The Fed As Bank

The Federal Reserve may be a central bank with special rights and obligations, but in the end it, too, is a bank and has to be very careful who it lends to and what kind of collateral it accepts in exchange.

From a bank analyst perspective, during the last few months the Fed has become increasingly more lax in its lending practices. It is financing highly leveraged investment banks and brokers and accepting a wide range of illiquid securities as collateral, particularly MBSs.

Let's look at the Fed's consolidated balance sheet (click to enlarge):



As of March 12, 2008 the Fed had almost $900 billion in assets, of which $700 billion were in Treasury bills and notes and the rest in an assortment of repos, the TAF facility, etc. The most recently announced programs like the TSLF ($200 billion), the open-ended discount window facility for investment banks/brokers and the $30 billion loan to Morgan (i.e. Bear's toxic assets) are not shown yet.

When those hit the books in the next few weeks, the asset mix will change drastically. The Treasury holdings will go down and be replaced by an assortment of GSE and private label securities. The Fed's risk exposure will jump higher, and significantly so.

Like any other bank, the Fed does not have an unlimited amount of money to lend - all it has is about $700 billion in Treasurys that it can exchange for other, less marketable securities (and it has already announced programs for a big part of that). In contrast, US home mortgages alone amount to $10.5 trillion; if things keep unraveling, the Fed's balance sheet will prove very small for the role it has now chosen for itself.

As for the liability side, the Fed has issued about $800 billion of its own Federal Reserve Notes, i.e. dollars. Our currency is thus increasingly going to be backed by lower quality, riskier assets that no one else wishes to buy or lend against, instead of Treasurys. In effect, Mr. Bernanke is betting the farm on a quick real estate/mortgage turnaround and a very shallow recession. Worse still, instead of charging a higher interest rate for the loans made against the riskier collateral, the Fed keeps cutting rates.

And just how sound is Mr. Bernanke's "bet the farm" wager on a quick turnaround of the US real estate market? Judging from the following chart, not very sound at all. Unlike previous real estate boom cycles that lasted 2 to 4 years and peaked at 700-800.000 new homes sold per year, the one now busting lasted 13 years and peaked in 2005 at 1.300.000 units. There has been a lot of housing demand satisfied for many years to come and the downturn will not likely end soon.


Without Greenspan's negative real interest rates after 2000, the cycle would have probably turned down (red line), avoiding the bubble of 2002-06. Based on this hypothesis, there have been almost 3 million "extra" homes sold (black line minus red line), creating a fundamental housing demand deficit that won't go away even if credit becomes cheap again.

Let's summarize: riskier borrowers, low quality collateral concentrated on real estate, questionable appraisals for market prices and "low, low rates". Is the Fed turning itself into a sub-prime lender? If I were a bank examiner, I would want to have a quiet word with Mr. Chairman about his lending practices.

And if I were a shareholder or creditor of the Federal Reserve Bank (remember what its liabilities are), I would be worried. As, indeed, so many already are - they are those who are exchanging their dollars for other currencies and commodities.

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Sir Arthur C. Clarke passed away today. He was 90 years old and his writings inspired millions, including this blogger.

RIP