Reuters Spells Out What Could Go Wrong for the Fed, Leaves Out the Biggest Elephant in the Room

It is an amusing read. In their article titled "Could the U.S. central bank go broke?", Reuters' Pedro da Costa and Ann Saphir wonder aloud if it is ever possible for the Federal Reserve to go broke and if so, how.

Their short answer is no, it is not possible because the Fed can simply print money. Nonetheless, they go ahead and list the problematic assets on the Fed's balance sheet, and completely missing the biggest problem.

From Reuters:

(Reuters) - The U.S. Federal Reserve's journey to the outer limits of monetary policy is raising concerns about how hard it will be to withdraw trillions of dollars in stimulus from the banking system when the time is right.

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?

According to the two writers, there are two potential problems with the Fed's balance sheet.

Problem No.1: Treasuries ($1.024 trillion)

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.

Problem No.2: Maiden Lane ($66 billion)

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.

But they also quite a reassuring message from Ben:

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.

OK, Ben says the worst-case scenario is that the Treasury will miss interest payments from the Fed. Big deal, right?

So what is Reuters (intentionally) missing?

Problem No.3: Agency bonds and mortgage-backed securities ($1.139 trillion)

The Fed has $147 billion agency bonds and $992 billion mortgage-backed securities guaranteed by Fannie Mae, Freddie Mac, Ginnie Mae (i.e. guaranteed by the US taxpayers). These securities are entered at the face value. In case of MBS, the current face value is the remaining principal balance on the underlying mortgages.

If Reuters thinks US Treasuries getting as much as 10% haircut due to an expanding (aka bubble) economy in the future is bad for the Fed, what about these mortgage bonds which, if marked to market now, would give an immediate significant haircut?

The biggest problem, even bigger than the agency bonds and MBS that the Fed holds, may be the uncertainty over its future. What if Congress finally decides to change the charter of the Fed so that the Fed cannot print at will any more? Or what if Congress allows competing currencies, as Ron Paul has proposed? Or what if the states assert their right to use gold and silver as currencies, like Virginia may be doing?

Then the very premise of the article that the Fed will not go bankrupt because it can print its way out of it would go down the toilet.

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Federal Reserve Contemplating Doubling the Size of Its Balance Sheet

to a whopping $5 trillion.

UK Telegraph's Ambrose Evans-Pritchard reports:

"Fed watchers say Mr Bernanke and his close allies at the Board in Washington are worried by signs that the US recovery is running out of steam. The ECRI leading indicator published by the Economic Cycle Research Institute has collapsed to a 45-week low of -5.7 in the most precipitous slide for half a century. Such a reading typically portends contraction within three months or so.

"Key members of the five-man Board are quietly mulling a fresh burst of asset purchases, if necessary by pushing the Fed's balance sheet from $2.4 trillion (£1.6 trillion) to uncharted levels of $5 trillion. But they are certain to face intense scepticism from regional hardliners. The dispute has echoes of the early 1930s when the Chicago Fed stymied rescue efforts.

""We're heading towards a double-dip recession," said Chris Whalen, a former Fed official and now head of Institutional Risk Analystics. "The party is over from fiscal support. These hard-money men are fighting the last war: they don't recognise that money velocity has slowed and we are going into deflation. The only default option left is to crank up the printing presses again."

"Mr Bernanke is so worried about the chemistry of the Fed's voting body – the Federal Open Market Committee (FOMC) – that he has persuaded vice-chairman Don Kohn to delay retirement until Janet Yellen has been confirmed by the Senate to take over his post. Mr Kohn has been a key architect of the Fed's emergency policies. He was due to step down this week after 40 years at the institution, depriving Mr Bernanke of a formidable ally in policy circles." [Emphasis is mine. The article continues.]

In other words, the Fed chairman is scared sh-tless.

5 Members of the Federal Reserve Board are:

• Ben Bernanke
• Donald Kohn
• Kevin Warsh
• Elizabeth Duke
• Daniel Tarullo

Of them, Kevin Warsh, former Morgan Stanley banker and former member of the Plunge Protection team (aka Working Group on Financial Markets), has expressed views almost identical to the critics in the Fed against Bernanke's policies. (For more on Mr. Warsh's views, read my posts.)

