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How to Unwind the Fed’s Balance Sheet

And no one is talking about this.

There is a taper plan is place but it is one by default not a strategy. If the Fed holds their portfolio MBS to maturity they will take a loss on some (which is never a concern of the State) but these bond maturing will reverse the flow quite naturally from the system without selling back into the market and disrupting the interest rates structure.

Here is what I mean by this and stick with me, this is original analysis and I am not that good of a writer.

During my career as a broker I only purchased MBS for one client, if was a father of a friend who didn’t trust the bank much less a broker. His son knew he needed a higher yield to make up an income gap (this is why I did this job, to help people that just didn’t know). While I wouldn’t buy Fannie or Freddie’s because of the implied guarantee, I would buy Ginnie’s because of their explicit guarantee. (Remember scared client). So not really having a lot of experience with pass through securities this offered an education. We all know here that when we pay our mortgages that a portion pays the interest and a portion goes to the principle. Well when an investor receives his monthly payment (and theses are really quarterly or semiannual or even annual) they receive interest and a portion of the principle back too. There lays some of the risk in MBS….reinvestment risk, along with the option of prepayment in any MBS. There is an embedded option in every MBS, the option that the borrower will either sell the property or refinance. This is priced into the bonds when you purchase them. There is also a term that most are not aware of “duration”. This is stated in years (unless maturing in less than a year) and implies when an investor will receive, what amounts to his original investment returned. Using the discounted cash flow model (which is the only other way to price a bond besides “marked to market”) all future cash flows (principal & interest) is discounted to today’s value and added together to calculate duration.

So let’s analyze what the Fed been up to. Dividing between QE3 & QE4, we will look at QE4 first. QE4 has only been in place for a year purchasing $45 billion a month off the primary dealer’s balance sheet. For those that may not know at every auction there is a portion auctioned that is rolling over existing debt and there is a portion that is newly issued financing the current year’s budget deficit. Currently about 60% of the new issue is being purchased by the Fed…The Fed is monetizing what the USG cannot either tax or borrow in the open market to cover their deficit. When the Treasury auctions debt it is bid on by the Primary Dealers (the big banks about 16 or 18 now), which drains cash out of the system until spent by the USG. Then the Fed goes into the market and buys this debt from the banks, replacing the cash back into the system almost immediately. Now when the USG spends it….the USG is competing with all of us for the same amount of goods and services and you get higher prices. This is one source of future inflation. Today the Fed is making sure that there is a market for the USG debt and keeping long term rates low. The Fed is also paying interest of excess reverse which they have never done until this crisis which keeps velocity low but that is not the point of this discussion.

As the crisis started to unfold the Fed had about $800 billion in assets on its balance sheet. With QE 1 & 2 the Fed had purchased approximately $1.2 trillion of Treasuries and MBS off the bank’s balance sheet. Then in Sept 2012 QE3 was announced as an opened ended program of $40 Billion of MBS would be purchased. Within a couple months QE4 was announced and $45 Billion of treasuries would be purchased. Today the Fed is sitting on approximately $1.4 trillion of MBS with assets on its balance sheet exceeding $3.8 trillion.

And this is where we finally get to the Unwinding Effect that no one is talking about.

A few months ago Rick Santelli stated that the term structure of the treasury complex had duration of 5 years. If that is the case, I will go out on a limb here and say, the term structure of the MBS market is somewhere in that range also. Because the treasury market is often used as a proxy when hedging the MBS market. It could be shorter because of the embedded option of refinancing of mortgages…..but let’s just say 5 years. They started QE in 09 with $600 billion in purchases. MBS’s are pass through self-liquidating instruments. So with a term structure of 5 years those MBS purchased in 09 may start to be paid off next year. Although they are listed on the Fed’s balance as “held to maturity” which is 10 years the earlier purchases should be maturing sooner. As far as the bonds that contained the most toxic of mortgages, remember when the crisis hit it was only expected to be 5% of the $11 trillion residential MBS market, or $550 billion. You can see these toxic assets in the line item of “unamortized discounts on securities held outright of $8.5 billion on the Fed balance sheet. The “unamortized premiums on securities held outright” would represent MBS that the Fed over paid for while they pushed down interest rates and will lose approximately $205 billion if held to maturity. Lower interest rates increase the prices of bond already in the market place that were sold with higher yields and these could hold toxic assets as well even though the Fed bought them at a premium above par.

Paying your mortgage payment each month would have the same effect as if the Fed was selling assets back into the market place, draining cash from the system. So this is a start to the unwinding that virtually no one knows about or is not talking about….this process will drain cash from the system naturally.

Scenario analysis is generating a combination of an optimistic, a pessimistic, and a most likely scenario.

