The Fed's Evolving Role

Econbrowser neatly summarizes shifts in the investments made by the Federal Reserve during and after the financial crisis.

The Fed before, during and after has always had a steady base of federal government debt, currently about $800 billion, that took a modest dip during the financial crisis. This is essentially risk free.

The Fed did a vast amount of short term lending to the banking sector and commercial paper markets ($1,600 billion at the peak), most of which has now been paid back, during the financial crisis, in the period from January 2008 to January 2010. This is now under $100 billion and falling. This was moderately risky at the time, but worked out without major losses.

The Fed has added, for the indefinite future, bailouts of AIG and Bear Sterns. AIG is the bigger of the two. But, both combined aren't that big a share of the whole (combined, about 5%, which is perhaps $120 billion). This is problematic and likely to produce losses.

Mortgage backed securities and related agency debt has ballooned into a major component of the Fed's balance sheet, from zero or near zero at the start of 2009. This now exceeds $1,100 billion. This has come close to reaching the peak of its planned amount. It isn't entirely clear how safe these investments are now. They are safer than the AIG and Bear Sterns bailout involvements. They riskier than Treasuries. Even a fairly modest percentage loss on these investments would be a big loss. Like the AIG and Bear Sterns holdings, these appear to be long term investments, with Econobrowser surmising from the newly reappointed Fed chairman's comments that "it sounds like the Fed basically intends to hold those MBS to maturity." Mortgage backed securities often have thirty year terms that match the underlying mortgage assets, but the average mortgage is paid off (often though a sale or refinancing) in ten years, and presumably these securities would tend to follow similar trends.

Pre-financial crisis, we would have assumed that mortgage backed securities and agency debt were very safe. Now, with default rates continuing to remain high on mortgages, it is hard to know how safe these will be. Loan losses are lagging indicators. The falling property values and weaknesses in the economy that made mortgages produce loan losses are precede the losses themselves.

It also continues to be unclear to what extent these losses represent a harm to American taxpayers, and to what extent these losses represent a harm to the shareholders of the privately owned federal reserve member banks. Many of the important financial assets held by the Fed also involve big financial institutions and government agencies that also have skin in the same investments in complicated ways. For example, Freddie Mac, Fannie Mae and the FDIC backstop in different ways, some of the assets on the Federal Reserve's balance sheet. Residual private owners in Freddie Mac, Fannie Mae and AIG have taken huge losses, but aren't entirely out of the entities they used to control. Essentially all of the new lending/asset purchases by the Federal Reserve Banks has been financed with loans from the Federal government itself.

Econbrowser's post points out that despite a lack of admitted linkage in the decisions, "it seems not coincidental that, when you look at the total of all the assets the Fed is holding, the expansion of MBS purchases exactly offsets the declines from phasing out the short-term lending facilities. As a result of the MBS and agency purchases, the total assets of the Federal Reserve today exceed the total reached at the peak level of activity for the lending facilities in December 2008."

With new MBS lending winding down and the bailout crisis of the financial crisis apparently over, it isn't clear that the Federal Reserve has any dramatic moves ahead of it in the foreseeable future.