Bernanke's critics in the Fed are:

• Kansas Fed chief Thomas Hoenig
• Philadelphia chief Charles Plosser says
• Richmond chief Jeffrey Lacker

The most vocal critic, Thomas Hoenig, is the only member among these critics in the FOMC. (Plosser is an alternate member for 2010.) Hoenig was strongly in favor of the regulation on financial derivatives, the position diametrically opposed to that of the Federal Reserve Board and the Treasury Department. He also wants to bring back Glass-Steagall-like law.

Bernanke's idea of more than doubling the balance sheet is not his original, by the way. He must have surely channeled from the Vampire Squid's economist, who said, back in August last year, the Fed could easily double the balance sheet to $4 trillion with no adverse effect. At that time, the Fed's balance sheet was closer to $2 trillion than to $2.5 trillion.

Unlike the last time, this time he would probably have to forgo the sterilization if he really wants to avoid recession (so-called 'double-dip', although many 'small people' didn't even feel the uptick). He would have to flood Main Street with money.

GOT GOLD?

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Borrowings from Fed Down, Reserves Way Up

...so what gives?

The Federal Reserve chairman Ben Bernanke, when he outlined his so-called "exit strategy" back in July, said that the bank reserves at the Fed would naturally decrease as the various loan programs winded down. (If you want to review his strategy, here's my post from July.)

Well, the Fed's various loan programs have been winding down. At their peak, the total borrowings by depository institutions (=banks) exceeded $400 billion. They have been flat about $100 billion since April this year. Have the bank reserves come down?

Answer: Not at all.

I created the graph using St. Louis Fed's FRED. The red line is the bank reserves. The blue line is the total borrowings by the banks from the Fed. As you can see, the bank reserves recently spiked to a new high to $1 trillion. In the latest Federal Reserve Statistical Release H.4.1 Factors Affecting Reserve Balances (10/22/09), the bank reserves are recorded at: $1,034,078 million, up $52,459 million from last week.

$1 trillion minus $100 billion equals $900 billion. How has this $900 billion in the bank reserves been earned? What securities could the banks have given to the Fed in exchange for the credit to their reserves, outside those lending programs that are winding down?

Scanning the Fed's Statistical Release, my eyes stopped at these line items:

Federal agency debt securities (2) 137,866 + 3,320
Mortgage-backed securities (4) 766,543 + 63,970

The first column is the total, the second column is the change from last week. If you add the two numbers in the first column, you get: $904,409 million. Rounding it up, $904 billion.

Oh what a coincidence.

Is it possible that, as the lending programs wind down and the banks takes the collateral back, the banks are selling them back to the Fed as part of the Fed's permanent open market operations (POMO)? So now it's not a loan any more, the sale has been made. The banks have sold the agency bonds and agency-backed MBS that hardly anyone in the world wants to the Federal Reserve, and in exchange they got their bank reserves credited. Probably at the face value, good as cash.

I may be missing some important things and I could be totally wrong and it is just a coincidence, but if this is what has happened, then all the Fed has done is to shift temporary assets (loan collateral) to permanent assets backed by the government.

At least, we now know that Bernanke's "exit strategy" No.1 didn't work. According to Zero Hedge, the New York Fed experimented on another of his strategy to use reverse repo with the primary dealers and the experiment reportedly ended in disaster.

The only way to effectively shrink the balance sheet would be to sell long-term securities in the open market. Treasuries, agency bonds and MBS, which account for $1.678 trillion of the Fed's $2.230 trillion balance sheet.

Why was Mr. Bernanke so eager to be reappointed to be the Fed chairman, given this practically impossible task?

Unless the Fed's interest is not to save the system or the economy, but save its credibility... (One Fed board member said as much, remember?)

Or, unless someone has decided that the proverbial "bad bank" is to be the Federal Reserve, never to fail...

