke, see a duty to prevent a further deterioration of economic conditions — and have signaled a readiness to use all the tools at their disposal.

Last November, as the economic recovery appeared to falter, the Fed said it would buy a new round of $600 billion in Treasury securities through June of this year. That’s on top of the $1.7 trillion in Treasuries and mortgage-backed securities it had purchased in response to the financial crisis.

Still, the pitfalls of the Fed’s approach are almost as numerous as the lending facilities it undertook to stem the crisis. Perhaps most daunting, the Fed’s purchases of Treasury debt and mortgage-backed securities have effectively turned it into a mammoth investor — a thoroughly undiversified one.

“The biggest risk is losses on its portfolio on long-term debt if inflation rises,” said Alan Meltzer, a Fed historian and economics professor at Carnegie Mellon University in Pittsburgh.

QUANTITATIVE TEASING

That threat is already apparent in the Fed’s latest round of bond buying, or so-called quantitative easing. According to calculations by Reuters Insider credit analyst Ed Rombach two weeks ago, the average duration of the Fed’s new portfolio of bonds is just under 5 years, and every 1-basis-point rise in 5-year to 6-year Treasury yields results in a loss of about $65 million.

The Fed is sitting on paper losses of about $2.3 billion on the purchases of U.S. Treasuries it made from November 12 until late last week, according to an analysis by Reuters Insider.

The Fed is also vulnerable to losses through its so-called Maiden Lane portfolios, a collection of investments it acquired when it brokered J.P. Morgan Chase’s takeover of a floundering Bear Stearns and bailed out failed insurer AIG.

The portfolio will likely generate losses, according to many analysts. Still, the total Maiden Lane portfolio amounts to just $66 billion, a small slice of the Fed’s growing pie of securities.

For most Fed officials, a concern over credit losses would be a luxury compared with the risk they see as predominant: that the economy will not grow quickly enough to return more than 14 million unemployed Americans to work, and inflation so low that it leaves the country exposed to possible deflationary shocks.

“The risks are worthwhile given that the economy would be in the toilet if the Fed never did anything to expand its balance sheet,” said Michael Feroli, chief economist at JP Morgan and a former New York Fed staffer.

Feroli does not believe asset sales will be a primary avenue for the Fed’s exit. Indeed, Bernanke appears to think the ability to raise interest rates on bank reserves might prove the most effective way to withdraw stimulus. But even that tool is not without its mechanical difficulties.

The problem lies in the basic workings of fixed income. By definition, bond prices decline when their yields or interest rates go up. That means that as the economy recovers and pushes inflation higher, the Fed will move to increase interest rates, pushing down the value of its giant bond portfolio.

“What would the international reaction be if the Fed suddenly had to go and be recapitalized?” said Bob Eisenbeis, chief monetary economist at Cumberland Advisors and a former head of research at the Atlanta Fed. “I don’t think that would bode well for Treasuries, or for the dollar, or anything else. It would be embarrassing.”

The tiny jewelry shop in the working-class Athens neighborhood was open for business

The shop’s proprietor, Tasos, who preferred not to disclose his last name, said he had not had a sale in more than three months. Because he cannot afford to pay his electricity bills, there was no light to illuminate his storefront display of jewels.

Like most Greeks here, he has, over the past few months, spent more time watching television than conducting commerce, as Greek politicians veered from one political crisis to another. His imagination has been battered with all possibilities of a disaster, not least the prospect that Greece might leave the euro. The effect on his small business — which he says may have to close — has been devastating. His regular customers, most of whom he rarely sees these days, owe him 14,000 euros, about $19,300. Those that he does see are looking to pawn their family heirlooms to get by.

“The politicians are playing games with the people,” he said, his eyes red with exhaustion and stress. “This city is boiling. I am not a protester, but soon the top on the kettle will pop.” That the Greek economy is in a downward spiral from a relentless program of austerity is well known. In October, Greek manufacturing had one of its sharpest declines ever, and this year overall production is expected to contract by more than 6 percent. What has not yet shown up in the official figures, though, is the extent to which the crisis atmosphere has brought the economy to a virtual standstill.

