With Geoffrey Batt
The ongoing troubles at the GSEs are no secret: it is public knowledge that Fannie had a 5.38% delinquency rate at December, while Freddie just passed the 4% threshold in January; both continue to rise rapidly each month. The fact that the mortgage-bond spread has just hit a record tight is merely an ongoing artifact of the Fed's endless meddling in the mortgage market, with the sole purpose of keeping rates artificially low, and preventing banks from being forced to take massive writedowns on their entire loan book. This is all well known. What, however, seems to have escaped public attention is what the impact of these delinquencies is on the one largest holder of Mortgage Backed Securities, the Federal Reserve. What also seems to have escaped the public is that the Fed is now the world's largest bank, with total assets near $2.3 trillion. We provide a weekly update of the Fed's balance sheet and while we briefly note the liability side, our, and everyone else's, attention, is traditionally focused on the asset side. Yet a more detailed look at the liability side reveals something very troubling, specifically that the Fed's capital, i.e. equity buffer, which as of most recently was $53.3 billion (a comparable metric for plain vanilla banks is their equity buffer, or Tier 1 Capital, or however the FASB wants to define it on any given day when it is covering up massive capital shortfalls) is in fact negligible and could well be substantially negative, if the Fed were to account for the rapidly rising level of delinquencies in its one largest asset holdings: the $1.027 trillion in settled MBS. And while there is no possibility of a run on the Fed, the reality is that the Fed now likely runs with a negative real capital balance, meaning that the US Federal Reserve is now essentially insolvent.
First, we present the Fed's assets broken down by key segments. The chart below shows the most recently disclosed asset holdings as per the H.4.1 statement. Of the $2.3 trillion in assets, the vast majority, or $1 trillion is held in MBS. As pointed out previously, this is only the settled amount - in reality the Fed has already purchased $1.22 trillion in MBS, which will settle over time. In practice, this merely means that the potential for asset impairment at the Fed is even greater by about 20%.The chart also shows what happens to MBS holdings if haircuts of 5%, 10% and 15% are applied.
Like any balance sheet, where there are assets, there are liabilities, and some version of capital/equity. The Fed's liabilities are two principal components: currency in circulation, which has been at about $900 billion for an extended period of time, and the much more relevant recently line item called "Bank Deposits", which has been popularized as Reserves with Federal Reserve Banks (or excess reserves). The Reserve line has increased from essentially nothing to nearly $1.3 trillion in the span of a few months. Furthermore, as more and more MBS purchased are settled, the excess reserve line will soon reach at least $1.6 trillion, if not more, if indeed Q.E. 2 is launched at some point in the future. The persistent discussions of potential inflation center precisely on the interplay between the green and blue blocks in the chart below: as long as the Currency in Circulation is flat, and Bank Deposits keep rising, the probability of inflation is slim to none. In essence, excess reserves exist only due to the Taylor rule implied negative Fed Funds rate. Should there be a material shift from green to blue, or from excess reserves to currency in circulation, that is when the hyperinflationary threat becomes all too real, as suddenly far too much money will chase a fixed amount of assets. This is also where the discussion about all the various mechanisms that the Fed has at its disposal to moderate tightening comes into play, whether it involves selling of assets, increase of the rate on reserves, or some combination inbetween (we point readers to yesterday's paper from the Minneapolis Fed which discusses these options, and the caveats associated with each). While the asset reallocation debate is very interesting, it is not the topic of this discussion.
The one item on the balance sheet that is often ignored, is the Fed's "Equity", or as it is defined, "Capital." As previously pointed out, this line item is currently $53.3 billion. It is shown graphically in the leftmost column of the chart below, which depicts actual Fed liabilities. Where the interesting part comes in, is when one analyzes what happens to the Fed's capital when the abovementioned MBS haircuts are applied.
A 5% realized haircut on MBS alone would result in a complete elimination of the Fed's capital balance. Applying a 10% or even 15% haircut, results in a capital deficiency of $50 billion and $100 billion respectively. This deficiency will grow as more and more MBS are settled, and as the serious delinquency rate on MBS keeps increasing (no danger in this moderating any time soon).
Now in an environment, such as the one we live in today, when mark-to-myth is the new normal, and when banks are encouraged to come up with creative ways to indicate that their Residential and Commercial Loan portfolios are worth par (despite recent disclosures by the FDIC), to assume that the Fed would do something that lowly depositor banks are told not to do, would be folly. Yet, for those who prefer to live away from Never Never land, and brave this thing called reality, just what will happen if and when the Fed finally does disclose that it is, for all intents and purposes, insolvent?