Here are some scenarios:
1. There is a lot in the press right now of another housing bubble developing; this is a double edged sword. While it would be good for the Fed by creating a situation where people could sell or refinance at lower rates, this could shorten the duration of their portfolio considerably. It could drain the cash from the system and allow the banks to remove their excess reserves from the Fed and loan that into the market place for higher net interest margin and higher profits. Rather than the banks going directly into the MBS market themselves they could recapitalize Fannie and Freddie (in their proper context they have always been quasi central banks) which could reinstate more sensible lending standard and hopefully keep another bubble from getting out of control. Because another housing bubble is the last thing we need.
2. The Fed remains scared to let off the accelerator and do nothing; they will continue to provide liquidity to the market place faster than the market can absorb it. This is also a double edged sword. Their MBS line item on the Fed balance sheet will continue to expand $480 billion each year and the effect of self-liquidating loans will continue to swamped in the market place. The stock market bubble will continue and that’s the last thing we need. When companies that have never earned a cent trade at valuation with companies that have been in business for 100 years there is something wrong in the world…..too much liquidity.
3. The Fed finally does taper the MBS purchases, the Unwinding Effect follows it natural course and the MBS are repaid and the cash removed from the system. The potential velocity inflationary effects from these MBS purchases that create the excess reserves position at the banks are lessened and we return to a more healthy housing market where prices are not raising faster than nominal GDP growth.

I will allow you to decide which scenario is the optimistic, a pessimistic, and a most likely.

Let’s turn our attention to the treasury market and let me to say that the purchase of the treasuries is not about saving the consumer, the economy or the country…..it’s all about funding the government massive deficits….period. Treasury bonds mature in a completely different manner. There is no self-liquidating process. As the bond mature they are refinanced with new bonds, so the USG actually never pays any of them off, it’s more like a revolving line of credit. Which could present a more difficult challenge. Because the USG never pays off this debt and only replaces it with more Treasury bonds the Fed would have to actually sell treasuries into the market place to drain these reserves. If the Fed was to “swap” (for lack of a better term) treasuries for MBS they could effetely remove these treasury bonds from their balance sheet and unwind the position by using the process described earlier.

With Fannie and Freddie absorbing 90% of the new issue of MBS in the secondary market, I think there is a plan to be had here.

What about instead of Fannie and Freddie selling any more MBS into the market they swap them for treasuries that the fed holds and sell them slowly into the market to raise cash. You could slowly unwind the position of the Treasuries and a debt basis for our money supply and create in effect a land bank…..or better titled (no pun intended) a mortgage bank and as it natural process unfolds you could close the Fed. With the Fed’s balance actually spread out over the 12 regional Fed branches the “swap” would take place according to the housing market condition in the region and away from the centralization of the New York Fed.

At the same time you could actually use Judy Shelton plan described in her book Money Meltdown return to the gold standard, and position this country now try a more market based money supply competing currencies issued by private banks, known as “Free Banking”.

But that is beyond the scope of this post. Like I said this is original thought, so I am sure there are holes in it. If someone else has already said it, I haven’t heard it and welcome input. But I don’t have all the answers. So don’t expect them I am just thinking of ideas, the devil is always in the details.

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Republicae's picture

Good post....

Good post....


"We are not a nation, but a union, a confederacy of equal and sovereign States" John C. Calhoun


Thanks again!

You blow me away.

You call me names, but you are here for nothing more than to save the Vatican derived system of banking for Control.

It's obvious why you are here on a freedom site, and it's obvious why you call me names.

Hate never wins Goldspan


I think the below statement was the most profound.

"Paying your mortgage payment each month would have the same effect as if the Fed was selling assets back into the market place, draining cash from the system. So this is a start to the unwinding that virtually no one knows about or is not talking about….this process will drain cash from the system naturally."

What I see is that cash in the hands of ordinary Americans will continue to be less and all assets and much of the cash will continue to flow to the banks where they will not put it back in the system fast enough for people to actually increase their cash inventory or purchasing power. The only way I see us actually coming out of this type of collapse with any quick positive outcome would be for there to be debt relief for persons who owe to banks and lenders who had access to the federal reserve discount window. That would also include the debt of these banks and lenders being forgiven from their federal reserve debt.

Thanks for the "upvote" Gmartine

I am not a fan of debt relief. Speaking of debt relief, why is it, when all the banks “supposedly” repaid TARP, none of that went to lowering the deficits?

The only real debt relief is to allow the assets to fall in price until a buyer see’s value and steps into the market place. This not only allows the buyer at a chance of making a profit (which I am always in favor of, because I am a Capitalist) but it also will reestablish the “pricing” mechanism which is destroyed by bubble and corrections.

Debt relief only encourages further bad behavior.

Okay.I appreciate the MBS


I appreciate the MBS knowledge you laid one me but isn't the real problem here that draining liquidity from the system, however it happens, is the last thing the central planners at the Fed want until the economy is steaming ahead?

