Caitlin Long: Vulnerability of Fed’s Balance Sheet
Caitlin Long, head of Corporate Strategies at Morgan Stanley, shared a report they have distributed to their clients. (She gave permission for me to quote from it.) Caitlin is a former student from my Mises Academy classes, and was one of the first people Carlos and I interviewed in our Lara-Murphy Report. Here’s Caitlin:
* Several companies have recently asked us for an analysis of the Federal Reserve tapering its quantitative easing programs.
* One factor that is not widely analyzed is the Fed’s own balance sheet, which could be a constraint on how far and how fast the Fed permits interest rates to rise in the US
* We calculate that a 143bp parallel rise in the yield curve would cause a drop in the market value of the Fed’s assets that exceeds the Fed’s own equity capital (as of May 15).
— economically, the Fed’s balance sheet is a leveraged portfolio of bonds whose value climbs when interest rates drop (and vice versa) — see chart below
— key facts (as of May 15):
* leverage: the Fed’s $55.2 billion of equity capital supports $3.4 trillion of assets, for a leverage ratio of 61:1
— adjusting for the Fed’s $214.5 billion of unrealized capital gains (as of 12/31/12), its market-value adjusted leverage ratio is 13:1
* duration mismatch: the Fed’s maturity extension programs have caused its asset duration to reach 5.91 years, compared to its liability duration that is mostly “on demand” (i.e., zero), for a duration mismatch >5 years
— our calculation used the market value of each bond in the Fed’s portfolio as of May 15, 2013 (sources: http://www.newyorkfed.org/markets/sysopen_accholdings.html, CapIQ)
— the Fed balance sheet’s capacity to absorb higher interest rates has deterioriated quickly, as the 143bp capacity is down from 185bp as of last October (owing to higher leverage and reduced unrealized gains since then)
“We calculate that a 143bp parallel rise in the yield curve would cause a drop in the market value of the Fed’s assets that exceeds the Fed’s own equity capital (as of May 15).”
Did Caitlin include the Fed’s non-borrowed, thus equity asset, which consists of the discounted values of future money printing? Seems important.
God, I hate this:
Who CARES about the Fed’s balance sheet? The Fed isn’t supposed to be a private, profit making institution. It has a dual mandate.
M-F- probably not, thats what would casue the Fed to survive and send extar money to the Treasury from the bonds it buys.
Oh and by the way, your chart earlier, it doesn’t prove anything, except that re-allocation was taking place long before the crash happened. Its consitent with Scott Sumner’s hypothesis
You’re totally lost. This has nothing to do with the Fed breaking even or making a profit, it has to do with the impossibility of it to unload its balance sheet in the event of increasing inflation. In other words, they have no possibility of an exit strategy.
“it has to do with the impossibility of it to unload its balance sheet in the event of increasing inflation. In other words, they have no possibility of an exit strategy.”
The Fed could always offer to pay an even higher interest rate on reserves. That ought to buy it some time. Or worse, it could declare the money the banks lent to it, null and void.
“The Fed could always offer to pay an even higher interest rate on reserves”
I already assume that’ll happen in such a case, but they will then be highly undercapitalized, which ultimately means default.
“Or worse, it could declare the money the banks lent to it, null and void.”
That sounds like a plain default to me, one that will cascade throughout the system.
“I already assume that’ll happen in such a case, but they will then be highly undercapitalized, which ultimately means default.”
Can you describe this in more detail?
What I am thinking is this: Let’s suppose that inflation is very high, and the Fed does not have sufficient capital to soak up reserves to contain inflation.
Why isn’t paying higher interest on reserves sufficient to containing the inflation?
Attracting, say, $1000 billion of reserves in loans, and paying out $100 billion (assume 10% IOR) in interest, which can be lent right back to the Fed at 10% which pays $10 in interest, which lent back pays…you get the picture.
None of this money has to “leave the central banking system.”
I don’t see how the Fed can ever be compelled into default, or be unable to contain inflation.
@M_F
high treasury yields should force Fed to raise IOER and a higher IOER should in turn raise treasury (and other market) yields and so on…
no?
Shailesh:
Why should a rise in IOR raise market yields?
MF, I am not sure though but I think if the FED would increase interest on excess reserves it might delay some events but cannot stop them.
Imagine inflation picks up and that the FED could not afford or risk (might get the government in trouble or some other holy market) selling enough assets from its balance sheet to suck up enough excess reserves to bring inflation down, then the only possible way to “tighten” was to increase interest payment on those reserves. I would argue every interest payment on those reserves will let them become bigger relative to the FED’s balance sheet, further decreasing the possibility to suck up all excess reserves at some time. Increasing the balance sheet with further purchases would not help in turning this ratio back since this is just an equal amount of new money added to excess reserves that now also is demanding interest as well. Mind you the FED can print money but not assets.
