You may have seen this news too.
If you, like me, are a member of the Antife (Anti Fed) you may be cursing the day. “Curses!” you shout. “There goes the Fed again! Losing taxpayer money! Our money!”
My friend, Professor Anthony Sanders, finance professor at George Mason University, pointed out to us yesterday that the Fed just reported that it has $66 billion of mark to market losses on its balance sheet. Horror of horrors!
Well woop de doo. The Fed doesn’t mark to market for a reason. It never sells anything. It will never be forced to sell anything.
The Fed does not need capital to operate. It can, and does, conjure money in and out of existence at will. And eventually, as its bond holdings mature, it always gets paid. Or at least so far, it has always gotten paid. So, marking to market is a nice philosophical exercise, but in practical terms, it’s meaningless. It has no impact on the market. It never will have an impact on the market. It should play no role in your thinking about investing or trading.
But boy are there plenty of reasons to pay attention to the Fed’s balance sheet, which is what I do a large part of my work time. I do it so that you don’t have to, and mostly because I have come to believe over 55 years of following markets that, while it might not be the only thing that matters, it sure as hell beats whatever comes second.
First, let’s look at this mark to market business. Here’s what is critical for you to know.
The Fed doesn’t mark its securities holdings to market. It carries them at cost all the time. And that’s ok. The Fed never sells.
As we know, the Fed is shrinking its balance sheet, reducing the size of its bond portfolio. But the Fed isn’t selling that paper. It’s simply allowing it to mature, and demanding that the Treasury pay off the paper it holds.
The Fed’s Treasury holdings mature at a known, scheduled pace. The Fed also holds Federal Agency and mortgage backed securities (MBS) which get paid off at a semi predictable pace.
In the past, when the Fed’s Treasury holdings matured, it always rolled the paper over. The Fed bought new debt from the US Treasury to extend the loan it had made to the Treasury under the original purchase bonds that were maturing. These transactions always took place at par. The Fed never lost a nickel on its Treasury holdings and never will, whether it rolls the paper over or demands repayment.
Trade Me or Pay Me!
While most of the bonds it bought in the past are now worth less than par if sold today, the Fed isn’t selling, so it doesn’t need to pretend that its portfolio is going to cost us taxpayers $66 billion. It won’t. The Fed will do one of two things. It will simply wait for the bonds to mature, and roll them over, relending the money to the government. Or under its balance sheet “normalization” program, it will tell the government, “Pay me back!” And the Treasury will have no choice but to do it.
They Fed has been doing that for a year already. The Treasury pays off the loan the Fed originally gave it in the form of bonds. The money to pay off the loan is withdrawn from the banking system and sent to money heaven.
Right now the Fed is redeeming its maturing Treasury note and bond holdings at the rate of roughly $30 billion per month.
It is also allowing $20 billion per month of MBS to roll off its balance sheet. In the normal course of business, borrowers pay off mortgages every day, either by making the final payment, or more usually, selling their property, or refinancing the loan. The MBS pools holding those mortgages get paid down. The Fed held $1.65 trillion of those securities as of December 12. That’s down $124 billion since October 2017, when the Fed started paring down its bloated securities portfolio known as the System Open Market Account (SOMA).
It hasn’t lost a dime on any of that paper, despite much of its current holdings being under water, that is, worth less than the Fed paid.
We know it will never lose a dime on its holdings of Treasuries, regardless of how much they may be under water. And so far, the Fed has been just fine on getting its MBS holdings repaid.
Here’s What Happens When House Prices Crash Next
But what happens when house prices plunge again and the value of the property collateral falls below the outstanding loan balances? We’ve seen this all too recently. When house prices fall, mortgages get foreclosed and there’s a lot of “jingle mail.” Jingle mail is when hopelessly under water borrowers simply stop paying the mortgage and mail the keys back to the lender. It was all just a decade ago that we witnessed that.
What happened? Fannie and Freddie were nationalized. The implied Federal Government guarantee that mortgage lenders would always get their money back became an explicit guarantee. So we taxpayers are, in a very real sense, now on the hook for any losses that accrue to the Fed’s MBS portfolio when house prices plunge.
I have no doubt that that will happen. So let’s do our own little Fed balance sheet stress test. Let’s assume that 30% of the mortgages go under water and that half of them stop being repaid. Let’s assume that those properties are liquidated at a loss of 30% below loan value. So we’re talking about a total loss to the Fed of a bit less than 5%.
In this test, let’s guess that these losses start to accrue in a year. By then the Fed’s MBS portfolio will be down to about $1.4 trillion. So we might be looking at a loss to the Fed, and ultimately to us taxpayers, of $70 billion. Normally these financial cataclysms unwind over a period of about 18 months. So we’re talking about a loss of $4 billion per month.
To put that in perspective, the Federal Government is currently borrowing an average of more than $100 billion per month at an interest cost of around 2.5%. So we’re adding annual interest expense of $30 billion every month. In the course of each year, the interest on the Federal debt is increasing at an average $180 billion per year, assuming rates don’t rise one iota. We know that they will continue to rise, but let’s not complicate this more than necessary.
The potential loss on the Fed’s MBS portfolio is barely even a rounding error in the big picture. Since there’s no tax increase on the horizon, and there’s zero sign that Federal revenues will outgrow the interest cost, the government will need to cover the interest expense by borrowing even more. In the big picture, yes, it’s maddening, but a $70 billion loss on the Fed’s mortgage portfolio over 18 months just isn’t that big a deal.
And if we’re going to recognize the Fed’s losses, then we should also recognize the hundreds of billions in unrealized gains in the Fed’s portfolio. Stay tuned for that story and more in Part II of this piece, coming Monday.
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