The Fed Has A Problem

by: Michael Gray
Summary

The Fed's balance sheet is underwater as the cost of their SOMA holdings exceed market value by $19.553 billion.

This unrealized loss represents almost half of the Fed's total capital of $38.901 billion.

The policy actions the Fed undertook to combat the Financial Crisis of 2008 has led to the current situation.

In June, the Fed released the results of their annual “Stress Test” on the nation’s 35 largest banks. The purpose of the analysis was to determine the ability of banks to withstand losses under different economic scenarios.

Perhaps the Fed should have examined themselves.

As the Fed is currently addressing their interest rate normalization policy (having raised the Fed funds rate 7 times since 2015) while also unwinding their bloated balance sheet, they have another problem to deal with that hasn’t received as much attention:

The Fed’s balance sheet is underwater!

According to the just-released Federal Reserve Banks Combined Quarterly Financial Report as of June 30, 2018, the cost of the Fed’s System Open Market Account (SOMA) Holdings exceeds their fair market value by $19.553 billion.

Table 2. Domestic SOMA portfolio holdings

(in millions)

June 30, 2018

Cumulative

Amortized

Fair value

unrealized

Cost

gains (losses)

Treasury Securities

Notes

$1,544,587

$1,522,472

($22,115)

Bonds

$919,134

$972,568

$53,434

Total Treasury Securities

$2,463,721

$2,495,040

$31,319

GSE debt Securities

$2,752

$3,228

$476

Federal agency and GSE MBS

$1,771,221

$1,719,873

($51,348)

Total domestic SOMA portfolio

securities holdings

$4,237,694

$4,218,141

($19,553)

The Fed uses accounting principles as determined by the Federal Reserve Board of Governors which, unlike GAAP accounting, allows the Fed to carry securities at “Amortized Cost.” As such, gains and losses due to market movement are only recognized upon the sale of securities. Instead, they monitor their unrealized gains and losses in a footnote.

Reported Total Capital for the June 30 period was $38.901 billion, so the unrealized portfolio losses would effectively wipe out half of the Fed’s capital. It wouldn’t take a very large rise in interest rates to wipe out the other half of the capital.

How we got here

To understand the current situation it helps to look back to the financial crisis of 2008. The Fed was very aggressive at that time in their efforts to prevent the economy from collapsing. They initially used their most effective monetary policy tool by cutting the fed funds rate to almost zero. Once that tool was no longer available to them, they turned to more unconventional methods.

Using Open Market Operations, the Fed embarked on a series of Large Scale Asset Purchases, more commonly known as Quantitative Easing, to try to stimulate the economy and add liquidity to the system. This resulted in a massive expansion of their balance sheet, from a pre-crisis $850 billion to today’s $4.3 trillion.

Traditionally, when purchasing securities, the Fed would buy mostly short-term US Treasury securities to avoid credit risk and interest rate risk. However, during this period, they deviated from this historical policy.

For the first time since the early 1990s, the Fed purchased Federal Agency and GSE mortgage-backed securities as part of their SOMA holdings. They were attempting to improve the liquidity of banks by removing these illiquid toxic assets, which were partially responsible for the onset of the financial crisis, from banks’ balance sheets. In doing so, the Fed reduced the credit quality of their own portfolio.

The Fed also deviated from their policy of mostly buying short-term US Treasury securities by purchasing a larger percentage of US Treasury Notes and US Treasury Bonds. These holdings significantly extended the average duration of their portfolio, from 2.5 years pre-crisis to 6.0 years. The Treasury Notes and Bonds, combined with the Agency MBS dramatically increased the interest rate exposure of the Fed’s portfolio.

A large part of lengthening occurred during the Fed’s Maturity Extension Program, more commonly known as Operation Twist, to try to bring down long-term interest rates. The Fed sold short-term securities and bought longer-dated securities, beginning in September 2011 and terminating at the end of 2012.

While successful in achieving the goal of extending the maturity of their portfolio, the Fed made a classic market timing error of lengthening when rates were near record lows. As can be seen in the chart below, the 10-year Treasury note averaged 1.7% during Operation Twist. At the end of June 30, 2018 the 10-year Treasury note was yielding 2.85%, hence the unrealized loss in the Fed’s SOMA portfolio.

By lengthening their portfolio holdings the Fed also created an asset-liability mismatch. That is, they bought fixed rate long-term assets, while their liabilities are short term and floating rate. As rates rise, the net margin between the income earned on their fixed rate assets and the interest expense of their floating rate liabilities is shrinking.

As can be seen below, the quarterly net income earned by the Fed in the second quarter of 2018 of $15.9 billion is down 12.6% from the prior quarter, and down 41.8% from the peak in the second quarter of 2014.

As the Fed continues to normalize interest rates, Net Income should continue to decline.

Current policy

The Fed embarked on a policy to unwind their balance sheet beginning in October 2017. Currently, they are reducing their holdings of Treasury securities by $24 billion per month and their holdings of Agency MBS by $16 billion per month. This is being accomplished by maturity roll-offs. The Fed will not sell securities because they do not want to realize their gains and/or losses.

As stated in the Quarterly Report on Federal Reserve Balance Sheet Developments, August 2018, the SOMA portfolio will “continue to decline in a gradual and predictable manner until the Committee judges that the Federal Reserve is holding no more securities than necessary to implement monetary policy efficiently and effectively.”

In late August at the Fed’s annual policy symposium in Jackson Hole, Wyoming, Chairman Powell laid out his plan for interest rates. “If the strong growth in income and jobs continues, further gradual increases in the target range for the federal funds rate will likely be appropriate.”

Given these policy actions, if interest rates continue to increase, the Fed’s portfolio problem will become even more severe. Assuming an overall portfolio duration of 5 years, if the 10-year T note yield rises even 10 basis points from the 2.85% rate as of 6/30/18 then the unrealized losses on the $4.2 trillion portfolio will be enough to completely offset the Fed’s total capital. A larger increase in rates will do even more damage.

Implications

While the Fed remains profitable on an operating basis, with rising rates and a shrinking net interest margin, profitability will decline, and may not be enough to cover the portfolio losses.

This is not to say that the Fed will become insolvent. Their portfolio losses remain unrealized and can be carried on their balance sheet for some time. However, the deterioration of the Fed’s balance sheet is not eliminated by their favorable accounting policy of using amortized cost. Their inability to sell securities limits their flexibility in conducting policy.

In addition, as the unrealized losses mount, there is the political risk that the current administration will become more critical of the Federal Reserve’s operations and will seek to limit their independence.

Although the Fed has several options to fund their liabilities if necessary, such as simply printing money, or receiving a capital infusion from the US Treasury, the optics of the Fed being bailed out are not ideal. Such measures could greatly impact the investment community’s confidence in our central bank.

The Fed is in this situation because they deviated from historical policy following the financial crisis of 2008.

- They dramatically expanded their balance sheet through several rounds of Quantitative Easing.

- They bought non-Treasury securities by adding Agency MBS to their portfolio.

- They lengthened their portfolio by selling short-term securities to buy longer-maturity Treasury Notes and Bonds.

- They extended when interest rates were near record lows.

- They created an asset-liability mismatch.

Now the Fed is dealing with the ramifications of the extraordinary policies they implemented to combat the financial crisis of 2008. Perhaps a stress test of their own operations is in order.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.