Draining liquidity will have the effect of raising interest rates, which they'll be more than happy to see when the economy starts to overheat, but not until.

And, despite their attempts over the last 5 years to convince us that good times are here, or if not here now just around the corner, we all know that the economy is far from overheating, or even running smoothly, but that in reality our economy faces structural problems caused largely by the parasite in Washington DC - a parasite that continues to grow and that no one believes we have much of a chance of removing from our dying economy anytime soon.

Nope, what I see is a Fed that is hoping beyond hope that we will all start borrowing and spending based on our rising 401K values. Maybe that will happen, who knows? Maybe (over)confidence will return, along with those animal spirits that drive economic expansions.

But my own sense is that the memory of the last bubble is still so fresh in everyone's mind that we don't trust those higher stock prices (assuming we're lucky enough to have the assets in the first place). And if we don't trust 'em we're not gonna be going on any spending sprees anytime soon.

Added to our mistrust of our paper wealth is our uncertainty of the future. We see the gap between rich and poor, between the educated and the uneducated rising, due largely to the selling of our manufacturing economy to Asia.

We see Obamacare and every thinking person knows it's gonna be a disaster that will likely eventually require the politicians to borrow huge new sums of new money from the Fed to pay for the bailouts of the insurance companies when they go bust due to healthy young people not buying the policies they need them to buy in order to offset the sick people who are scarfing up their pre-subsidized policies.

In summary, until the economy actually heats up the Fed can't drain liquidity, so they won't, regardless of the natural MBS drainage process. They'll just offset that process with additional liquidity in some other manner.

That is, until and unless the people start believing the "good times" propaganda, or until the one thing happens that everybody here hopes for (but, in our hearts believe isn't going to happen until there is no other choice) - REAL change in Washington DC.

I must be willing to give up what I am in order to become what I will be. Albert Einstein

Thanks for reading & responding Wacko Bird

Sorry I haven’t respond sooner, but let me answer some of your questions.

“draining liquidity from the system, however it happens, is the last thing the central planners at the Fed want until the economy is steaming ahead?”

You have to examine the QE's as 2 separate parts; The MBS's were purchase from the banks to get assets off their balance sheets while the banks healed from the crisis. After the “cash injections” stabilized their short term solvency the MBS were continuing to fall due to the MBS market being shut down. No one could value these things in a short term time frame. So to protect the cash injection the Fed began QE 1 with an initial $600 billion of MBS purchasing.

BUT and here is a ever important point, Then the Fed initiated the plan of paying banks for their “excess” reserves ( which is the first time in their 100 year history) the Fed basically acknowledge their “true” intention, The Fed did not want the banks’ lending this money out….they wanted to give the banks time to heal. The “last thing” the Fed really wants is to have the banks creating “credit inflation” (the second derivative of the inflationary process) through fractional reserve lending. With 2.5 trillion in excess reserves that could have the ability to create 25 trillion in purchasing power yet to come. Talk about “too many dollars chasing too few of goods”. This is the “cash” I am saying the Fed needs to drain from the system, it not actually in the economy, it fueling the bubbles in the stock & bond market.

The second part to examine is what the Fed is doing in the treasury market. First and foremost they are monetizing the irresponsibility of the management of the country’s government. The Fed is really being given no choice and the blames lays in the laps of the politicians……period. They either need to stop the deficit spending or raise taxes to balance the budget. With that being said the market CANNOT return to normal as long as the Fed is backstopping the market. This is where they need to exit.... period. And yes draining liquidity will be in effect “raising interest rates” and you are absolutely correct. The economy is too fragile…..but if the market decides to do it they will not care about the economy. The market ( including foreign investors) can and will someday instill disciple on the USG.

You should read my post “the Deficit Oo one is Talking About”

You also right about the “wealth effect” of 401 k rising but also housing prices return to higher levels…..if you aren’t so far underwater in your mortgage you will “feel” wealthier and likely to borrow to spend. I think most people see what is happening and are paying down as much debt as they can.

And …..Obamacare…..100 years from now (if this country survives) our descendants will look back on this and think it had to be a conspiracy because NO ONE could be this stupid to let this thing pass as law, just like we look at the Fed today. We should NEVER forget they Republicans position on this was to pass it Because THE FREAKING Supreme Court will certainly find it unconstitutional…….which is as insane as saying “we have to pass the bill to know what in it”.

This post was only an attempt at some suggestion that I would do if I was in charge…..someone else will eventually figure this out or maybe even read this post and fine tune it for a process that might actually work, I just wanted to put the idea out there.

The change is DC that needs to take place is to nullify the Constitution (the only legal and non-violent way) and return to the Article of Confederation……and unplug the Matrix.

Thanks for your constructive thoughts.