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Goldman: Fed Could Double Balance Sheet to $4 Trillion

Now that Wall Street got the central banker that they wanted (partly due to the self-promoting campaign by the Fed chairman himself), they may be getting bolder in their calls.

Goldman Sach's chief U.S. economist Jan Hatzius thinks the Federal Reserve's balance sheet, which has been at $2 trillion since last September, could double to $4 trillion in order for the Fed to support the economy.

Goldman’s Hatzius Says Fed Balance Sheet Could Hit $4 Trillion (8/25/09 Bloomberg)

"Aug. 25 (Bloomberg) -- Jan Hatzius, chief U.S. economist at Goldman Sachs Group Inc., said the Federal Reserve could double the size of the central bank’s balance sheet again if needed to support economic growth.

"A rise in the balance sheet to $4 trillion is a “possibility,” Hatzius said in an interview on Bloomberg Radio in New York. “It is going to depend on not just what inflation does, but also on whether the economy does move back to a slower growth pace.”

"The Fed must now guide the world’s largest economy back to growth and reduce unemployment approaching 10 percent while shrinking the balance sheet to prevent a surge in inflation, Hatzius said.

"“Rates need to stay low,” he said. The Fed “could become more aggressive in purchasing assets. They have not gotten a lot of bang for the buck on that policy so far.” "

Hmmm. Aren't the last two statements contradicting with each other? If the Fed aggressively purchase more assets, that's going to increase the balance sheet, not shrink it.

Let's go back again to the Fed's balance sheet and look at the components on Assets and Liabilities. These are selected components so they do not balance.

The top table is created from the balance sheet as of May 20, 2009, and the bottom one from the latest as of August 19, 2009. The Fed's various loan programs do seem to be winding down, for which the Fed is compensating with increased purchase of Treasuries, agency bonds, and MBS backed by Fannie, Freddie, and Ginnie. (Hardly anyone wants the last two types of government securities these days.)

Now to the Liabilities side. Notice the currency in circulation (M1) has had a slight increase, and the deposits from depository institutions (i.e. banks) have decreased markedly. That's 14% decrease. Is it possible that banks have started to put the money to use?

In order to double this balance sheet, I see only two ways to do it. One is to expand the lending programs again (assets) and have the banks deposit the money back into the Fed (liabilities). That presupposes another financial disaster, a huge disaster. The other way is to double the size of the government securities holdings (assets) and either figure out the way to entice the banks to park the money at the Fed or print more money into circulation (liabilities) or both.

If the Fed doubles the balance sheet by buying more government securities and at the same time devises a plan to keep or increase the deposits from the banks, that defeats the purpose of stimulating the growth, doesn't it? Can we say "inflation"?

See also my post on Bernanke's so-called exit strategy.

Goldman Sachs is also calling for oil price to go back up to 2008 high.

(They must know what we do not yet know.)

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How will Federal Reserve Pull Back Support?

This is a yesterday's headline from CNBC. I couldn't help laughing when I saw the headline.

As Economy Starts to Recover, Fed Weighs When to Pull Back (6/15/09, CNBC)

"As economy starts to recover..." When? The article says the Federal Reserve thinks it will be the 3rd quarter of this year, hopefully.

"The U.S. economy looks poised for a return to weak growth in the second half of the year and the Federal Reserve is giving careful thought to how to pull back its support when the time is right, Fed officials said Monday."

What is "weak growth"? Can you define that?

Amid the dribbles from the various Fed presidents, this caught my attention:

"Evans [Chicago Fed], a voting member of the Fed's policy panel, said some of the central bank's programs, especially those that provide back-up for short-term loans, will shrink naturally as market conditions improve.

"But he also said a "significant portion" of the Fed's balance sheet will likely not do so, which will force the central bank to develop what is likely to be a multi-pronged exit strategy."

Short-term loans will shrink naturally? Really? The Federal Reserve has been lending out U.S. Treasuries to the borrowers in exchange for whatever assets they can come up with as a collateral. The criteria for the collateral has gotton very loose over time, and the Federal Reserve has refused to discuss who the borrowers are, and what kind of collateral the Fed is getting.

