I was curious to take a look at the details behind the following story:
The Federal Reserve Board on Tuesday announced preliminary unaudited results indicating that the Reserve Banks provided for payments of approximately $46.1 billion of their estimated 2009 net income of $52.1 billion to the U.S. Treasury. This represents a $14.4 billion increase over the 2008 results.
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The reported $46.1 billion figure is a 37% increase over the fiscal year 2008 value (as reported by the U.S. Treasury) and nearly double the average annual amount returned from the Fed to the Treasury over the last two decades. The Fed earned some income in 2009 from the limited liability corporations it created to manage some of the unconventional assets it acquired, and also reported some income from its new loans. Coincidentally, the combined income from these items turned out to be exactly equal to the various expenses that the Fed reported, with the result that the $46.1 billion returned to the Treasury is exactly equal to the $46.1 billion that the Fed reported it earned from the interest on its holdings of U.S. Treasury securities, agency debt, and mortgage-backed securities.
From Table 4 of the Monthly Treasury Statements we can also see when during the year the Fed turned these receipts over to the Treasury. The sum of the monthly totals that the Treasury reported it received from the Fed during 2009 comes to $43.8 billion, a little less than the $46.1 billion that the Fed claims it delivered to the Treasury. My guess is that the discrepancy results from the fact that the Treasury has netted out what the Fed describes as “amounts reimbursed by the U.S. Treasury and other entities for services the Reserve Banks provided as fiscal agents” whereas the Fed’s $46.1 billion is a gross total that excludes these offsetting payments from the Treasury back to the Fed. In terms of the monthly breakdown of the $43.8 billion number, 77% of it came during the second half of the year.
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At the beginning of the year, when the Fed’s assets were concentrated in the various special new facilities, the Fed was returning less to the Treasury than it had on average over the previous 20 years. The big Treasury receipts began as the special lending facilities were wound down and replaced by outright purchases of Treasuries, agency debt, and MBS.
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I have suggested that the right way to think about these operations is that the Fed acquired the funds for these operations by borrowing them from banks in the form of the huge expansion of interest-bearing reserves. In essence, the Fed is borrowing short through banks’ excess reserves and lending long through the MBS purchases, and profiting from the interest rate spread.
The ultimate rationale for such actions might be that private banks should be conducting this arbitrage on their own, but are prevented from doing so by ongoing financial difficulties. The spread between the MBS yield and the overnight rate can be broken down into two components, the first being a risk premium and the second being a term premium. We can get an idea about the size of the risk premium by looking at the difference between the yield on 30-year fixed mortgages and 10-year Treasury securities. This spread averaged 170 basis points over 1971-2009. It was well above that value in the last half of 2008 and first half of 2009, but currently stands at 134 basis points, somewhat below the historical average. But surely an objective observer would agree that at the moment mortgages are a riskier investment than they typically were over the previous 40 years. When you look at the current risk premium, it seems hard to motivate continuing Fed MBS purchases on the grounds that private banks are asking too big a compensation for mortgage-lending risk.
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The second component of the MBS-overnight spread is the term premium, which we can measure by the difference between the yield on 10-year and 3-month Treasuries. This spread has averaged 176 basis points since 1982, but currently stands at 354 bp, about twice its historical average value.
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Some might think the point of the MBS purchases was not so much to arbitrage an overly high long-term yield as to do something to stimulate the economy, since Fed purchases of short-term T-bills clearly accomplish nothing in the current near-zero interest rate setting. However, the difference between what the Fed has been doing in 2009 and true quantitative easing is that under the latter strategy, the Fed would be funding the MBS purchases with zero-interest money, with the intent of the operations indeed being to get that cash into circulation rather than trying to construct a device to persuade banks to hoard it.
The problem with the Fed’s preferred tactic– borrowing short and lending long– is the same as that facing anyone else who plays that game: are you sure you’re going to be able to continue to roll over the short term debt (i.e., persuade banks to keep holding a trillion in excess reserves) or liquidate your long position (i.e., sell a trillion in MBS back to the market without loss) when the playing field changes?
But at the moment, borrowing short and lending long proved to be a very profitable trade for 2009.
The Fed has a couple advantages in the borrow short – lend long game. They don’t have mark-to-market requirements, and they don’t need to comply with Basel 2 or 3.
Of course when long rates go up, the current price of MBS goes down, so if they needed to sell they would take a substantial loss(do they have clawback provisions on their bonuses? Will we find the money to clawback?)
Then if they make 5% on their balance sheet, somewhere around 5% is what they can pay for liquidity draining measures like paying interest on reserves, term accounts and/or reverse repos. Just a short few years ago they thought interest rates needed to be 5.5%, so this is not a lot of money.
At some point this all hampers their ability to do the job they are supposed to do without resorting to the ultimate source of capital…the printing press. And selling a trillion of MBS will be disruptive to the long end of the market, especially when combined with the size of projected Federal deficits.
