The Big, Bad, Bloated Fed Balance Sheet

As we see in Nick’s series, balance sheets are of utmost importance to all businesses. This got me thinking: what does the Federal Reserve Bank’s balance sheet look like? Well it’s not all too pretty. Before we dive into that, let’s first talk about what it is and how it works. Then, we can start calling Janet out for getting out of control, ‘cause I know that’s why you’re really here. Think of going through life with an unlimited bank account. Every time you want to buy something, the money you need is right there for you, with just a snap of your fingers. You buy whatever you want: exotic sports cars, lavish homes, and a singular college education. Then you realize there are two issues. First, you could hypothetically buy the planet (buy each property in each country), and you have created a rapidly spiraling nightmare of inflation that only gets worse with every purchase. You’ll be telling your kids, “I remember when three trillion dollars got me more than one slice of pizza!”

While that might sound a little far-fetched, it’s not too far off from a day in the life of Janet Yellen, Chair of the Federal Reserve’s Board of Governor. While she is not in charge of printing money (that’s the Treasury’s job), she and her motley crew hold power over the supply of money by way of Open Market Operations (AKA the purchase and sale of U.S. Treasury Securities). Think of the Fed like a mattress-hoarder. Every dollar they get is put under their mattress and rarely seen again full of money. When they sell securities, they are removing money from the market and when they buy securities, they are adding money into the market.

It might sound pretty simple. It actually gets fairly complex, both in size and scope of assets. Currently, the Fed holds about $4.52 trillion in “assets” (what they own). Where do they hold it? You guessed it: The balance sheet, just like everyone else, which is known as the Fed’s “Factors Affecting Reserve Balances,” or document H.4.1. Let’s get back to that number, $4.52 trillion—what does that even mean?

Well, let’s just say that it isn’t good.

On the left-hand side of the H.4.1 you find the Fed’s “factors supplying reserve funds,” which is more or less a fancy way to say “assets.” The “run-of-the-mill” holdings are Treasury securities that it purchased on the open market (the same ones that they issued, of course: bills, notes, and bond, to keep things general). In addition, they hold Mortgage-backed Securities, which they bought during the financial crisis to “save” the country (a view that I’ll let you be the judge of). Heck, I wouldn’t even put it past the Fed to buy that your cousin’s “really dope Delorean.”

While the factors currently supplying reserve funds is comprised of the aforementioned Treasuries and Mortgaged-backed Securities, it also includes Gold Certificates, to the tune of approximately $1 billion. These are actually non-redeemable certificates given to the Fed by the Treasury after the Gold Reserve Act of 1934, which basically mandated them to hand the gold over.

The key phrase in the last sentence? “Non-redeemable.”

On the other side of the H.4.1 we have “Total factors, other than reserve balances, absorbing reserve funds” (liabilities) and “Reserve balances with Federal Reserve Banks” (stockholder equity). As we know with balance sheets, there must be balance, so the sum of these two must be equal to that monumental $4.52 trillion. The factors that are absorbing the balance sheet are, most importantly, the dollars in your pocket. Why? Well, that’s the whole idea of “the government owns all of the money, but they have to give you something in return for them.” That “something” was once gold, but we waived the Gold Standard good bye a long time ago.

The second most important item that absorbs reserve funds is Reverse Repurchase Agreements, also known as a “reverse repo.” A reverse repo is a transaction between the Fed and some other institution (known as a “counterparty”) in which the Fed sells a security to the counterparty with an agreement to buy that some security back later with a specified price and at a specified time. This transaction temporarily takes the securities off of the balance sheets of the individual Reserve Banks and onto the Fed-at-large.

Now, let’s chat about the number $4.52 trillion. Is it too high, too low, or just right? If you can’t take a hint from all of the times that I have mentioned the total, it is much too high. To give you an idea how large, let’s take a look at some of the largest companies in the world and what their balance sheets look like:

Berkshire GE VW Toyota ATT Shell Exxon Mobil Apple

To save you a bit of effort, if you add up all of them you would only come out to $3.248 trillion. The Fed could (hypothetically) buy all of them and still have money left-over to throw a big party with taxpayer money (here’s looking at you, AIG). And, if it helps to see the number drawn out, here it is: $4,528,886,000,000.

So now that we know the Fed has a huge balance sheet, we now as “why ?” Well, the Fed is right with its peers across the world (*****). Just as Exxon Mobil and Shell, VW and Toyota are all close with their peers. But the real issue is that overblown balance sheets are the norm among large, developed nations across the globe. This started during the financial crisis, when central banks, like the Fed, were trying to buy-up toxic securities (like mortgage-backed securities) and also pump money into the economy in order to drive down rates (check out Quantitative Easing 1 and 2, better known as QE1 and QE2).

While QE did help, it also served to build the Fed’s control over the economy. At the present time, any significant change in holdings would create a serious effect across the economy through rates and change in money supply. Furthermore, if there were to be another economic downturn, the same amount of QE (about $3.5 trillion) might not lead to any significant effect.

The solution? Well, Janet has finally woken up from what seemed to have been a multi-year slumber and announced that the Fed will begin to slowly decrease their balance sheet. The hope is that, done slowly enough and with an appropriate degree of scrutiny, they can start to lean-out without causing another financial crisis (or another “Taper Tantrum”). In other words: start praying now.

What Asset Classes and your GPA Have in Common

Finding Power in the Circus that is North Korea’s Government