Given Its Highly Risky Balance Sheet, It’s Time To ‘Stress Test’ The Fed (Jun 2013)

federal-reserve

Source: Forbes –  Given Its Highly Risky Balance Sheet, It’s Time To ‘Stress Test’ The Fed

Notable excerpts:

The Federal Reserve has been actively applying “stress tests” to the nation’s banks. Surprisingly no one has suggested a stress test for the Fed.  Yet, in today’s economic environment the Fed’s balance sheet is far riskier than private banks’.

The Fed’s concern about banks is whether they can survive another economic shock.  For the last few years that was assumed to be another sharp decline in the economy and surge in unemployment.  Only recently have they admitted today’s biggest threat – a sudden rise in interest rates.

When interest rates rise, bond values fall.  Institutions holding bonds find the value of assets on their balance sheets falling.  The longer the bond duration, or the greater the percentage of the portfolio, the bigger the value lost.  The institution finds itself less able to cover its liabilities.  Confidence in the institution falls.

Here’s the problem.  Long-term bonds are only about 14 percent of banks’ balance sheets, while they compromise almost 90 percent of the Fed’s. So, as interest rates rise, confidence in the Fed is destined to fall more than for banks.

The Fed’s vulnerable position is a result of its easy monetary policy over the last six years.  It all started harmlessly enough.  When the economy dove into recession in 2007, the Federal Reserve bought T-bills to shove down short rates.  But after the Lehman Brothers debacle in 2008, the Fed began to target the other end of the yield curve.  First it bought mortgage-backed securities in a futile attempt to keep mortgage rates low and revive the housing market further.  When that did not do the trick, the Fed switched to selling those securities for 10-year Treasuries to push long rates in general southward.

Yet economic growth remained surprisingly slow and unemployment stubbornly high.  Enter the next Fed policy – “Operation Twist.” The goal was to flatten the yield curve by buying 10-year Treasuries in exchange for T-bills.  Then came a policy of open-ended purchases of long term securities.  The initial mandate to buy about $40 billion per month in long-term Treasuries eventually morphed into today’s policy of gobbling up monthly $85 billion of Treasuries and mortgage-backed securities.

As a result, comparing today’s Fed balance sheet to its balance sheet before the recession yields two stark differences.  First, the size of the balance sheet has tripled from less than $1 trillion to more than $3 trillion.

Second, the asset composition has changed dramatically.  At the start of October 2008 long-term Treasuries were about 30 percent of the portfolio.  Now they comprise almost twice that proportion (56 percent). The proportion of mortgage-backed securities also soared. In October 2008 the Fed’s balance sheet had few if any mortgage-backed securities. Today they are one-third of the total.  In other words, today long-term assets make up nearly 90 percent of the portfolio.  The average maturity of the balance sheet is over 10 years.

Imagine 10-year rates suddenly jumping to 4 percent from recent lows.  The Fed’s assets shrink by about half a trillion dollars.  On the other side of the sheet, the Fed still has over $3 trillion in liabilities, but significantly less to back them.  Investors will begin to question the Fed’s ability to stand behind the dollar. The value of the dollar on international markets likely will fall, triggering inflation.  That inflation might not stop until the purchasing power of all those dollars the Fed created are again in alignment with the value of the assets – cumulatively over 16 percent.

It would be comforting to propose an easy out for the Fed.  However, they have painted themselves into a corner.  They could continue buying up long-term assets, but that only increases the eventual exposure.  Stop, slow down or reverse that policy, and the market will quickly force rates significantly higher, setting off the negative scenario.

In short it is not a question of if such a scenario will happen, but rather when and how severe. The coming loss of purchasing power is a threat to us all.  Let’s stress test the Fed, find out how bad it will be, debate the outcome and determine how to minimize the impact.

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