I get asked almost weekly, "Chris, what scares you about the financial markets? Chris,
what is your biggest worry about the future in the capital markets? What keeps you awake at night? Is
there a black swan out there? To which I almost always reply, "I worry about everything; that's
why I am bald. It's part of any CIO or portfolio manager's job, worrying for our clients." However,
when pressed, I do have a lingering concern about the Federal Reserve balance
sheet that many people have yet to discuss. I am Chris Perras with Oak Harvest Financial in
Houston, and welcome to our weekly stock talk podcast. Before we get into this week's topic
titled "The Federal Reserve's balance sheet, what keeps me awake at night." Please take a
moment to click on the subscribe button and click on the notification bell so you will be alerted
when our team uploads our latest content. We've covered the Federal Reserve's balance
sheet and its expansion and contraction for over three years now at Oak Harvest. We've discussed
numerous times its apparent beneficial impact during expansions on asset prices
and the general difficulty "risk assets" have had during periods of portfolio runoff and shrinkage.
While equities have struggled in the past, they still have eventually been able to hit new
all-time highs. Case in point, the Fed's balance sheet shrunk throughout 2018 and 2019, and it
was a tough road filled with volatility, but the markets still made new all-time highs. Take a look
at the Fed balance sheet versus the S&P500 from the St. Louis Federal Reserve Board's website.
The explosion in the Fed's balance sheet, under QE4, or the fourth round of Quantitative Easing,
which was a monetary program used to offset the Covid lockdowns, is apparent on the graph.
Post Covid, the Feds balance sheet expanded from $3.8 Trillion, or about 15-18% of GDP pre-Covid
in March 2020 to a peak of around $8.9 Trillion a few weeks ago, which is about 36-38% of GDP. The
Fed and other central banks used QE to stimulate economies when policy interest rates were near or
below zero and interest rates couldn't effectively be lowered further. The Fed now owns about $5.76
Trillion in Treasuries bonds and $2.72 trillion of MBS, or mortgage back securities.
The Fed planned to reduce its $8.9 trillion balance sheet beginning June 1, when it would
no longer reinvest proceeds of $30 billion in maturing Treasury securities and $17.5 billion in
maturing agency MBS per month. Beginning September 1, those caps will rise to $60 billion and $35
billion, respectively, for a maximum potential monthly balance sheet roll-off of $95 billion.
The worry for me and potential problems down the road, whose timing I cannot claim to foresee yet,
is how big are the Fed's current losses on their balance sheet? Will they ever
be reported? And who is responsible for them? A recent estimate by the American Enterprise
institute places the estimated unrecognized losses on the Fed's balance sheet, as of a month ago,
at around -$540 billion, that's billions with a B in losses, on its portfolio of bonds.
Almost half a trillion dollars in losses in barely six months. This loss seems a sensible estimate as
of mid-June; a weighted average maturity treasury of about eight years was down -9%ish, and the MBS
indexes were down almost -11.5% on the year. Of course, this loss will likely get even bigger
if the Fed keeps raising rates. Recall, the Fed was buying these Treasuries and mortgages
in mid-2020 through the first half of 2021 when the yield on a 10-year Treasury was .5%
to 1.5%. The 10-year yield now sits at 3%. This over half a trillion unrealized loss is
more than 13 times the Federal Reserve System's consolidated capital of $41 billion. Here's a
snapshot of the Feds Balance sheet, including its paid-in capital by its member banks of $41.7
billion. Let that sink in for a moment. Yes, it's the Fed, and they can turn on the money
printing machine. But think about that. The Fed is now margined or leveraged 210 to 1 times.
What would this look like in the public world we live in? It would look like you are buying a
million-dollar house by putting up less than $5000 of your own money! It would be you, trading a
million dollars worth of stocks with only $5000 of collateral. How risky would that be? Well, if you
were doing this trade, you would be insolvent or wiped out entirely by a price decline of only .5%.
Not 5% or 50%, but half of one percent. You would be wiped out. Out of business. Foreclosed on.
