With the recent announcement that the Fed is going to increase its balance sheet by about $4 trillion, I thought it might be a great time to discuss the Fed’s balance sheet in-depth.
The good news is that all of the data is public knowledge and is free to explore, just like any publicly traded company. Frankly, there was not much interest in the Fed’s balance sheet until the Great Recession and the announcement of quantitative easing.
Once that news broke, suddenly, there was a lot more interest in the balance sheet and what assets or liabilities were being added or subtracted.
Taking a dive into the balance sheet of the Fed may seem as if that is an unknowingly deep dive to take, but I think you will find that it is not that dissimilar to any other balance sheet of a public company. It contains all the same elements, assets, and liabilities, granted the amounts discussed are usually larger than other companies.
Unlike any other business, the Fed can expand or contract its balance sheet depending on its needs at any time. That fact alone makes it fascinating to explore, to me.
Our goal with this article is to navigate the Fed’s balance sheet in an attempt to help you understand it without getting overwhelmed.
Items we will discuss:
- What is the Fed Balance Sheet
- Discount Window
- Repo Markets
What is the Federal Reserve Balance Sheet?
Like any other balance sheet, the Federal Reserve balance sheet is a breakdown of the Fed’s assets and liabilities. The Fed’s balance sheet is a report of the Fed’s means to stimulate the economy by injecting cash into the system.
The report that is put out weekly, typically at 4:30pm every Thursday, is known as “Factors Affecting Reserve Balances.” The report that the Fed puts out weekly lists the assets and liabilities, it also provides a consolidated statement of the status of all the 12 regional Reserve Banks.
Until the 2007 financial crisis, the Fed’s balance sheet was a boring subject without a lot of scrutinies. But they were starting in 2007 with the announcement of quantitative easing in response to the financial crisis. The Fed balance sheet gave analysts insight into the scale of the Fed’s market actions. Of particular interest was the look inside of the expansionary monetary policy used during the Great Recession.
Items available to view on the balance sheet:
- Level of reserve balances
- Treasury securities
- Mortgage-backed securities
- Federal Reserve notes
Notice that it is a lot of the same items you would find on a bank’s balance sheet such as Wells Fargo, minus all the fraudulent accounts. Sorry, I had to slide that in there.
You can find the reports here.
Each report is made up of four sections:
- Factors Affecting Reserve Balances of Depository Institutions
- Maturity Distributions of Securities, Loans, and Selected Other Assets and Liabilities
- Supplemental Information on Mortgage-Backed Securities
- Consolidated Statement of Condition of All Federal Reserve Banks (The Balance Sheet)
Item number four is the balance sheet; the other sections provide additional information to the balance sheet. The other sections help fill in the gaps of information and give you a broader idea of the scale and scope of the market operations of the Fed.
Let’s explore each of these sections briefly.
Table One discusses everything related to the reserve balances of the Federal Reserve banks. The table is not a balance sheet, but it contains the components that come from the balance sheet. Additionally, items from the Treasury’s balance sheet are included, items that may affect the reserve balances.
Of particular interest from this table are the breakouts of the assets held by the Fed, among them being the Treasurys, mortgage-backed securities, and discount window lending.
There is a memorandum of Table One that includes information relating to securities held by foreign governments and businesses. The Fed of New York is the custodian of these securities, and the memorandum can give clues to the demand and interest in US securities abroad.
Table two is a breakout of all the maturities of securities held by the Fed.
Of particular note, for me, is the length of the Treasurys, which the majority are of five years and less. Another cool item is you can see that the Fed added over $337 billion of Treasurys last week.
Table three breaks down the mortgage-backed securities for our review, with notes below that give more detail on the above line items.
Another cool chart is the look at the financial strength of each Reserve Bank in the system.
Ok, now that we have looked at what the Fed balance sheet, let’s look a little closer at each section of the balance sheet.
Assets of the Fed Balance Sheet
The Fed’s balance sheet is pretty simple; anything the Fed pays money for becomes an asset. Typically the assets on the Fed balance sheet consisted of items such as government securities and loans made through the discount window.
When buying Treasurys or extending loans through its discount window, the Fed simply pays a crediting the reserve account of the commercial bank through accounting or book entries.
In theory, there is no limit to the expansion of the Fed balance sheet. The Fed’s balance sheet automatically expands when it purchases assets. As we noticed from above, there was an increase of $337 billion in Treasurys last week, which was an increase of 11.3% for the week. All of this in accordance with the desire to add more credit to the existing system in the hopes that it will inspire more borrowing and more spending.
As you can see from the asset side of the balance sheet above over the last two weeks, there has been an increase across the board of buying of Treasurys, in particular, and smaller amounts of others such as mortgage-backed securities.
