"The Fed’s asset-liability mismatch
Ben Bernanke’s Friday speech, on the Federal Reserve’s balance sheet, has got us thinking.
According to the latest Fed data, the central bank now has $2,080bn in assets. That’s more than double what it had in July last year. Are there risks to this?
It seems others have been asking the same question - specifically Deutsche Bank economists led by Mustafa Chowdhury. They say:
The two largest risks are an asset-liability mismatch, and a possible diminution of the Fed’s independence.
First, a recap: While the Fed’s unconventional measures appear to be succeeding in lowering mortgage rates, they’re also having two major effects on its balance sheet. The asset side has been increasing as the central bank snaps up things like mortgage-backed securities, and extends short-term liquidity provisions to financial institutions and direct lending to borrowers. Meanwhile, the liabilities side has been rising in tandem — as the Fed expands the monetary base through the process of quantitative easing (not sterilising excess reserves, explained in detail here). And here’s the danger according to DB:
For the asset-liability mismatch, on the liability side, growth has been mainly in excess reserves, since the SFP [supplementary finance program) has not grown at all in the last several months, having been stabilized at $200 bn. These excess reserves are effectively overnight money. On the asset side, as the liquidity programs run off, short-term assets are being gradually replaced by long-term ones.
As the MBS portfolio grows, the level of duration and negative convexity of the Fed balance sheet grows. The part of the convexity risk that may be the most troubling sometime in the future will be extension risk. In a scenario where inflation comes back into the picture and interest rates start to creep up, homeowners with newly originated loans will be very reluctant to refinance as their rates will have been historically very attractive. On the other hand, the Fed could thus be financing these mortgages at interest rates higher than the yield on these mortgages - a negative carry scenario that might persist for a long time.
Unlike most bonds, which have “positive convexity”, MBS is said to have “negative convexity” since they tend to fall in value as interest rates decrease. That’s because in low-interest rate environments — like now — homeowners have a tendency to prepay their mortgages, refinancing them to take advantage of the lower rates. When this happens the MBS investors get a return on principal faster than they expected and they’re left to reinvest in a lower yield environment.
When interest rates start to increase it’s the exact opposite scenario; homeowners are reluctant to refinance since, as DB notes above, they have good deals by historical standards. Thus, it might take longer for MBS investors to get back their principal than they initially expected. And that’s when the potential problem for the Fed starts, when the cost of financing such mortgages exceeds the yield the central bank is earning on them. Back to DB:
The negative carry would impinge on the Fed’s “profits” that it forwards to the Treasury throughout the year, and, in a worst case, might cause cash flow losses. These losses might impinge on the Fed’s notional “capital”, thus possibly necessitating a Treasury recapitalization.
In other words, the Fed effectively has an asset-liability mismatch. This mismatch might diminish the Fed’s ability to control inflation in the long run, as it might have to keep creating money, even if the right policy would otherwise have been to shrink the money supply. As a result, the Federal Reserve’s independence could be compromised if it has to rely on the Treasury to funding its mortgage position. However, one mitigating strategy would be to give the Federal Reserve the right issue its own debt.
Now, for companies there are various ways to hedge against convexity, but we’re not sure if the Fed can do the same.
Finally, the prospect of the Fed issuing its own debt is something which has been discussed before. Not only would it help in the scenario recounted above, but it would also help it drain some of the liquidity that’s been injected into the system. In other words, while the move might sound ominous, it’s actually a way of destroying the inflation potentially caused by that asset-liability mismatch. Interesting.
Related links:
Bernanke’s balance sheet - FT Alphaville
Convexed - FT Alphaville
Fed seeks to issue own debt to soak up excess liquidity - The Market Oracle
Fed ponders issuing debt to finance its mushrooming balance sheet - Naked Capitalism
Mortgage convexity risk - Lehman Brothers
To twist a Treasury - FT Alphaville
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