So I think in the future we will have a Fed that is even more conflicted in their decision making than they have been in the past.
Plus the fact we are likely to have sequels to the current financial crisis, and the Fed is running out of tricks to save banking, banking bonuses and keep alive the popular notion on Wall Street that God dropped Gabriel on Manhattan. I guess they can try adding another trillion to their balance sheet each time, and hope the world still believes in King Dollar, but you have to wonder when we hit some sort of limit here.
I hope this strategy works out better for the Fed than it did for Countrywide.
The following is probably not entirely correct:
“But surely an objective observer would agree that at the moment mortgages are a riskier investment than they typically were over the previous 40 years.”
Newer mortgages created after the subprime mess blew up (e.g. those created in 2008 and 2009) are probably the safest ever. Lending has over corrected from being too loose to now too tight.
Do we know if the Fed paid full price for the MBS?
If the Fed paid market price that accounts for the risk to some degree, than the risk/reward picture could be very different.
Another important missing info is the vintage composition of the MBS the Fed brought.
The Fed printed the money to buy the assets, not borrowed from the banks. The Fed paid for the securities by writing a check on itself, which gets deposited in the receiving bank’s reserve account. This increases the monetary base and depending upon the reserve multipler for the banking system as a whole can increase the potential money supply by a factor of 10 if the funds are held in the form of demand deposits (with some technical simplifications) or even more if the deposited funds are held in the form of time deposits that have no reserve requirements. The Fed could just as well have issued currency to pay for the assets, in which case the money supply would have gone up commensurately and the Fed would have made an even greater profit. In either case, its balance sheet would have increased by the amount of the securities bought as would the money supply. This is why the inflation risks have gone up. The Fed isn’t simply borrowing from banks.
“Newer mortgages created after the subprime mess blew up (e.g. those created in 2008 and 2009) are probably the safest ever.”
You are only thinking of credit risk. An investor in Agency MBS passthroughs should be far more worried about OAS and the absolute level of mortgage rates.
The following is probably not entirely correct:
“But surely an objective observer would agree that at the moment mortgages are a riskier investment than they typically were over the previous 40 years.”
Newer mortgages created after the subprime mess blew up (e.g. those created in 2008 and 2009) are probably the safest ever.
The risk isn’t default risk, it’s interest rate risk.
The Fed’s doing on a huge scale what the S&Ls did on a relatively more modest scale — and you know how that turned out for them when rates rose in the 1970s.
I still don’t understand why the banks are not using the fed’s strategy to make money by borrowing short and lending long. Shouldn’t they use their vast source of reserves to buy up MBS given the low risk premium?
Absent a resort to conuring up money from a computer, what % of people walking away from their mortgages (Fed-owned-MBS) would result in a technically insolvent Fed?
Well, at least they’ve earned their bonuses…
JDH said…
I’ll take a stab at what I reckon JDH meant:
I’m with Eisenbeis. The Fed doesn’t borrow from banks to fund its MBS purchases. It pays cash directly for them, like a pawn shop. Rates on government bonds are not relevant to the way gains and losses are recognized in this market, other than in the sense that the Fed should track its own purchases to the market’s favored means of funding, so as to help temper deflationary spirals. The gains and losses on ABS, in the meantime, are on secured capital which is marked to market just as they were prior to the crash. Inflation will not be a monetary phenomena this time any more than it ever was, and at some point Bernanke et al. should be given some credit for learning this. Their behavior over the last year demonstrates that they do have a method approach, but to measure it or make meaningful statements about it first requires a recognition of what processes are actually in play. And in this case, as always, the processes are market processes, not Fed processes. That the Fed occasionally holds up a mirror in place of its public face does not mean that the Fed is the origin of national solvency, or insolvency.
The Fed simply does not have the power or the macroeconomic meaning that so many in the media and academia want to ascribe to it. Even so, idea that the Fed is taking on some kind of extraordinary risk in retailing MBSs at this point is a bit strange, given what Treasury has already survived via TARP. Banks have been using their reserves to accumulate international carry which will be used to buy back ABSs from the Fed in due time. There is more margin of safety in the banking system now than there has been for at least 2 years, but this does not need to imply we are at risk of “inflation,” as real markets will be fragmented, uneven and incomplete for some time to come…
I understand your point in analyizing the Fed’s MBS purchases and paying of interest on reserves as akin to borrowing short and investing long. But it’s only part of the story, and in my opinion not the most important part.
What the Fed is doing in fact is buying MBSs by creating money and putting it into a private bank’s reserve account at the Fed on behalf of the seller, while paying enough interest on reserves to ensure that no more than a very small portion of this new money will be converted to currency.
