Thursday, 30 August 2012

Excess Reserves, Federal Debt held by the Fed and the U.S. Bond Bubble

Ever noticed the large excess reserves the U.S. banks hold these days and have been holding for some time? Depository institutions (banks) tend to hold little or no excess reserves simply because the return on them have been zero. In the U.S., these depository institutions hold both the reserves and excess reserves with the federal reserve system (the Fed). Historically the Fed did not pay any interest on neither the required nor the excess reserves. Following the financial panic starting in September 2008 this was all changed as the Fed made a change on October 6 2008 allowing it to pay interest on both required and excess reserves (see this press release). The Fed announced at the time,

The payment of interest on excess reserve balances will give the Federal Reserve greater scope to use its lending programs to address conditions in credit markets while also maintaining the federal funds rate close to the target established by the Federal Open Market Committee.
Employing the accelerated authority, the Board has approved a rule to amend its Regulation D (Reserve Requirements of Depository Institutions) to direct the Federal Reserve Banks to pay interest on required reserve balances (that is, balances held to satisfy depository institutions' reserve requirements) and on excess balances (balances held in excess of required reserve balances and clearing balances).
The Fed also stated at the time that "Together these actions should encourage term lending across a range of financial markets in a manner that eases pressures and promotes the ability of firms and households to obtain credit".

Following the implementation of this new policy, depository institutions' excess reserve balances with the Fed continued to increase as the chart below demonstrates.

The period selected in the chart is from 2005 only as excess reserves have been virtually zero since 1960 and the chart reads better for this shorten period (go here if you want to see for yourself). A closer look at the weekly data shows however that excess reserves increased 421% in the week when Lehman Brothers filed for Chapter 11 bankruptcy protection (September 15 2008) and continued to increase significantly over the next 12 weeks. Excess reserves remained high and continued to increase until it peaked in Q1 2011 at USD 1,617.4 billion. Since then it has declined only slightly. A substantial portion of these excess reserves were generated from the "quantitative easing" or money printing programs implemented by the Fed at the time (QE 1 and 2). However, QE1 was only implemented on December 16 2008 and before that day excess reserves had already increased to USD 777.875 billion. The week before the Lehman collapse excess reserves stood at USD 9.020 billion.

As bank reserves and excess reserves consist of the same thing, namely deposits held with the Fed plus currency physically held in the bank's vault, the sudden increase in excess reserves must have come from the banks selling other assets (in return for cash). The details of what they sold and to who is beyond the scope of this article. But looking at the changes in the weekly balance sheet of the Fed reveals that it bought USD 14.347 billion worth of Federal Agency Debt Securities during the three weeks ending October 8 2008 or about 10% of the increase in excess reserves during those three weeks. "Quantitative easing" actually commenced then before it was announced and formally implemented.

When QE 1 was implemented however the Fed was of course the main buyer. Federal Debt held by the Fed increased from USD 475.9 billion at the end of Q3 2008 to USD 1.6611 trillion at the end of Q4 2011. An increase of USD 1.1852 trillion. The charts below demonstrates the relationship between banks' excess reserve holdings and Federal Debt held by the Fed (same data but different time span for the two charts).

What happened as a result of this money printing exercise by the Fed was to transfer risky assets (including treasuries) from the banks to the Fed. The Federal Reserve Bank of New York claims,

The total quantity of reserves in the banking system reflects the scale of the Fed’s policy initiatives, but conveys no information about the initiatives’ effects on bank lending or on the economy more broadly.

But simply looking at the dramatic decrease of the M1 Money Multiplier tells a very different story and excess reserves today still remains near an all-time high.
So, have QE1 and QE2 failed? Yes, it was doomed to fail as it was wrong to implement it on so many fronts. Anyway, to answer the question, it depends on what the actual purpose of QE 1 and 2 were and not necessarily what the Fed claims it was supposed to achieve ("encourage term lending"). It has certainly worked for the large banks themselves as toxic mortgage backed securities (MBS) have been reduced (removed) from their balance sheets while the Fed, backed by the tax payer, now sits on these toxic MBSs currently with a balance sheet value of USD 857.412 billion as of August 22 2012. In addition, the Fed currently sits on more than USD 1.640 trillion in treasury securities (10.5% of total Federal Debt), an increase of more than USD 1.160 trillion pre Lehman. And it would be no need for it to do so if the banks, as they normally would, had bought them all. But they don't want them, certainly not in the quantity demanded by the federal government, for obvious reasons: U.S. government bonds are no longer a safe investment as rates are kept artificially low by the Fed (in normal circumstances they would be substantially higher) and as the deficits of the federal government plunged to unprecedented levels in recent years (see The Current Economic Situation of the U.S. for more on this). U.S. government securities are no longer risk-free investments (instead they are "return-free risk instruments") and are now a mammoth of a bubble. The banks probably know this, the Fed ought to. And that might very well be the real reason the Fed is doing their bit to keep interest rates artificially low (e.g. "operation twist"): this bubble will burst with a bang when interest rates rise. And it will not be pretty.
A back-of-the-envelope calculation demonstrates the potential damage this bubble can do. As of Q1 2012 the federal debt, which consists of treasury and other federal government agencies securities, was USD 15.582 trillion and counting. Assuming the average duration of these securities are 5.0 and that all of the debt is interest rate sensitive, a 100 basis points increase in the yield on these securities would lead to a drop in their value of 5%. In money terms this means a loss of USD 779.104 billion. If yields were to increase by 500 basis points, the loss in percent would be 25% and in money terms USD 3.895 trillion. Completing the same calculation assuming a 500 basis points increase in interest rates, but applying only the federal debt held by the public, which was USD 10.852 trillion as of Q1 2012, the total loss in money terms would be USD 2.713 trillion. To illustrate the potential size of the losses involved here from this bubble, Reuters reported that top U.S. and European banks lost more than USD 1 trillion from the subprime crisis during the period 2007 to November 2009 and that it was expected to be USD 2.8 trillion by 2010. In effect, the Fed has transferred risk from the banking sector whom it serves to the Fed. Any losses occurred, either through inflation or (partial) default, will be borne by the U.S. tax payer eventually. In the mean time, the banks have been shielded from a portion of this potential loss through the Fed buying treasury securities.

1 comment:

  1. Not risk free. Good point. Your the only one I've seen quantify this interest rate risk.