I spent part of this afternoon reading an article discussing the Fed’s balance sheet in the US and was shocked when I read that they are 50 times leverages at the moment. To put that into perspective, I wrote a research paper on the affects of leverage on financial institutions and found that Bear Stearns maximum leverage ratio was 38 to 1, which was reached in September of 2007. While this afternoons article, written by John Maudlin, points out that the US government has a greater leverage ration then Bear Stearns and the same amount of interest rate risk, they do have less default risk.
The Fed’s balance sheet is composed of “1.3 trillion in treasury debt, 937 billion mortgage securities (Fannie and Freddy), 132 billion of direct obligation of Fannie, Freddie and FHLB and nearly 80 billion in TIPS and T-bills.” (1) According to Mauldin, the distribution of these assets have a duration- which means the sensitivity of the price to changes in interest rates, of roughly 6 years for ever 100 bp hike in long term interest rates.
So what this really comes down to is the fact that based off the duration of the Fed’s assets and the reality that they only own 2% of these assets, if the country increased long term interest rates by 2% the value of the Fed’s assets would be “wiped out” (1)
Given this fear mongering talk I am spreading today, I should mention that the paper goes on to describe that the Fed’s do earn an interest rate spread of about 3%, which will provide a 50 bp rise in interest rates before we would see a decrease in the fed’s capital. So what Mauldin expects would be that the interest paid on federal debt held by the treasury would be used to cover any losses in the Fed’s capital, rather then being paid to the treasury.
Reading Mauldin’s thoughts, I was shocked and thinking that the Fed’s money managers need to take some time to take a class on Financial Institution Risk Management, so that they can realize the situation and how has been reflected in the leverage and duration of other financial institutions that have been either wiped out or would be shut down by regulators based on recent history.
So what value does this blog have today? Well basically the above conversation leads to what the fed’s can actually do to interest rates, according to Mauldin, they have three options:
1) Economy weakens; leave interest rates unchanged and initiate a round of quantitative easing. In this situation, we would expect not to see inflation, if interest rates are controlled to a low rate. However- the larger the monetary base, the lower the rate must be.
2) External pressure on short term rates. In this circumstance, Mauldin sates that we would see a rapid contraction in fed’s balance sheet as they sell to avoid inflation developing.
3) Intentional reduction in the balance sheet. This model would have the Fed’s gradually moving interest rates and is Mauldin’s first recommendation even
though the increase in interest rates would cause a giant size reduction in the Feds’ balance sheet.
We can see what happens when any institution, whether that is an individual, financial institution or a government has too much leverage, it becomes impossible to drive into the future without experiencing some unpleasant events. Stayed tuned for Wednesday announcement from the Feds.
1) Mauldin, John. (April 18th, 2011) Charles Plosser and the 50% contraction in the Fed’s Balance Sheet. Retrieved on April 25th, 2011 from: www.johnmauldin.com

Bookmark It

Hide Sites