Holding a mortgage investment portfolio bigger than Fannie Mae’s or Freddie Mac’s, along with a massively expanded government bond portfolio, puts the Federal Reserve into uncharted waters of interest rate risk.
The combined balance sheet of the Federal Reserve has $2.9 trillion in assets and $55 billion in equity, for leverage of a heady 52 times and a capital ratio of a paltry 1.9 percent. On top of this high leverage and little capital, the Fed runs massive interest rate risk, with investments in long-term mortgage-backed securities (MBS) of over $900 billion and longer-term Treasuries of $1.65 trillion.
“The huge and rising government bond holdings of Japanese banks leave them vulnerable to a spike in interest rates, the International Monetary Fund has warned,” the Financial Times reported recently. But somehow the IMF did not warn about the Fed’s huge and rising bond holdings, which leave the Fed vulnerable.
A rise in interest rates from their historic lows is inevitable at some point. How vulnerable is the Fed’s balance sheet to interest rate risk? We can estimate the market value impact of a 2 percent increase in interest rates, a common benchmark.
The Fed has announced it will be adding $40 billion a month to its $900 billion in MBS, so it’s fair to consider that in a few months it will own $1 trillion in these mortgage securities. A reasonable estimate is that a 2 percent increase in interest rates would reduce the value of long-term fixed rate MBS by about 15 percent. On $1 trillion of mortgages, this would be a hit to the Fed’s market value of about $150 billion.
The $1.65 trillion in longer-term Treasuries probably has an average maturity of at least five years. A reasonable estimate of market value loss on this position for a 2 percent increase in interest rates might be 10 percent, or $165 billion.
The total loss to the economic value of the Fed’s aggregate balance sheet would therefore be about $315 billion, compared to total capital of $55 billion. The Fed is thus vulnerable under this reasonable scenario to market value loss of over 5 ½ times its total capital. Of course, to the extent that the securities were sold in this scenario, the market value losses would become cash losses.
A question whose answer we know is: what would an ordinary bank examiner say to a financial institution that had the same interest rate risk position relative to its capital? It would involve the institution being characterized by a lot of unflattering, not to mention threatening, terms.
Read More at american.com . By Alex J. Pollock.