So when the time is right, those borrowing institutions will gladly return the perfectly good Treasuries in exchange for the assets of dubious quality back onto their balance sheets.

Does that make sense?

"A significant portion" of the balance sheet that Mr. Evans refers to must be everything else but the short term loans:

Here are some major items on the asset side of the Fed's balance sheet. I don't think there has been any material change since May.

• Treasuries marked at face value: $622 billion
• Agency debt from Fannie and Freddie marked at face value: $84 billion
• Mortgage-backed securities guaranteed by Fannie and Freddie and Ginnie Mae: $427 billion
• Assets from various LLCs (Maiden Lane stuff, Bear Stearns, AIG) marked at "fair value" (or you could say mark-to-model, as there is apparently no market for them other than fire sale): $62 billion

Other than Treasuries, it's hard for me to believe that these assets could fetch a good price, or the price that the Fed wants to sell at (which I assume to be very very close to face value).

To remove excess liquidity, instead of reducing the asset side of the balance sheet, the Fed could try not to reduce the liability side, so that they don't need to sell the assets. I think that means excess reserve, which is currently at $816 billion. The Fed could raise reserve requirement for the banks, so that the banks will have to continue to park their money there. Or they could the combination of the two: sell some assets, and raise the reserve requirement.

However, raising the reserve requirement would mean loans that banks could make to businesses and consumers. How would that help the economy recovering weakly?

Any other options? I would like to hear from the Fed soon. If weak growth may be coming in the 3rd quarter, as the Fed says, that's July-August-September. July is less than a half month away.

Another day of quiet selloff in the stock market. The market doesn't seem to believe in "green shoot" all of a sudden. Dow Jones Industrial Average is down another 95 from yesterday, at 8,516. S&P 500 down almost 10, to 913. Nasdaq is down 15 to 1,801.

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What's on the Fed's Balance Sheet?

One of my long weekend's readings was the Federal Reserve's latest balance sheets (May 20, 2009). (I'm probably semi-autistic and) I just like to absent-mindedly look at the numbers. So the following is just my leisurely observation and not a rigorous balance sheet analysis, which I will leave it to Representative Paul and his co-sponsors (his "Audit the Fed" bill, by the way, now has 179 co-sponsors.) Besides, my knowledge of financial accounting was almost all cleared from my cache as soon as the final exam at B-school was over...

The Fed's balance sheet is over $2 trillion. The following spreadsheet simply shows major line items in their consolidated balance sheet. (As such, they are not supposed to balance.) The Fed does seem to be between a rock and a hard place.

First, take a look at a Liability item, "Federal Reserve notes". That's our currency. According to the Fed's consolidated statements, Federal Reserve notes are backed by Treasury securities, federal agency debt (Fannie and Freddie), and mortgage-backed securities (guaranteed by Fannie and Freddie), which are accordingly on the Assets side. The latter two are held at face value.


I hope you are all comfortable with "face value" of the debts issued and/or guaranteed by Fannie Mae and Freddie Mac, because they are part of collateral held against Federal Reserve Notes. Even with the recent purchase of Treasuries by the Fed, Treasuries alone are not enough to cover the entire currency circulated. No wonder US dollar is declining.

Then, take a look at another Liability item, "Deposits from Depository institutions". That's the bank reserves, including huge excess reserves (actually almost all of it). Right now, the Fed is paying interest to the banks for keeping the reserves at the Fed. Sooner or later, once inflation hits, these reserves will be withdrawn and put to work to earn higher returns. The Fed will have to reduce the Asset side of the balance sheet to compensate for the decline in the liabilities. That means they have to sell either Treasuries, agency debts (that no one will want), or mortgage-backed securities (will anyone want those?). Treasuries may get a decent price still, but the other two won't get sold at face value. That will put further downward pressure on the US dollar.

Or how about those term auction stuff and other LLCs that they created (most of LLCs are managed by the New York Fed)? If they gets unwound, what will happen to the liabilities side? Which items will get unwound? And what are the consequences? We don't even know what's in these LLCs.

On top of all that, the Fed wants to issue its own debt.

What a mess.

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