The Fed's Balance Sheet & Leverage

The Wall Street Journal lead staff editorial yesterday detailed the rather horrifying nature of the current Fed balance sheet.

It's rather shocking to be informed that, with the 2008 financial crisis now past, the various short-term credit facilities with which the Fed took in short-term instruments in exchange for cash, have ended. Instead, the Fed owns, on current value, $1.1T in mortgage-backed securities and $154B in GSE debt.

The editorial notes that, while these securities provide a sort of phantom income of some $70B in fiscal 2010 which covers some of the budget deficit, they also pose a highly significant interest-rate risk to the Fed's balance sheet. Simply put, if and when rates inevitably move up, whether from tightening by the Fed, or selling of these securities, the remainder on the Fed's balance sheet will naturally decline in value.

Unlike US commercial banks, which are capitalized at about 8%, the Fed is now running at a 1.45% capital/assets ratio. Yet the assets are half-composed of highly risky fixed income instruments.

We are now actually in the position of potentially seeing our central bank have its assets decline in value to an extent that it wipes out the notional capital of the institution.

This surely must be the most perverse form of financial bubbles we have yet to see. The editorial points out that any added income booked in the past few years from the Fed's fantastically-bloated balance sheet is sure to be overwhelmed by asset-value losses in the years ahead, if things don't go perfectly when these private-sector fixed income instruments are unwound.

Scary, isn't it?