Friday, April 18, 2008

an update on the fed's balance sheet

the fed's balance sheet did not change much in the latest week after having undergone significant changes in the several weeks prior, according to new data. the main highlight in the Fed's so-called H.4.1 report, which is titled "Factors Affecting Reserve Balances of Depository Institutions and Condition Statement of Federal Reserve Banks," was the continued decline in the Fed's Treasury holdings, which totaled $11.5 billion in the week ended April 16. that decline was the smallest in five weeks since before the creation of the Primary Dealer Credit Facility (PDCF). the fed now holds $589 billion of Treasuries, which is $232 billion lower than at the beginning of December when the Fed launched its Term Auction Facility and began making big loans to banks.

the decline in the fed's treasury holdings reflects the fact that the Fed has substituted facilities such as the TAF as a way of injecting reserves into the financial system. this is causing some degree of anxiety among market participants, with some observers extraordinarily anxious about these developments. the focus on the Fed's balance sheet is likely to remain intense for as long as the financial sector is tapping the Fed's balance sheet for extraordinary amounts of liquidity. observers will show particular consternation with the decreases occurring in the Fed's holdings of U.S. Treasuries.

Some Background

here's a bit of background on the fed's balance sheet. in the H.4.1 release, the fed indicates the amount of "Reserve Bank credit" outstanding. the figure, which in the week ended April 16 was at $867 billion, represents the amount of money that the Fed has placed into the banking system.

the vast majority of the money is injected into the financial system through the fed's purchases of us treasury securities. since december, when the fed began its Term Auction Facility, the Fed has been selling its Treasuries to offset the other means by which it is injecting money into the financial system. if it didn't, the amount of money in the financial system would balloon, pushing the federal funds rate below the target rate set by the Federal Open Market Committee. in other words, if the Fed lends banks $100 billion via its Term Auction Facility, it must sell $100 billion of Treasuries, or else $100 billion of additional monies would be put in the financial system, an amount large enough to cause the federal funds rate to plunge, hence igniting inflation pressures.

Dollars in Our Pockets

it is important to keep in mind that of the $867.7 billion of money placed in the financial system by the Federal Reserve, most of what is on the other side of the accounting ledger consists of claims that are extraordinarily unlikely to be presented to the Fed, chiefly currency in circulation, which accounts for $816.6 billion of claims against the fed. in other words, the only way by which the Fed would be forced to liquidate its assets would be if there was a sudden surge in claims against the Fed by those holding paper money. this is extraordinarily unlikely.

Where the Risk Is

where there is risk is in the collateral held by the Fed for the credit it is providing to the financial system via the TAF and PDCF and against its repurchase agreements. the fear is that the assets might decline in value and the Fed, which has recourse against the assets, would lose money if the counterparties failed to meet their obligations to the Fed.

tis fear is somewhat rational only because it is possible, but such fears are very misplaced given the types of collateral that the Fed is collecting and because the collateral has already been marked down by an amount that already assumes massive foreclosures in the housing market. moreover, given the movement in washington toward buying or insuring risky mortgages, a further backstop against losses on the high-quality collateral submitted to the Fed is implicitly in place. an added backstop is that inventory tallies are beginning to fall and will probably fall enough to enable blk to go slow on its sales of bsc's collateral given that the Bear loan needn't be repaid for 10 years.

Figures Are Fine, but Psychosis Matters

still, what i am citing are facts and figures, which in most cases would be enough to figure on what might be next for the economy and the financial markets. what we are facing, however, is psychosis and confidence issues, which can easily overwhelm the facts and figures.

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