The thing I like about this is we can see the money being created to be added to the Reserve system through in large part by purchases of Treasurys. Also notice in the notes that all of the mortgage-backed securities are guaranteed by the federal institutions Fannie Mae, Freddie Mac, and Ginnie Mae and that they are for the face value of the loans, no interest is included in the balance sheet.
Now let’s move on to the liabilities side of the balance sheet.
Liability Side of the Fed Balance Sheet
A few of the major items of the liabilities of the Federal Reserve are the Federal Reserve notes, or paper currency, and all the deposits of the thousands of commercial banks.
With the aggressive actions of purchasing more assets by the Fed, there has been an increase in the liability side of the equation, particularly in regards to deposits to commercial banks.
More than 5500 banks maintain an account with the Federal Reserve. And many of them borrow and lend according to the fed funds rate, which we now move those funds from the Reserve to the commercial banks for lending to customers.
An increase in the Reserve’s holdings of securities also increases the deposits of banks. When the Fed buys securities, either on the open market or through repo operations, the Fed credits the money to the Reserve banks.
During the Great Recession, the Fed opened up its open market purchases of Treasuries in an attempt to expand the balance sheet of the Reserve banks by injecting more money into the system. The actions were reflected on both the asset and liability sides, with the addition of assets vai Treasurys, and the increase of deposits with the Reserve banks.
As with any company, there is a balancing act to the balance sheet for the Fed as it adds assets either through the purchase of Treasurys or mortgage-backed securities. There is a corresponding liability accounted for in the nature of a deposit added to the Reserve bank, which is then distributed into the economy in the form of a loan to you when you buy a car.
A note about the liabilities of the balance sheet, unlike assets that have no theoretical limit, there is a limit to contraction to the liabilities on the Fed balance sheet. As all liabilities are backed up by assets, once the money is spent, it is gone, and the Fed can only create more money by buying more securities, for example, but the unwind the liability side of the balance sheet involves either writing off the asset or letting the Treasurys expire.
Recent Trends the Fed Balance Sheet
The balance sheet since 2007 has undergone a lot of turmoil. From the beginning of the financial crisis, the total assets of the balance sheet were $870 billion in August 2007. The total assets increased to a final toll of $4.5 trillion as of 2015; then, the assets stabilized for a few years before there was an unwinding of the balance sheet to a total of $3.8 trillion by August 2019.
But then in September 2019, total assets started to increase gradually with the addition of more purchases of securities to inject more liquidity into the market.
Of course, then we reached the current situation of March 2020 and the complete meltdown of the market with the Coronavirus pandemic. As of the beginning of the year, the market is currently down approximately 21% by the S&P measure.
The Fed has begun an aggressive move to try to prop up the economy by first using its first tool, which was to lower the interest rates to a fed fund target of 0 to 0.25%. When that failed to do much, they next escalated to announcing that they would inject about $5 trillion into the economy in the form of buying securities on the open market.
The addition of that many assets is beginning to add a corresponding increase in the liability side of the Fed’s balance sheet in the form of deposits that banks can lend out to its customers.
The unprecedented use of such aggressive expansion of the monetary policy has caused the markets to stabilize currently, but many think that this expansion at all costs will have long-term consequences in the devaluation of the currency. The thought is this could cause a huge increase in inflation, and with interest rates, at record lows, there is no weapon against inflation. And ultimately, that could be far more devastating than the current market meltdown.
But once the Fed opened this Pandora’s box under Bernanke’s leadership, it will be extremely difficult to put the cap back on that box, and I fear this expansion of monetary policy will continue indefinitely.
Repo markets or repo operations garnered a lot of scrutinies lately with the blowup of the repo markets early in September 2019.
So what is a repo agreement?
According to Investopedia:
“A repurchase agreement (repo) is a form of short-term borrowing for dealers in government securities. In the case of a repo, a dealer sells government securities to investors, usually on an overnight basis, and buys them back the following day at a slightly higher price. That small difference in price is the implicit overnight interest rate. Repos are typically used to raise short-term capital. They are also a common tool of central bank open market operations.”
The party was selling the security and agreeing to repurchase in the future; it is called a repo. For the buying side of the agreement and agreeing to sell it in the future is a reverse repo.
Repos are usually considered safe transactions because the instrument traded is a Treasury, which functions as the collateral. Repo purchases are considered a money-market instrument, which functions as a short-term, interest-backed loan.
With the buyer as the short-term borrower and the seller as the short-term lender and the safety comes in the form of the collateral, which satisfies both the borrow and lender of securing funding and liquidity.
Repo agreements can occur many different types of parties; the Fed Reserve is involved in regulating the money supply and reserves.
The Fed uses repos as another tool to regulate the money supply in the economy. The Fed conducts reverse repos when it sells Treasury securities and federal agency debt securities to parties who agree to sell the securities back to the Fed at a future date.
