Fed's Balance Sheet Exploding: Why You Should Care

Once a mundane data point for a handful of money market traders, the weekly release of the Federal Reserve's balance sheet has become an eagerly anticipated newsworthy event covered by the press. Ordinary folks unaccustomed to hearing the financial press describe the money markets as if it were a horror show may wonder why they should care about the recent ballooning of the Fed's balance sheet. How is this any different from what the Fed has been doing for years on end?

The primary reason for concern about the Fed's balance sheet is the recent alarming change in the Fed's mission that was brought about due to the poor investment choices and excess leverage of Wall Street during the housing boom. The Fed's original mission was to enact monetary policy to ease the effects of the business cycle by performing open market operations with Wall Street primary dealers. The Fed injected and withdrew money from the money supply using short term loans that accepted Treasury securities as collateral. The Fed's new mission appears to be bailing out the banking sector by providing cheap financing for their inventories of illiquid securities from MBS and ABS to mutual funds and equities. Don't worry if you don't understand these securities or what they are worth, neither does the Fed. Make no mistake, if the Fed had not broadened the collateral it accepted for its loans, and increased the amount of loans it was granting to banks, the entire banking sector would have already collapsed. Nevertheless, it should matter to every US citizen because the taxpayer is on the hook for any losses that the Fed may take on these loans. If another major bank fails, which at this point is not that hard to imagine, and that bank has loans outstanding to the Fed, the Fed will need to liquidate the collateral into a very unfriendly market. Or, I suppose, it can always hold the securities to maturity like it is doing with the Bear Stearns loan and hope for the beast.

In the past two weeks, the Fed has borrowed money from the Treasury and used it to balloon its balance sheet by $400 billion. Yesterday, October 1, primary dealers borrowed $150 billion from the discount window, banks borrowed $50 billion, dealers borrowed $150 billion in the new ABS CP facility, and AIG increased its borrowing to $61 billion. None of these facilities, nor the TAF or TSLF, existed a year ago and now most of the US banking sector's survival depends on them. On Oct. 23, the Fed will be updating the public on the valuation of the securities backing the loan that the Fed gave to JP Morgan to facilitate the takeover of Bear Stearns. Analysts estimate that the Fed will take a write-down of between $2 and $6 billion on the $30 billion loan. When the Fed granted that loan back in March, the market rallied, credit spreads narrowed and everyone, including our Treasury Secretary, proclaimed that the worst was over. But now, six months later, the securities may suffer a significant loss. This comes out of the taxpayer's pocket. What does this imply about the accuracy of the valuation of the other hundreds of billions in illiquid securities sitting on the Fed's balance sheet in the event of a default by a counterparty? More importantly, what does it indicate about the Treasury Secretary's ability to buy distressed assets at prices he deems cheap and then guaranttee profits for the taxpayer? The implications are not encouraging. I, for one, will be emailing my congressman.