This means finally the FEDs balance sheet would become totally useless in managing monetary policy and only interest rates on excess reserves remain. Declaring excess reserves null and void would completely destroy trust in the FED, and if it worked it will work only once. I guarantee that they would need to declare all excess reserves null and void at once or what is left will (no matter the interest on excess reserves) go back into the economy increasing inflation. However if all excess reserves are canceled out then all those TBTF banks will be capital impaired and go down. I doubt that this will ever happen.
So what is left then are ever increasing excess reserves on which banks can earn risk free income. I am really not sure what now might go on from this point on. However it just doesn’t sound promising to me, if the only way to bring down price inflation, is to print money… What do you think?
It is important to note that currently (as far as I know), interest on excess reserves is paid out of the income the FED gets from its assets. At some point this income would not be enough, which is why I wrote they will need to print new money to pay interest on excess reserves…
I was thinking along very similar lines.
When the Fed creates money it hands out that money in exchange for someone else offering it a treasury bond or an MBS. Thus, the reverse transaction is required for the Fed to unwind the position — someone has to use their money to buy a treasury bond from the Fed.
Generally speaking, raising interest rates should be a cure for inflation, but if interest rates go up, that would devalue the bonds that the Fed is holding right now. The Fed will have to sell those bonds cheaply in order to get rid of them.
The more interest they pay on the reserves, the more difficult it becomes to sell their assets. Only an outright tax can fix this — if the Fed can somehow just demand the money be handed over.
Think about it from this point of view… holding money represents an intention to consume at some future stage (Say’s Law). So if the Fed pays 10% interest on reserves, it is in effect bribing people to not consume now by promising them more consumption in future. Only if those people are willing to defer indefinitely will the money stay out of circulation, but indefinite deferral of consumption is no consumption at all!
The other problem of course is that the US government is the biggest payer of interest to the Fed, so if rates go higher, the US government is rapidly going to run out of capacity to pay. The government will insist it can keep getting cheap loans.
“M-F- probably not, thats what would casue the Fed to survive and send extar money to the Treasury from the bonds it buys.”
That’s why it’s important.
“Oh and by the way, your chart earlier, it doesn’t prove anything, except that re-allocation was taking place long before the crash happened.”
The widespread reallocation, with all the temporary unemployment, *is* the bust.
“Its consitent with Scott Sumner’s hypothesis.”
Market monetarism doesn’t “allow” for sector readjustments as the meaning of recessions. It considers them as purely monetary.
Unemployment started rising from a local minimum in early 2007.
http://research.stlouisfed.org/fredgraph.png?g=iYe
The “bust” was already underway by the time late 2008 rolled around.
Yes, nuch was known in 2007 Bernanke even said to expect a buge decline in housing values back in 2007. I was really confused at the time by how long the market drop took to hit.
“that’s what would cause the fed to survive and send extra money to the Treasury from the bonds it buys
“Unemployment started rising from a local minimum in early 2007.
http://research.stlouisfed.org/fredgraph.png?g=iYe
The “bust” was already underway by the time late 2008 rolled around.”
Pathetic. A minor blip, compared to the huge jump in late 2008.
Edward, you are clearly only seeing what you want to see.
Busts are not instant double digit unemployment periods. They gradually arise over time. Individuals, sequentially and at their own individual times, come to realize that their separate plans are in error, and act, as individuals, accordingly.
Booms don’t instantly end and busts don’t instantly occur. The economy is far more complex than that.
Your problem is that you are not thinking like an economist, despite the fact that you are engaging economic phenomena.
Economics is the study of individual actions, and individual acts of wealth production.
With near 300 million individuals in the US, engaging in very diverse productive activities, who have diverse economic plans, if there is something wrong with the capital structure of the economy, there is no mystical God or central computer that tells everyone at the same time that there is a problem, such that everyone realizes their errors at the same time, and lays off people at the same time.
Some individuals experience problems before others, due to the nature of their productive activities, and their relative valuations by end consumers. Some individuals realize their errors sooner than others, due to their relatively superior knowledge.
Busts are gradual, not instant, in the temporal sense.
The huge jump in late 2008 was after less huge jumps just before late 2008, which was after lesser than less huge jumps just before that, and so on.
There is no one day that “the bust” began. It was gradual, individual by individual.
