The Fed Balance Sheet Explained

Since the troughs of 2009, the main market benchmarks have grown more than 150%, while the Fed balance sheet has more than doubled.

That's no coincidence.

Former U.S. Federal Reserve Chairman Ben Bernanke never saw a mortgage-backed security or U.S. Treasury he didn't want to buy. He went on an unrelenting bond-buying spree after the financial collapse started in late 2007.

Now Bernanke's successor Janet Yellen has the unenviable task of ending the Fed's easy money policies.

She has already started. Over the next two days, the Fed's policy-setting Federal Open Market Committee (FOMC) will convene for the final FOMC meeting of the "easy money era." The Fed is expected to end the two-year, massive bond-buying program known as the third round of quantitative easing (QE3).

fed balance sheetAnd the magic number is 4.5 trillion.

After almost seven years of asset purchases, the Fed balance sheet now has $4.5 trillion in assets. Yellen will have to release them back into the economy.

There are real concerns about how the Fed is going to do this without scaring the markets. How will the economy react after it's taken off life support?

Before we answer that, it's important to understand exactly how we got to $4.5 trillion....

The Fed's "Unusual and Exigent" Policy

The timeline begins in 2007 - the start of the financial crisis.

In August 2007, French bank BNP Paribas announced it couldn't properly value certain mortgage-backed securities. This was because of exotic financial engineering that masked the risk and quality of the borrower underlying the mortgages. Think subprime mortgage crisis.

This caused a stir in interbank lending as the year moved forward.

Banks were reluctant to lend to each other on anything other than overnight loans. They feared the BNP episode was a signal that banks were highly leveraged on shoddy investment instruments.

This panic prompted the Fed to launch a series of emergency lending programs. The central bank claimed authority to do so through the "unusual and exigent circumstances" clause in the Federal Reserve Act of 1913.

The Fed stepped in with the Term Auction Facility (TAF) in December 2007. It was an effort to offer interbank loans without forcing banks to borrow through the Fed's discount window. Borrowing through the Fed often carries the stigma of weak finances for any bank that does it, whether the institution is struggling or not.

From December 2007 to March 2010, the Fed held 58 auctions for 28-day - and later 84-day - term loans. Financial institutions would submit interest rate bids for a piece of tens of billions of dollars in Fed funds. Through TAF, the Fed loaned out more than $3.8 trillion, all of which was paid back.

Around that same time, the Fed also looked to address a dollar shortage in international markets. Foreign banks holding dollar-denominated investments needed dollars. Growing demand made them harder to obtain.

This was the start of the Fed's central bank liquidity swap lines in December 2007.

Central banks from around the world could exchange their currency for U.S. dollars and shore up dollar liquidity in their own countries. The program totaled $10.1 trillion and had involved 10 countries by its end in July 2010.

The bulk of swaps were with the European Central Bank, which comprised about $8 trillion. Swaps were also conducted with the United Kingdom, Switzerland, Japan, Denmark, Sweden, South Korea, Australia, Norway, and Mexico.

By March 2008, the financial system was unraveling.

As the financial meltdown unfolded, Bernanke took an interventionist role in the markets. He micromanaged bank balance sheets and oversaw creative lending programs to keep the nation's banks liquid.

The first unprecedented central bank action was a $12.9 billion bridge loan to keep investment bank Bear Stearns from declaring bankruptcy over a weekend in mid-March.

The second was a new lending program at the Fed known as the primary dealer credit facility that allowed other investment banks like Bear Stearns easier access to Fed loans.

The Bear Stearns saga ultimately ended with JPMorgan Chase & Co's (NYSE: JPM) acquisition of the struggling firm.

The Federal Reserve Bank of New York created a limited liability company called Maiden Lane LLC, which soaked up $30 billion of Bear's troubled mortgage assets. Of that, $29 billion was funded from a Fed loan and a $1 billion loan from JPMorgan. This allowed JPMorgan to make the purchase.

The Fed pursued a similar resolution with the struggling American Insurance Group Inc. (NYSE: AIG). This began with an $85 billion line of credit in September.

Then the Fed created Maiden Lane II and III, to help absorb AIG's troubled assets. Those two companies were funded by Fed loans totaling $43.8 billion.

But it wasn't until the end of 2008 that the Fed really began to expand its balance sheet...

The Start of Quantitative Easing

For context, by the end of 2006, the Fed held about $911 billion on its balance sheet. Super safe U.S. Treasury debt made up $778 billion, or 85.5%, of total assets.

As of last week, the Fed held about $4.5 trillion on its balance sheet. Only about 54% of those assets are Treasuries. The rest is a combination of mortgage-backed securities and riskier assets acquired since 2008.

And when the Fed announced it would begin its first round of quantitative easing (QE1) in November 2008, its assets totaled about $2.2 trillion.

QE1 aimed at putting more money into the economy. The Fed announced it would buy $600 billion worth of agency and government sponsored entity (GSE-backed) mortgage-backed securities over several quarters.

By March 2010, the Fed further expanded QE1. By the time the central bank exited the program, the Fed had bought $1.75 trillion of debt from the financial markets.

The Fed balance sheet now totaled $2.3 trillion. Of that, 33% was Treasuries and 45.4% was mortgage-backed securities.

But the easing didn't end there. A soft economy prompted the launch of QE2 in November 2010. The Fed would "print money" to buy up $600 billion in government debt.

When the program ended in June 2011, the Fed's assets had now grown to $2.9 trillion.

And the great balance sheet expansion still wasn't over...

Fed Balance Sheet: Where We Are Now

Bernanke announced QE3 in September 2012.

The Fed would purchase $40 billion in mortgage-backed securities and another $45 billion in long-term Treasuries each month. This was intended to put downward pressure on long-term interest rates to improve the U.S. economy.

QE3 continued unabated until December 2013. Bernanke then announced the Fed would taper its bond purchases by $10 billion a month. From the start of QE3 to the taper, Fed assets grew from $2.9 trillion to $4 trillion.

The taper continued with each FOMC meeting.

Each meeting ended with another $10 billion cut to the pace of asset purchases. It even continued when Bernanke passed the torch to Yellen in February.

The result?

Since its lows at the height of the panic, the Dow Jones Industrial Average has topped all-time highs and grown more than 160%. The S&P 500 has advanced close to 200%.

But the monetary policies that fueled that growth are about to end.

The question then becomes: can markets still grow when the Fed takes away the punch bowl?

"The Fed is functionally insolvent," Money Morning Chief Investment Strategist Keith Fitz-Gerald said. "Someday, its party will end. For now, though, its flawed policies are creating some of the biggest profits in 100 years."

So how do you invest against a tightening monetary policy?

The best strategy is to target what Fitz-Gerald calls "Global Growth & Income" holdings. These are companies with globally recognized brand names with highly localized offerings, solid balance sheets, and that provide above-average dividends.

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They are "must haves," that deliver on real needs and capitalize on growing trends.

ABB Ltd. (NYSE ADR: ABB), for example, is a multinational Swiss industrials firm that focuses on power and automation technologies. ABB works to help companies become more energy efficient and less wasteful with their electricity use.

"The world literally needs to have the lights on," Fitz-Gerald said.

Investing in unstoppable trends is the best way to invest around the Fed's uncertain monetary policy.

More on the Fed: The Fed is getting louder after the recent market sell-off, leaving many to wonder, "Will the Fed extend QE3?" If you look at the big declines in the market over the last month, the Fed always seems to show up to reassert its dovish policy and support what has been a five-year rally. But how long can they do this? And will they actually extend QE3?