Having waged a battle against financial mayhem for the last two years, the Federal Reserve is tentatively declaring victory. As it guaranteed debt and swapped cash for all sorts of assets, the Fed's balance sheet grew—from about $850 billion in assets before the crisis to about $2.3 trillion this spring. The binge included the purchase of $1.25 trillion of mortgage-backed securities issued by Fannie Mae and Freddie Mac. But in testimony to Congress in March, Federal Reserve Chairman Ben Bernanke said the purchases were coming to a close and that the Fed was now seeking to lessen its burden. The Fed is now discussing how to sell off these new assets.
The prospect of the Fed dumping hundreds of billions of dollars of bonds and mortgage-backed securities onto the market has unsettled some market watchers. But they shouldn't worry—too much.
Each week, the Fed's H.4.1. publication gives a snapshot of the Fed's balance sheet. Table 10 provides the headline number: $2.334 trillion on April 28, down $7.1 billion from the week before.
The Fed, for example, has $90 billion tied up in investments related to stricken insurance company AIG—loans to the company, preferred stock in two AIG subsidiaries, and Maiden Lane II and Maiden Lane III, the vehicles created to remove toxic assets from AIG's balance sheet. But as I documented in a recent column, that's all on a glide path to going away. The closing of the sales of Alico and AIA will return $50 billion to the Fed, and the Maiden Lane vehicles are generating sufficient income to pay down the debt extended to them—and then some.
Meanwhile, many of the market and asset guarantees that the Fed put into place in '08 are expiring. At its peak, the commercial paper funding facility, which guaranteed short-term corporate debt, held more than $300 billion. Now its balance is down to zero. The Term Asset-backed Lending Facility, or TALF, which was started in late 2008 to revive the market for loans backed by assets like car loans and credit card receivables, is closing to new business in June. TALF's balance stands at $45.3 billion, down from more than $48 billion in March. Why? Some of the three- and five-year loans guaranteed by TALF have already been paid off. This balance should shrink to zero by 2013.
The Fed's balance sheet will also diminish as bonds that it has acquired mature and pay off. The Fed, in the past year, bought some $169 billion in corporate debt issued by Fannie Mae and Freddie Mac. (This is debt backed by the company's credit, not by its mortgages.) About $44 billion of those bonds, or 25 percent of the total, mature in the next year.
The largest single item on the Fed's balance sheet is the $1.1 trillion in mortgage-backed securities it has acquired since the meltdown began. These are bonds issued by Fannie Mae and Freddie Mac and guaranteed by the U.S. government. The Fed has signaled that its buying campaign is over. And while the mortgages backing these bonds don't mature for 15 to 30 years, many of them will be disappearing from the Fed's balance sheet in the near future as people pay down, prepay, refinance, and sell homes. An informed analyst might presume that some $200 billion of that portfolio will mature or be paid down by the end of 2011. And as those bonds disappear, the Fed is not replacing them with new ones.
The last large item is $776 billion in U.S. Treasury securities, which have traditionally been the core holding of the Fed. (Before Bear Stearns went under, the Fed had about $713 billion in such securities.) As was the practice before the crisis started, the Fed rolls over maturing government debt into new government debt.
The bottom line? The Fed wants to get the junk off its balance sheet and return to a situation in which it has about $1 trillion in assets, the lion's share of them in the form of government bonds. To do so, it will need to rid itself of about $1.3 trillion in assets. That's a lot. But when you add up the components of the balance sheet that are shrinking, the task doesn't seem quite as daunting. By the end of 2011, by my rough calculations, at least $300 billion of the Fed's current assets will be gone with a substantial additional amount on the way out—and all without the Fed having to stage a huge sale of assets. The Fed will be left with a large portfolio of government-guaranteed mortgage-backed securities and the difficult chore of weaning the economy off its diet of rock-bottom interest rates. Ben Bernanke and his colleagues have a long way to go in deleveraging. But if the broader economy and markets cooperate for another few quarters, a few miles may be shaved off the Fed's debt-reducing marathon.