The reason there was a small jump in employment in early 2007 was because around that time the first individuals realized there was “a problem with the capital structure”, as manifested in their own particular projects that were different from other people’s projects. Then, somewhat after that, more individuals realized their errors. This process of acceleration continued, and would have eventually come to and end via people using the free market process. But the Fed put an end to it artificially, through issuing more green pieces of paper, to stop more individuals from realizing their errors. So at some point, unemployment stopped falling, and reversed, not because the projects that replaced the old ones were closer to being sustainable, but because of the same old tired state “solution”: delude investors by funny money, and hope that they continue to “do something” which changes the “employment” statistics.
Now we’re currently in another boom, which again requires widespread corrections, but this time, even more because the Fed, again, did not let the market process be the utilized method of interpersonal activity.
Just like the 2008 bust was worse than the 2001 bust because the Fed did not let the corrections be carried out by the market process, so too will the corrections currently needed will feel even worse than 2008.
Joseph Fetz.
I hate to agree with MF, but of course they have an exit strategy: They can increase interest on reserves. They can slow major purchases, in other words, ‘passively
‘ let the money supply decline.”
Which is what REALLy happened in late 2008,
MF.
And we aren’t in a boom. That idea is laughable
“Which is what REALLy happened in late 2008,”
The money supply rapidly increased just prior:
http://research.stlouisfed.org/fredgraph.png?g=iYu
“And we aren’t in a boom. That idea is laughable.”
It’s only laughable to those who don’t understand the market process, and who believe that booms cannot occur with struggling employment growth.
We are very much in a boom. It’s just not a boom that has low unemployment like the last one.
Booms are not composed of employment or price levels. They are composed of the capital structure and the plans for the available capital.
The Fed is not raising interest rates to near zero by its activity, it is pushing them down by its activity, and has been for many years.
Just like people like you were clueless during what many people call “the housing boom”, so too are you clueless now. You people don’t seem to be able to learn from your mistakes.
“The money supply rapidly increased just prior”
Even more, it shows the MZM money supply continued to increase except for a very short time in 2010. M2 NEVER declined.
The capital structure can sort itself out without requiring massive, disastrous unemployment.
Just look at Japan’s recovery from the 2011 tsunami. Here we have a natural experiment comparing the supply side view with the demand side- a negative supply shock on a very advanced economy, and there was no enormously large uptick in unemployment.
That isn’t to say their was no impact on wealth or Japanese living standards. If we are poorer than we realize in real terms during the boom years, then when the bust arrives, shouldn’t we have LESS unemployment and shouldn’t we be working HARDER to increase the supply and quality of real goods in the economy?
“The capital structure can sort itself out without requiring massive, disastrous unemployment.”
It cannot sort itself out with massive, disastrous monetary manipulation.
“Just look at Japan’s recovery from the 2011 tsunami.”
Just look at the absence of significant inflation of the money supply.
“Here we have a natural experiment comparing the supply side view with the demand side- a negative supply shock on a very advanced economy, and there was no enormously large uptick in unemployment.”
Austrian theory does not predict specific sizes of increases or decreases in unemployment during credit cycle busts, let alone natural disasters.
Your tests are moot.
“Austrian theory does not predict specific sizes of increases or decreases in unemployment during credit cycle busts, let alone natural disasters.”
A theory with very limited explanatory and/or predictive power is not very useful at best, and completely worthless at worst.
“Your tests are moot.”
translation: I don’t like the results of the test, so I’ll deny it’s relevance.
Edward,
You said we are not in a bubble. What would it take to create a bubble then?
“A theory with very limited explanatory and/or predictive power is not very useful at best, and completely worthless at worst.”
Exactly, which is why Keynesian/monetarist models are completely worthless, since they did not predict the crash.
“Exactly, which is why Keynesian/monetarist models are completely worthless, since they did not predict the crash.”
Yup. As RPM recently said in a post on Krugman, RPM got the magnitude wrong, Kruggy got the direction wrong. (% inflation / deflation prediction). Although Kruggy did predict the housing bubble in 2006, after he called for its creation years prior.
This quote from Mises applies,
”
In the realm of physical and chemical events there exist (or, at least, it is generally assumed that there exist) constant relations between magnitudes, and man is capable of discovering these constants with a reasonable degree of precision by means of laboratory experiments. No such constant relations exist in the field of human action outside of physical and chemical technology and therapeutics. For some time economists believed that they had discovered such a constant relation in the effects of changes in the quantity of money upon commodity prices. It was asserted that a rise or fall in the quantity of money in circulation must result in proportional changes of commodity prices. Modern economics has clearly and irrefutably exposed the fallaciousness of this statement. ”
Understanding our limitations does not make Austrian economics limited in use or worthless. In fact it makes Austrian economics far more valuable. Keynesians and MMT essentially preach that we should not have full employment. The solution to achieve this is counter to how micro econ works. It requires a belief that there are no unintended consequences when printing money and mass government spending.
