Fed Portfolio Duration Risk: $1.3 Trillion And Growing
The topic of the Fed's balance sheet has (rightfully) attained prominent status in recent weeks, due to the T-minus 3 months and counting until the last MBS are purchased on behalf of US taxpayers. Yesterday, the Federal Reserve issued an advisory on interest rate risk management that had the following cautionary language: "In the current environment of historically low short-term interest rates, it is important for institutions to have robust processes for measuring and, where necessary, mitigating their exposure to potential increases in interest rates." Ironically, it is none other than the Fed that due to its $1.8 trillion in outright security holdings may be best advised to heed its own warning, as it is on the hook for at least $1.3 trillion in interest rate risk.
As can be seen on the below chart, the Fed, in its quest to become the repository of every unwanted asset in existence, has accumulated over $1.8 trillion in assorted trash, with the bulk of maturities occuring in 2040, courtesy of its holdings of $908 billion in Agency MBS. Keep in mind these numbers will likely continue growing well past the $1.7 associated with just QE. We fully expect another $1 trillion in MBS to be purchased in QE 2.0 implying the Fed's balance sheet will likely come to rest at about $3 trillion in total security holdings (it also means you can throw out any hope for an efficient market out of the window for many years: if today's "good" NFP and consumer credit news are sufficient to result in an green close, we once again strongly urge you to pull all your money out).
Going back to the interest rate risk advisory, we note the following prophetic language:
Material weaknesses in risk management processes or high levels of IRR
exposure relative to capital will require corrective action. Such actions could include
recommendations or directives to:
- Raise additional capital;
- Reduce levels of IRR exposure;
- Strengthen IRR management expertise;
- Improve IRR management information and measurement systems; or
- Take other measures or some combination of actions, depending on the facts and circumstances of the individual institution.
We hope the Fed takes its own advice to heart. A simple analysis indicates that the duration of the Fed $1.8 trillion portfolio is over 17 years. In the warning, the Fed has said a move of 3-4% is to be modelled and expected:
As a result, institutions should regularly assess IRR exposures beyond typical industry conventions, including changes in rates of greater magnitude (e.g., up and down 300 and 400 basis points) across different tenors to reflect changing slopes and twists of the yield curve.
Applying a 4% IR shock to the Fed's portfolio results in 17 years x 4% x $1.8 Trillion = $1.27 Trillion. Furthermore, if as we expect the Fed's "assets" grow to $3 trillion, the portfolio risk becomes a stunning $2 trillion. Of course, the Fed can merely print money to bail itself out when it needs to.
Yet the Fed should certainly go through the abovementioned checklist of "recommendations and directives" and announce to US taxpayers, with whose money it gambles and continues to inflate the stock market to simply incredible heights, just what remedial actions it itself is taking to moderate Interest Rate Risk exposure.
h/t Mike C.