Margined out. Repossessed. Bankrupted. Liquidated. That is terrifying to me. A one-half of one
percent move wipes you out for good. Of course, unlike our regulated banks or everyday people
like you and me, no matter how big the losses it may face, the Federal Reserve will not fail. Why?
Because it can continue to print money even if it is insolvent.
Even if its unrealized losses exceed its capital. Unlike regulated financial institutions, no matter
how big the losses it may face, the Federal Reserve will not fail. It can continue to print
money even if it is deeply insolvent. But, here is where it gets interesting and more concerning
to me. According to the Federal Reserve Act of 1913, Fed losses should impact its shareholders,
who are the commercial bank members of the 12 district Federal Reserve banks. These
Member banks must purchase shares issued by their Federal Reserve district bank.
The Federal Reserve Act says that Member banks only pay for half of their required
share purchases "while the remaining half is subject to call by the Board." Member banks
are also required to fund any district reserve bank's annual operating losses. This is not
optional to the member banks. The term "shall" is used. There is not a "may" term used in the Act.
The same group from the American Enterprise Institute has calculated that with interest
rates rising, the Fed will begin reporting net operating losses once short-term rates exceed
2.7%. And that's without recognizing what would be ongoing portfolio losses at that level.
With higher interest rates, the Fed is in the dually horrific position. It would have massive
mark-to-market investment losses at the same time, it would have ongoing negative operating losses.
It would have operating losses because the Fed would be paying out
higher interest rates on both bank reserves and reverse repurchases while its own balance sheet
was invested in low yielding fixed rate debt. If or when the Federal Reserve is forced to comply
with the Federal Reserve Act of 1913 and assess its commercial bank members and shareholders for
its operating losses, it would almost certainly impact both domestic and global monetary policies.
Passing Fed operating losses on to its member banks could create pressure to avoid losses by
limiting the interest rate paid to member banks or discouraging the Fed's balance sheet runoff.
Worse yet, if the Fed's losses were passed on to its members, some banks may face capital
calls and issues themselves. Some might be forced to issue equity to help recapitalize
the Fed capital account. According to a 2020 article in Institutional Investor magazine,
Citibank held about 43% of the New York Fed Reserve Banks shares. JP Morgan held about 29.5%,
with those two accounting for almost three quarters of the total New York Fed. Morgan Stanley
owned about 3.7%, Goldman Sachs 4%, and Bank NY Melon owned 3.5%. Believe it or not, there are
also several foreign shareholders of the New York Fed bank, the largest being HSBC at around 6%.
If things went south in a bad way with the Feds balance sheet liquidation?
Under the strict interpretation of the Fed Reserve Act of 1913, all these publicly traded companies
might be required and forced to contribute additional capital into the Federal Reserve
to cushion its capital against losses. You want to worry about a replay of the Great Financial
Crises of 2008-09 or worse? You want me to write a nightmare financial" black swan" for our domestic
banking system for the coming decade? This might be a good place to start, the Feds current balance
losses and potential future operating losses. Our team here at Oak Harvest knows that the
first half of 2022 has been a trying time for those in the equity and bond markets who are not
trading oriented. The sustained volatility year to date is a harsh reminder to investors
that stocks do not always go up. Remember, unlike the insurance markets and those tools, there are
no guarantees in the public equity markets. The Oak Harvest team knows that sharp market moves
drive emotions and the urge to make changes to what are supposed to be longer term asset
allocations worked through with your advisor. If the ongoing market volatility is making you
feel uneasy, give us a call, and schedule a meeting with an Oak Harvest advisor. Our team
does have insurance-based tools that do not have the volatility of public markets.
However, we remind you, that these investments may also have lower long-term expected returns.
At Oak harvest, we think our clients are best served by us helping them plan for their future
needs, instead of focusing on the past. The future and stock markets are always uncertain and that is
why our retirement planning teams plan for your retirement needs first, and your greed's second.
Give us a call to speak to an advisor and let us help you craft a financial plan that helps you
meet your retirement goals. Call us here at(877) 896-0040 and schedule an advisor consultation.
We are here to help you on your financial journey into and through your retirement years.