The pragmatics among you will say: this is irrelevant, the Fed can just print more money and fill in any capital hole. Well, yes and no. As an increase in cash would have to be offset by a comparable increase in some asset, it is not that simple. For a refined analysis of what would happen in that moment of clarity when the world realizes the world's biggest bank is broke, we turn to a presentation by Chris Sims, given before Princeton University, titled "Fiscal/Monetary Coordination When The Anchor Cable Has Snapped." We encourage all readers to read this powerpoint cover to cover, as it discusses precisely the issues were are faced with today: namely a monetary policy that has run amok, seignorage, exploding excess reserves, the impact of these on "power money", and, in general, a Fed balance sheet that is increasingly reminiscent of a drunk, rapid and schizophrenic bull in a China store.
Among other relevant things we note that as the author points-out that "Interest bearing deposits at the Fed do not (yet) count against the Federal debt ceiling" and "if substantial interest is paid on reserves, they could constitute a major leak in the US system for legislative control of debt creation or they are not backed by the full faith and credit of the US government, which has implications for inflation control" - the consequences here are material - with a $1 trillion plus in vacuum interest-collecting paper which in all other world would be counted toward the debt ceiling, the US debt subject to limit would increase from the $12.5 trillion currently to about $13.7 trillion. Add in $6 trillion from the GSEs and America is already at the dreaded $20 trillion threshold. And furthermore, what happens to the interest payments by the Fed should rates go up to 100 bps, 200 bps? On $1.6 trillion in excess reserves this is a material amount that would reinforce inflation in a circular loop, further justifying why the Fed is mortally worried about a rise in rates.
As for the topic at hand, we turn to pp 23-24 of the presentation:
- Central bank operations generate fluctuating levels of net earnings (seigniorage), most of which are turned over to the Treasury as revenue
- Central bank balance sheets sometimes go into the red. The Treasury may then recapitalize it by creating, and giving to the central bank, new government debt
- [The Fed's] Independence meant that the legislature and the Treasury did not complain [much] about seignorage fluctuations or about the effect of interest rate changes on the Treasury's interest expense
- Fed can always "print money" to pay its bills.
- There is no possibility of a run on the Fed, since its liabilities make no conversion promise.
- A commitment to a path for inflation or the price level makes the balance sheet matter.
- Without Treasury backing, the Fed must rely on seigniorage to raise revenues, and that can conflict with inflation-control goals.
So here is the crux of the issue: the only way to deal with a mark-to-market of the Fed currently is to embrace monetization. It is no longer a question of semantics, of who promised what: it is the only mechanical way by which the Fed can dig itself out of a capital deficiency. With GSE delinquencies exploding, and with the Fed (and Congress) singlehandedly facilitating imprudent lender policy by allowing ever more borrowers to become deliquent without consequences, the MBS delinquency rate will likely hit 10% over the next 6-12 months. At that moment, someone will ask the Fed: "what is the true basis of your capital account?" And when the Fed is forced to justify a valid response, is when monetizaton will begin.
Since the market deals in expectation absolutes, all it would take for rates to breach the inflection point black swan and commence going up, is the mere possibility of open monetization.
What we hope to show with this exercise is that no course of action, even the one currently employed by the Fed, can continue in perpetuity: you can't have infinitely low housing rates in an environment of exploding delinquencies, as even more MBS are onboarded on the taxpayer's balance sheet. The reality is that inflationary conerns will come to a fore, and have a material impact on rates, the second all these speculations are voiced in a more reputable arena. At that point the game will be up; the Fed's attempt to continue the status quo will be over, and the relentless rise up in rates will begin, culminating with the long-awaited Minsky moment.
As for the timing of this development? We will join the Bob Janjuah camp on this one. While few have the guts to take the money printer head on, doing so early is certainly suicidal. Yet with each passing day, all those who are fully aware that the Fed's course is one of self-destruction, grow bolder, until finally one day a new class of investors - the Fed vigilantes will emerge, looking for cheap opportunities to make a killing (think ABX) on the other side of the "Fed trade", which ultimately will lead to a systemic catharsis of unprecedented proportions.
At that point neither gold, nor lead will be in any way useful. Beta and gamma radiation will make sure of that.