Thursday, November 4, 2010

High Rollers at the Fed

I have asked for some time now, where are the assets on the US balance sheet that the govt took over? Well it appears that some of them are on the treasuries balance sheet and apparently making good earnings.

Aivars Lode

High Rollers at the Fed
The central bank becomes a Treasury profit center—for now

The Federal Reserve's Open Market Committee seems poised today to make a historic decision to expand its balance sheet by as much as $1 trillion or more to boost inflation and reduce unemployment. We've said before that we think this is a monetary mistake, but the public and Congress should also be aware that it increasingly carries fiscal risks.

In conducting monetary policy, the Fed has historically stuck to the purchase of short-term Treasury securities and other highly safe assets. That changed amid the financial panic, as the Fed grew its balance sheet to $2.1 trillion in 2009 from $900 million in 2007. That expansion was controversial but it was defensible on grounds that the central bank was fulfilling its duty as lender of last resort during a liquidity squeeze. Roughly $1 trillion of the new assets were in short-term credit facilities, including foreign central bank swaps.

In 2008, the Fed began its dive into riskier assets by adding securities from Bear Stearns and AIG totaling about $70 billion, Fannie Mae and Freddie Mac debt of $45 billion and over $200 billion in Fan and Fred-guaranteed mortgage-backed securities. But those purchases remained a small part of the Fed's portfolio and were widely viewed as emergency measures amid a crisis. As it turned out, the Fed was only warming up.

Today the Fed's balance sheet of more than $2.3 trillion has no term auction facilities, commercial paper funding facilities or liquidity swaps. In their place mortgage-backed securities have ballooned to $1.1 trillion, U.S. Treasurys to $821 billion and Fannie Mae and Freddie Mac debt to $154 billion.

In the short-term, these investments have proven to be a revenue windfall for the U.S. government. In the first six months of 2010, the Fed says this portfolio produced net earnings of some $36.9 billion. Most of those earnings came from Treasurys, Fannie-Freddie debt and mortgage-backed securities (MBS). This compares to $16 billion in the first six months of 2009.

The Congressional Budget Office reports that in fiscal 2010, which ended September 30, the Fed earned $76 billion, a 121% increase from a year earlier. To put that in perspective, $76 billion is more than a third of the $192 billion that the corporate income tax raised in fiscal 2010. The Fed has become one of the Treasury's biggest cash cows, helping to mask the real size of the budget deficit.

As you may have read, however, there is no free lunch, and this revenue stream is the result of taking new risks. Before 2008, short-term government debt was the Fed's traditional instrument of monetary policy. Today the Fed's mortgage-backed portfolio has a maturity of more than 10 years, and nearly half of its portfolio of Treasurys is now greater than five years.

This means greater interest rate risk, as outlined in a new paper in the American Institute of Economic Research, "The World's Most Profitable Corporation," by former Atlanta Fed President William Ford and Walker Todd, a former New York Fed lawyer specializing in monetary affairs. The authors estimate that if interest rates on 30-year fixed-rate MBS were to rise to 5% from 4%, "the Fed's current portfolio of such bonds ($1.079 trillion) would decline in value by about $162 billion—nearly three times the $57 billion of capital on the Fed Banks' consolidated balance sheet in mid-October 2010."

The Fed's new risk profile also shows up in its capital to asset ratio. Messrs. Ford and Todd point out that the Fed's short-term portfolio has allowed it to carry only a 4% ratio of capital to assets compared to an 8% ratio at commercial banks. But since 2008, while the portfolio has become more risky, the capital ratio has dropped. The authors says that today the New York Fed's capital ratio is a measly 1.45%, which means a leverage ratio of 69 to 1 and the entire Fed system has a ratio of 2.46% or 47 to 1.

More leverage together with extended maturities means that if there is a sharp rise in the yield of long-term bonds, perhaps due to rising inflation expectations, the Fed's balance sheet could look very ugly, very fast. Fed officials will rightly argue that they are able to hold these long-term assets to maturity without having to realize losses. But what if the Fed has to sell assets to drain liquidity from the economy faster than it might prefer, and thus take losses on its portfolio? The revenue gain for the government would become losses. Imagine how delighted that would make Congress, not to mention complicating the political task of Fed tightening.

Everybody loves the Fed when it is easing money, as all but a few of us did during the credit boom and housing bubble of the mid-2000s. The trouble comes when the bill comes due. One task of the next Congress should be to better inform the public about the risks the U.S. central bank is taking, ostensibly on our behalf.

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