Auto sales have essentially stopped and are at their lowest level since 1993. People who do have cars have trouble with the expenses of operating them. In the last three months, the number of uninsured drivers increased by 500,000, bringing the total to 1.5 million. Small shops, in many ways the lifeblood of the Greek economy, which relies on domestic demand, are closing by the day. And the heightened speculation that Greece might have to return to the drachma has sped up the flood of money leaving Greek banks: money to be deposited abroad, stashed at home or in one’s car, and most certainly not spent.

Since January 2010, Greek banks have lost $63.5 billion in deposits — or about 20 percent of annual economic output. But bankers here say that in September and October the numbers rose substantially, with estimates ranging from $13.8 billion to $20.7 billion for just these two months. Dimitris, a retired truck driver who also did not want to have his full name revealed, recently sent his life savings, about $69,000, to Sweden because, as he put it, “Greece is going bankrupt.”

He has no doubt where the blame lies. “I am impressed that the people have not yet stormed into Parliament and burned the politicians alive — like a souvlaki,” he said. The vitriol toward politicians is in many ways more intense than the outrage expressed toward the European Union and the International Monetary Fund. Politicians here rarely venture out in public, and when they do, even the most obscure member of Parliament is accompanied by at least one bodyguard.

All of it is giving rise to talk that, instead of putting forward another coalition of failed parties and leaders, new people with new ideas outside the political establishment should be brought in. Among the people mentioned are Lucas D. Papademos, a former vice president of the European Central Bank, and Stefanos Manos, a former economy minister for the New Democracy Party who has long argued that any chance of true reform is hopeless until Greece lays off a large chunk of its inefficient public work force.

Mr. Manos’s latest program is even more controversial. He proposes that as much as $415 billion worth of Greek assets be put into a vast “goody bag,” including plots of land, sites of historical significance and even prized islands, as collateral to secure an immediate loan of about $105 billion from Europe that would be used to buy discounted Greek bonds and pay off debtors. In return, Greece would agree to sell most of the assets in the goody bag within the next 10 years or so and pay back the loan — with a bit left over, he hopes.

“Call me a taboo killer if you will,” he said. “Fire Greek workers, sell Greek islands — politicians here have to overcome their taboos.” And, he added, they have little time to do so. “Everything has stopped here,” he continued. “People are taking their money out of the country. The bomb is ticking.” For many in Athens, it has already gone off. In the upscale neighborhood of Kolonaki, where much of the Athenian elite live and shop, stores selling luxury goods are shutting down left and right, the result of a Greek consumer strike that includes not just the lower and middle tiers of the economy but its highest as well.

In part, this has been driven by the intense pressure the government has been under to meet targets to secure its next round of loans. With tax collection still a challenge, Greece has imposed heavy value-added taxes on consumers and, most controversially, a special real estate tax has been attached to Greeks’ electricity bills. But making matters worse, shop owners say, has been the political uncertainty and the constant strikes and riots that can shut down their stores for days at a time.

“Our business is in a free fall — down 70 percent since the crisis,” said Giovanni Urciuolo, the owner of Maurizio’s, a high-end women’s clothing boutique. At the end of the day on a Friday, while the street outside bustles with activity, his store was empty of customers — as it has mostly been during the past two months. He is closing his flagship Kolonaki store in January and he, too, knows who is to blame. “We hate all politicians,” he said. “We think they are responsible for all this.”

U.S. Sues Deutsche Bank Over Loan Practices

The United States government sued Deutsche Bank on Tuesday, accusing it of lying about the quality of home loans it handled under a government program and demanding that the bank repay hundreds of millions of dollars of losses on those loans.

The mortgages, guaranteed by the Federal Housing Administration, are expected to cost the government more than $1 billion. They came from loans issued by a company called MortgageIT, which Deutsche acquired in 2007. The F.H.A. said it discovered the fraud in 2009, while reviewing its overall portfolio. At the time, loans were defaulting at record levels and worries were growing about the ultimate cost to taxpayers. Since the financial crisis, the F.H.A. has broadened its role in the housing market and now backs about one-third of all new mortgages, up from just 5 percent a few years ago. In the last couple of years, the F.H.A. has also overhauled its processes to improve quality control, and loans made more recently are performing better.

