In 2007 before the Fed ballooned its balance sheet its largest creditor were us currency holders. Fed liabilities counted currency at $776 billion and deposits by other banks at $22 billion. Fast forward to present day and currency now stands at $960 billion and bank deposits have jumped ahead to $1.5 trillion.
Moving to the asset side, Treasuries once made up the majority of the Fed balance sheet with gold trailing behind it as well as foreign currencies and repo agreements. Today Treasuries still rank as the largest asset at $1.3 trillion, but we have new company that supports the dollars in our wallets; $943 billion in mortgage-backed securities. Fortunately for us, these assets are secure, guaranteed by Freddie Mac and Fannie Mae...
The Fed offers little guidance on how it values its assets. Assets that are not going to be held to maturity need to be marked-to-market. The Fed lists the $63 billion of Maiden Lane assets it acquired from Bear Sterns and AIG at “fair value.” The Fed describes “fair value” as “An estimate of the price that would be received upon selling an asset if the transaction were to be conducted in an orderly market on the measurement date.” In other words, they’re valued in the best possible market.
Indeed any write-downs of these assets could be particularly painful. When commercial banks identify impaired assets, the asset gets written down and the equity of the bank similarly gets written down to once again level the balance sheet. With a tiny $52 billion in capital any amount of write-down from the $63 billion in Maiden Lane or other MBS could be devastating.
There are some gems in the Fed balance sheet; its gold holdings. The Fed currently holds about $11 billion in gold, but it values the gold at a price of $42.22 per ounce. Gold is presently valued at over $1400 per ounce so if the Fed were to revalue the gold it would get a jolt to its assets and equity of over $340 billion. This boost would bring down its leverage ratio to single digits.
So then what about those $1.5 trillion in bank deposits the Fed holds as its liabilities. Are those banks going to be perpetual creditors to the Fed like us currency holders? Most likely that won’t be the case. The Fed started paying interest on these bank reserves after the credit crisis. The banks are presently content with keeping the deposits at the Fed as there are scant opportunities to lend in the economy. Eventually that will change and the Fed will need to liquidate some assets.
Will gold be sold? Treasuries? Or arguably one of the least coveted assets; mortgage backed securities. Just as the Fed ballooned its balance sheet in such a short period, there may come a time when it will have to deflate just as quick. As I mentioned in an earlier piece, selling of treasuries has an upward effect on interest rates and downward effect on the price of the underlying bond. Likewise with gold, when $100’s of billions of gold is dumped on the market, just like houses, the price comes down.