Mike Norman just stated that printing more money leads to more goods and services……..
We are essentially told that the economy should be managed by politicians, people that make even Keynesians shake their heads. One should seriously doubt an economic school that says we never have to face hard times after wreckless and stupid decisions en masse. The same school that called for burying money and hiring people to dig it up as a solution. The same basic economics apply whether in a strong economy or weak one. Lowering productivity destroys society’s wealth. It should never be “good” to purposefully lower productivity.
“A theory with very limited explanatory and/or predictive power is not very useful at best, and completely worthless at worst.”
I guess mathematics, formal logic, and philosophical inquiry are not very useful at best, and completely worthless at worst.
“translation: I don’t like the results of the test, so I’ll deny it’s relevance.”
No, the tests are moot. It doesn’t even matter what the results are. Either outcome doesn’t matter.
I don’t think “losing money” is even relevant for the FED. Right now they pay their “profits” to the Treasury. Assume interest rates rise enough to half the mark-to-market value of their portfolio. So what? They can raise reserve requirements on increase IOR. They won’t go bankrupt and they don’t need money from the Treasury to pay their bills. Ditto if they just called the president and forgave every cent of debt they hold.
Agree. The FED cannot be bankrupted. It has the power to do as it likes, and to influence the money supply to do as it likes. It has all the tools it needs. It just cannot control the economic response to its actions.
The only question is 1)what the big banks want it to do, and 2)whether or not political forces will be brought to bear on its activities. Congress could always nationalize it, if push came to shove, and that sword hanging over its head could potentially push policy in a direction unfavorable to the banks.
Otherwise, it’s whatever the banks want.
I laugh when people talk about Krugman knowing about the housing Bubble in 2006… I knew we had a bubble in 2003 and saved for it accordingly believing it would ‘burst’ in 2005… But it didn’t It kept going until 2007/8 due to market distortion via the FED and banks new packaging system.
As far as the Fed over leveraging itself. Well duh. The real question is what will the long term consequences be if inflation roars to life.
Now we are not Currently in a bubble. ( or else we are always in a bubble ) However I think we are priming the pump for the next bubble. I do not think we will see anything ‘burst’ for a good 2 – 5 years. I am betting on four and a little from now.
Should you ride the Bull? I prefer to wait and save my nickles now for when cash will be king in about four years and things go to pot again and then ride the next one up…. My guess is this current market has about 15% additional rise in it before it stagnates for a while and then pop goes the weasel followed by about a 35-45% drop.
It will be interesting to see what the Fed will do ‘again’ at that point.
“I prefer to wait and save my nickles now for when cash will be king in about four years and things go to pot again and then ride the next one up…”
You are not innocent you are a hoarder! It’s your fault that the economy is not really picking up and the FED cannot pull out of its unusual programs and normalize interest rates etc… Free yourself from your animal spirits and let your expectations be wax in the hands of Bernanke.
Greg Weldon released a couple of charts showing that Median New Home sale price has topped the previous mid-2007 high to set a new all-time record, and that Single-family home sales have risen back up out of the historically low level and are well on their way back to the long-term average level. This coincides with reports that hedge-funds have basically bought up most of the available foreclosures, and have begun buying new homes directly from builders!!
IMO, this puts us firmly into the early bubble stage. Given that this appears to be driven purely by hedge-funds, and still has the chance for a lot more people to enter going forward (though presumably not as many sub-prime buyers as before), this bubble could grow quite a bit, so I agree it could be years before it pops, but given the unhealthy state we’re starting from, and the stage it’s already reached, I’m not sure it can go four years. Purely my gut feeling, but it could pop in less than two.
I grant that underestimating the ability of investors to ignore bubbles is a perennial trap for any prognosticator.
Didn’t read through all the above, but the Fed can raise reserve requirements. I don’t think they ever intend to sell the QE purchase, just hold and mature.
So the Fed has no equity. In the private world, this results in a run when it seems inevitable. Who is going to call their Fed deposits when they can be required by law? Where would they put free dollar reserves in that market environment, given that required reserves at the theoretically insolvent Fed would comprise about 100% of the capital in the private banking system? As long as the dollar is ok, the Fed would be the ‘least dirty shirt’.
It either doesn’t happen or it is part of civilization’s biggest currency crisis, right?
For those who think raising reserve requirements was an easy answer.
http://mises.org/daily/5110/