Officials from the Justice Department and the Department of Housing and Urban Development said the lawsuit should serve as a warning to other lenders that are issuing loans using a government guarantee. At a news conference on Tuesday, the United States attorney for the Southern District of New York, Preet Bharara, said Deutsche “cannot get away with lies and recklessness.” He said there was not evidence to justify a criminal complaint and declined to say whether there would be more cases claiming F.H.A. fraud.

In an interview, Helen R. Kanovsky, the general counsel of the Department of Housing and Urban Development, said that Deutsche Bank was an outlier and that most loan originators had not had such high incidences of fraud.

Responding to the government’s case, filed in Federal District Court in New York, the bank issued a statement saying it was not involved in most of the 39,000 loans cited in the complaint. Almost 90 percent were issued before the bank acquired MortgageIT, a real estate investment trust, the bank said. At the time of its acquisition, MortgageIT had been operating under H.U.D. oversight for nearly a decade, the bank said.

“We believe the claims against MortgageIT and Deutsche Bank are unreasonable and unfair, and we intend to defend against the action vigorously,” the bank statement said. Of the MortgageIT loans backed by the F.H.A. from 1999 to 2009, worth $5 billion in total, about one-third have defaulted, according to the government’s complaint against the bank. MortgageIT was not a large F.H.A. partner — it ranked 33rd by volume at the end of 2008 — and it stopped issuing government-backed loans in 2009. The F.H.A. referred the problems it spotted with MortgageIT to the Justice Department because it could not bring its own action once the company stopped issuing loans. The case was pursued by a civil fraud unit that Mr. Bharara set up about a year ago.

The complaint against Deutsche Bank stands out because the government has filed relatively few cases against big banks related to the financial crisis. Its actions have mainly been civil complaints, as was the one against Deutsche Bank. The government has found it difficult to prove intent to defraud, a requirement for a criminal case, and investigators got off to a slow start in building possible cases during the crisis because regulators were primarily focused on stabilizing the system. The Justice Department has generally had more success prosecuting small mortgage brokers and borrowers for mortgage fraud than it has had in pursuing major financial institutions.

The Deutsche suit does not name any individual bank employees. And it is not centered on the subprime loans that kicked off the housing collapse. Deutsche was, however, a large player in the subprime market, and mortgage bonds created by the bank sit in many investors’ portfolios. Its mortgage bundling behavior was outlined in a recent report issued by the Senate’s Permanent Subcommittee on Investigations. The Deutsche loans that were backed by the F.H.A. jumped out during the portfoliowide review of mortgages, said Ms. Kanovsky. “The real harm to us was clear,” she said.

MortgageIT had been warned by the F.H.A. for years, Ms. Kanovsky said, long before Deutsche bought it. Workers there frequently told the government that they were taking care of the problems, “all of which turned out to be not true.”

The problems at MortgageIT are rooted in the same sort of behavior that plagued the overall lending market — bankers did not take enough care to ensure the quality of their mortgages because they could resell the loans to private investors. Deutsche, the complaint said, had “powerful financial incentives to invest resources into generating as many F.H.A.-insured mortgages as quickly as possible for resale to investors.”

MortgageIT was qualified by H.U.D. to issue mortgages guaranteed by the F.H.A. MortgageIT and Deutsche filed annual certifications that the loans they issued complied with H.U.D. rules. The complaint says the bank had a fiduciary duty to make correct representations to the government. Yet, the complaint says, Deutsche “repeatedly lied to H.U.D. to obtain and maintain MortgageIT’s direct endorsement lender status.” In particular, the complaint said Deutsche did not monitor how often home owners defaulted on their mortgages immediately after receiving the loans.

Trouble was apparent at MortgageIT as early as 2003, according to the complaint. When a HUD audit revealed that the company had not met quality control levels, the company assured the government that it had altered its practices to comply. But it had not, the complaint says. There were several other instances where the company made similar false statements about its quality control unit, which was chronically understaffed, the complaint says.

MortgageIT, based in New York even before the Deutsche acquisition, once had over 2,000 employees, mortgage loan offices across the country and licenses to issue loans in all 50 states.