Following our latest Fed balance sheet update, where we get another confirmation that for another week the Fed's assets have hit a fresh all time record (Bernanke now owns nearly $200 billion more Treasurys than China), there are two items that we believe deserve far closer scrutiny. The first is the as expected drop in MBS and Agency prepayments, which after seeing an initial surge in activity when rates were low enough to merit prepaying existing mortgages, has now plunged. In fact in the last several weeks the average prepay activity is roughly half of what it was in the September-December period. This is critical as it impacts the amount of debt the Fed can monetize via the QE Lite component of the ongoing monetization procedure. Should this weekly prepayment amount remain constrained, the Fed will have far less of a marginal impact on share prices (which is what POMO ultimately is) then if QE Lite was working at its expected $25-35 billion a month monetization run rate (in addition to the $70-80 billion from QE 2). Yet far more questionable is the recent surge in "Other Federal Reserve Assets" - an observation we have commented on previously, yet which we attributed merely to capitalized accrued interest on the Fed's portfolio. However, following the recent remittance of tens of billions in interest expense from the Fed to the Treasury we now know that is not the case, so we kindly request that the Fed answer the following simple question: just what is the key driver in the growth of this asset category, which in the week ending March 23 hit a fresh all time high of $120.4 billion? In fact, we are rather stunned that nobody before has asked just what "other assets" comprise a line item that is greater than the GDP of about 80% of the world's countries.
Charting the change in the "Other assets" category in time:
Here is how the Fed defines this catch all category:
This item includes other Federal Reserve assets and non-float-related as-of adjustments. In addition to the as-of adjustments, there are many components in this category, including the following major items:
Assets denominated in foreign currencies: Foreign currencies are revalued to reflect movements in market exchange rates each day. If, in the revaluation, the value of the currency increases, then other Federal Reserve assets increase. On the other side of the balance sheet, "Other liabilities and capital" increase because the increase in value of the currency becomes earnings, which are reflected in the earnings category within the capital account. Other liabilities and capital decline in value as the earnings are removed from this category and the U.S. Treasury's general account increases because the funds are remitted to this account at the Reserve Banks.
Since 1963, the Federal Reserve has occasionally agreed to warehouse foreign currency for the Treasury. In such transactions, the Federal Reserve takes the foreign currency from the Treasury in return for dollars provided to the Treasury. The Federal Reserve makes a spot purchase of the currency and protects the value of those currencies purchased by simultaneously selling the same amount of currencies forward at the same price to the Treasury.
When the Federal Reserve warehouses foreign currencies for the Treasury, both "other Federal Reserve assets" and "U.S. Treasury, general account" increase in value at the time of the spot transaction. Both accounts decline when the forward transaction is completed or when currencies are withdrawn from the warehousing arrangement prior to maturity.
Premiums paid on securities bought: This release reports Federal Reserve holdings of securities at face value, not necessarily at market value. If the Federal Reserve pays more than the face value for securities it purchased, the premiums over the face value are amortized as the securities mature. Part of the premium is transferred daily to the earnings category as a "negative earning." As the premium in "Other Federal Reserve assets" is reduced, a simultaneous balancing reduction is made in "Other liabilities and capital." Securities purchased at a premium over face value are accounted for in this way because, at maturity, the Federal Reserve Banks receive only the face amount of the securities, not the amount actually paid.
The premiums paid on securities bought under repurchase agreements, though, are not amortized. These premiums are, in effect, returned to the Federal Reserve Banks when the securities are repurchased by the dealer, since the negotiated price in the original transaction reflects the premiums.
Accrued interest and other accounts receivable: This item represents the daily accumulation of interest earned on U.S. government securities--other than bills--owned by the Federal Reserve or held under repurchase agreements, on loans to depository institutions, and on foreign currency investments. Interest is accrued daily.
Reserve Bank premises and operating equipment less allowances for depreciation: This item states the value, at initial cost, of the land and buildings of the Reserve Banks and branches less an allowance for depreciation on buildings, including building-related machinery and equipment.
If the accrued interest category is not applicable (which we believe may be the case as the value has not had a step down following the remittance of unpaid interest back to the Treasury), the only other possibility is the "Premiums Paid on Securities Purchased" - if indeed this is the marginal variable, then the Fed in essence confirms that since the start of QE1 it has overpaid in POMO operations by roughly $80 billion (the value trended at ~$40 billion pre QE1 and is now a record $120 billion). And one wonders where the Primary Dealers get their bonus money from these days...
Of course, since this is a non-exclusive list, it could very well be the catch all value of ES holdings warehoused at the Fed, that the FRBNY purchases from Citadel whenever the Plunge Protection Team goes active. $80 billion in ES purchases, magnified using HFT reflexive algorithms, can surely push the market up quite nicely...
Alas, this is all purely speculation - without further information and clarification from the Fed, there is simply no way to know. Luckily, we are confident some journalist will ask Ben Bernanke in April during the Chairman's first ever press conference just what this incremental $80 billion in "other assets" truly is.
Next up, here is a chart of the declining prepayments of MBS and Agencies. In essence, QE2+Lite is running at 80% of full power due to the recent spike in interest rates.
Another curious observation is the previously noted surge in the adjusted monetary base, due almost exclusively to the sudden jump in Excess Reserves, predicated by the now completed unwind of the SFP program.
The surge in Excess Reserves (which is at $1.4 trillion) and the AMB should now moderate a bit, although we still expect it to reach $1.7 trillion by the end of QE2, nearly double the amount of currency in circulation.
The change in the key holdings of the Fed's balance sheet since the start of QE2 is presented below: an increase in Treasury holdings, offset by a slowing decline in MBS, Agency securities, as discussed above.
For the convenience of all who claim that the Fed can simply keep the market on edge by being a marginal buyer of rolling Treasurys, we have some bad news. There are only $110 billion in Treasurys on the Fed's balance sheet that mature in under a year (and another $33 billion in MB). This combination will do nothing at all to appease a market which is used to seeing this much monetization in a month, let alone a year.
Last, here is a summary snapshot of the most recently updated Fed balance sheet.