The point of buying MBSs is to minimize banks’ mortgage-related losses (by depressing mortgage rates and thus supporting housing prices and facilitating refinancing), and to cushion the decline in spending by home-owning consumers.
The point of having the Fed buy the MBSs with newly created money is to provide monetary stimulus, and to avoid having to raise funds with new borrowing or taxes, as the Treasury would need to do if it were doing the buying.
The point of paying interest on the reserves and thus avoiding the conversion of reserves to currency is to avoid over-stimulating the economy. Conversion of reserves to currency is not a simple one-for-one exchange; it is a stimulus of private lending up to the point that there is demand in the economy for that much extra currency. This process expands commercial bank money by a volume several times greater than the amount of reserves being converted to currency. Several times $1.25 trillion of new commercial bank money would be highly inflationary.
However, the keeping of large reserve accounts at the Fed is not equivalent to or a sign of cash hoarding. Banks are constantly conducting transactions with the money in their reserve accounts, and money is constantly moving between the different banks’ reserve accounts. It is fungible money and part of the overall liquidity of the financial system. Just because there is little incentive to convert the reserves to currency does not mean there is no incentive to put the reserves money to work.
Robert A. Eisenbeis,
The FED purchased many of its balance sheet assets with money borrowed from Treasure so not all of the purchases were money creation.
Spry,
The FED bought up the MBS from the banks to make their balance sheets look better. The banks could not buy what they already owned. The FED has a special situation where it can get low interest money to buy these assets. That is how they make the spread. Because the money is either created or borrowed at a low interest rate the FED can make a spread that most banks cannot.
Note that the investment banks were given TARP money and did in fact gain income on the spread similar to what the FED did. Goldman Sachs got low interest money from the government them bought t-bills from the government, made the spread then paid the government back. If it looks like a scam it would be if it has not been written into law.
Professor,
Thanks for this post. It was timely. I have been discussing this very issue with some friends. My conclusion is that much of this is funny money. The FED borrows from Treasury, buys from Treasury, Treasury pays interest, the FED gives the interest back to the Treasury.
Your comment, “Some might think the point of the MBS purchases was not so much to arbitrage an overly high long-term yield as to do something to stimulate the economy, since Fed purchases of short-term T-bills clearly accomplish nothing in the current near-zero interest rate setting. However, the difference between what the Fed has been doing in 2009 and true quantitative easing is that under the latter strategy, the Fed would be funding the MBS purchases with zero-interest money, with the intent of the operations indeed being to get that cash into circulation rather than trying to construct a device to persuade banks to hoard it,” is very interesting. The FED appears to be juggling a lot of balls right now. It is trying to repair bank balance sheets, engage in quantitative easing, limit the money entering the economy to hold down inflation, proping up Treasury auctions, and probably some things we don’t even know about. What happens when they get so many balls in the air that they start to fall? The FED keeps creating complexity and each move increases the risk of a major failure.
The FED today is just as confused as the FED during the Great Depression. Everything is an experiment.
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I hope you find it interesting!
Thanks RicardoZ. Your explanation makes sense. So if I understand correctly the banks’ reserves with the fed have increased tremendously but their balance sheets are still in a bad condition that they cannot lend out the reserves or use them for something else. Then the concern for the fed from an inflationary point of view is that at some point in the near future these reserves will be lent out?
Spry,
I don’t think that the reluctance of the banks to lend is because bad balance sheets. There are two reasons they do not lend their reserves. One is there are legal requirements for reserves based on their capital rather than their operating reserves. If their capital is high then their reserves are high. The other,and I believe this is what Professor Hamilton states, the FED by paying interest on reserves creates a situation where banks can make money with virtually no risk by sitting on their reserves. Professor correct me if I have mischaracterized your view.
To RicardoZ
I am sorry, but you are wrong. The Fed doesn’t borrow from the Treasury. The currency it issues is its own liability not the Treasury’s. It doesn’t have to because it can issue its own liabilities.
The Fed is the fiscal agent for the Treasury and thus does have a relatively small balance from the Treasury to conduct daily transactions.
If you go to the Fed’s balance sheet on its website you will see by looking at its liabilities that there are no Treasury borrowings.
RAE
Agree with JDH (and disagree with Eisenbeis) that the Fed is effectively borrowing short from the banks to lend long to the mortgage market. This on the presumption that the fed cannot allow the banks to lend the excess reserves thus created, so payments for reserves must be sufficient to cause the banks to hold the reserves.
Hephaestus: “Banks have been using their reserves to accumulate international carry which will be used to buy back ABSs from the Fed in due time.”
This may be a very risky bet – the dollar might rise substantially.
Hello,
Quick question here when you say that the amount the Fed returned in profit to Treasury equals the amount that the Fed earned on its holdings of USG bonds does that mean the Treasury did not actually get any net revenue from the Fed’s profit?
Thanks,
Jason