Monday, May 4, 2009

The Fed can handle it

On April 23, the Fed released its 2008 annual financial statement for the combined Federal Reserve System. I saw two different types of commentary related to the financial statement: those pertaining to the $3.1 billion in losses on the acquisition of Bear Stearns assets, and those highlighting the record $43 billion operating profits (hat tip, Mark Thoma), up $2 billion over the year.

This is my interpretation: the Fed can handle its massive policy measures (i.e., take the losses) going into 2009 and 2010, since the expected risk, size, and income earned on the Fed's portfolio will increase.

The Fed's balance sheet is set to surge. On April 29, 2009, the Fed held $2.1 trillion in assets, up $1.2 trillion over the year. The chart to the left illustrates the Fed's asset holdings then (September 2008), now (April 29, 2009), and a rough approximation of the future (rest of 2009-2010). As illustrated, the assets are expected to grow to over $4 trillion, given that the Fed buys the remaining of its announced asset purchase programs:
  • $1.25 trillion in GSE-backed MBS ($367 billion currently, April 29, 2009, on balance)
  • $200 billion in GSE debt ($66 billion currently on balance)
  • $300 billion in Treasury buybacks ($77 billion acquired to date)
  • $1 trillion in TALF funding ($6 billion currently on balance)
The Fed is adding risk to its portfolio - ABS backed by consumer, student, and small-business loans, CMBS (commercial mortgage-backed securities, RMBS (residential mortgage backed securities). To be sure, the growing slack in the economy guarantees that the Fed will take losses on its massive portfolio going forward. However, as long as the Fed has earned income enough to cover its losses and expenses, and transfer its historical profits to the Treasury, then holding inflation constant, the net explicit cost to taxpayers is negligible.

An example. The Fed earned $43 billion in operating income on its 2008 portfolio that averaged $1.4 trillion in 2008 (you can see the historical date of the Fed's weekly balance sheet here), of which $39 billion is net income. All else equal, that's roughly $120 billion in expected net operating income on a portfolio that is over three times as big, $4.3 trillion. Hold the Treasury's expected earnings from the Fed constant at roughly $30 billion - the Fed transferred $35 billion to the Treasury, which it does every year (see page 5 of the .pdf) - leaves the Fed with about $90 billion of wiggle room for losses.

Losses are going to rise beyond the $3 billion reported in 2008. However, the overly simplistic example that I have presented above illustrates that the Fed will be able to internalize its measures on higher expected earnings.

Rebecca Wilder

5 comments:

  1. Hmm: I think that the FED is DEAD.

    There is no way it can unwind even a quality portfolio of that size - 1/3 of the US GDP - so it is not even going to try!

    Instead the FED via it's many "programs" have become a conduit for converting crap debt into "quality" US Treasury Notes ... for as long as there are still suckers willing to buy zero yield treasuries.

    First sovereign default and it's all over - someone else, preferably foreign, will be left holding the bag.

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  2. THE CREATION OF NEW MONEY & CREDIT IS A VERY PROFITABLE BUSINESS FOR ALL INVOLVED -- THE BANKS, THE FED, AND THE TREASURY.

    MAYBE THE "INTEREST REBATE PAID ON RESERVES" TO THE MEMBER BANKS SHOULD BE TRACKED AS WELL.

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  3. Maybe the "interest on reserves" regime is horrifically expensive considering the collosal volume of idle, unused, excess legal reserves. How was this supposed to benefit the public?

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  4. Well, what could you do with $88.00billion anyway?

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  5. Hi Flow5,

    You are correct - interest on reserves could be a potential cost going forward, especially if the Fed uses it as a tool keep some of its liquidity at bay.

    David Beckworth writes about this at macro and other market musings blog:

    http://macromarketmusings.blogspot.com/search?q=excess+reserves

    Best, Rebecca

    Hi fanjensen,

    Goldman Sachs estimates a Taylor Rule target at -8% (or so). And if I remember correctly, they also estimate that it would take another 10 trillion to lower the rate effectively 100 bps (again, if I remember correctly). Try unwinding $10 trillion. The Treasury market is $6.5 trillion or so...

    Rebecca

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