In normal times, the Fed doesn’t involve itself much in the repo market. During the financial crisis of the fall of 2008, the Fed used the repo market as a means of selling Treasurys to primary dealers, which increased the reserve balances and increased the Fed’s liquidity. But the more important effect of the transactions was to make more Treasurys available to private agents to use as collateral to help improve the struggling money market accounts.
The use of repo agreements continued throughout the financial crisis and beyond, and in 2015 the Fed decided that this would be added as a regular instrument of use during normal operations.
Currently, repo operations are used by the Fed as a tool to help control the fed funds rate in the target range that is established by the FOMC. All of the repo agreements are conducted by the Federal Reserve Bank of New York, where all buys and sells of all Treasurys occur in the Fed Reserve system.
The repo agreements are considered a part of the continuing expansionary monetary policy set by the Fed back in 2008 and continue to this day.
You can find more information about the weekly activity of the repo agreements on Tables One, Two, and Four in the Fed’s balance sheet.
As a source of lending of the last resort, the Fed established the discount window. Banks that are not able to borrow from other banks in the fed funds market can belly up to the bar and borrow from the discount window at the Feds discount rate.
The Fed’s discount window is a short-term lender (overnight) that provides liquidity to banks that are unable to borrow from other banks, mainly because they are viewed as too week to loan money.
A downside of the discount window is that the rate is higher than the fed funds rate; another reason it is considered the lender of last resort.
The discount window loans are money that is lent overnight and are collateralized, and they carry a higher interest rate than the fed funds rate. These funds are available to foreign banks as well.
Banks borrow from the discount window only when they are facing a short-term liquidity squeeze and need cash quickly. Banks generally prefer to borrow from the fed funds rate because the money is cheaper, and there is a perceived weakness from borrowing from the discount window.
Because of the nature of the discount window, you normally see an uptick in activity in the discount window during times of financial turmoil, like today. As banks are facing more pressure and liquidity issues with the downturn in the market, you can bet there will be more activity in the discount window in the coming months and years.
In 2008, banks borrowed $403.5 billion at the discount window, compared to $3.4 billion during the dot.com bubble bursting in September 2001.
There are three rates that banks can borrow from:
- Primary credit – the first rate is for banks that are in financially good standing, and the collateral is waived, and the interest rate is generally lower than the other two options. The credit is short-term, typically overnight, and provides a secondary source of funding if the market rates jump overnight.
- Secondary credit – this second rate is provided to banks that are not eligible for the primary credit rate and is 50 basis points above the primary credit rate. Secondary credit has more restirctions and oversight than primary credit and is typically short-term or overnight.
- Seasonal credit – this line of credit is for small banks in helping managing seasonal swings in the banks loans and deposits. Eligible banks may borrow for periods of any seasonal issues, and the rates are a floating rate. These types of loans are only extended to banks that have exhibited consistent seasonal patterns.
All of the loans that are utilized by banks from the discount window are listed on the Fed’s balance sheet under the assets section as loans. You can also find a breakdown of each type of credit on Table One of the balance sheet.
The Fed’s first actions during this current market crisis were to try to inject funds into the repo market as there was seen a liquidity crunch, and the Fed tried to create more liquidity by offering more Treasurys for purchase.
The next tool they unpacked was the lowering of the fed funds rate target a full basis point to 0% to 0.25% in the hopes that creating more money in the market buying up all the Treasurys and creating more credit in the Reserve system would help stabilize the crashing markets.
It didn’t seem to make much difference at the time, but now they have embarked on a no holds barred effort to create money at all costs. They feel that flooding the market with as much liquidity as they can will help prop up companies that are getting butchered in the market right now.
For those of you living under a rock, the S&P has seen a decrease of over 30% in the last few weeks, which is the quickest drop in the history of the stock market, and with the economy in a standstill because of the Coronavirus pandemic, there is a lot of fear in the world and markets.
The Fed has opened up their balance sheet and said to the world that we would do whatever it takes to stop the next depression from happening on their watch.
We can see the transactions on the Fed’s balance sheet each week, and you will be able to see the asset side of the equation basically go straight up.
What effect will all of this have? I am not sure, as I am no economist, or can I tell the future. What I do know is that we are in uncharted territory right now, and time will reveal what effects this will all have.
My goal with this series of articles was to lower the veil on the Federal Reserve system and hopefully help you see what kind of impact the central bank can have on our economic system.
- The History of the Federal Reserve
- The Structure of the Federal Reserve
- How Fed Economic Stimulus Works
Do you need to be an expert on the Fed to be a good investor?
No, but I think a little understanding can give you a better understanding of the impact that interest rates and the creation of more money can have on the market.
Think about the companies right now that are struggling as they took on more debt because it was cheap, and primarily for the reasons of buying more stock to line their pockets, I am looking at you Boeing, McDonald’s, and Caterpillar.
As always, I thank you for taking the time to read this article, and I hope you find something of value to help you.
If I can be of any further assistance, please don’t hesitate to reach out.
Take care and stay safe,