How to Make Money off the Fed's "Losses," Part 1

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If you, like me, are a member of the Antife (Anti Fed), you may be cursing the day. "Curses!" you shout. "There goes the Fed again! Losing taxpayer money! Our money!"

My friend, Professor Anthony Sanders, finance professor at George Mason University, pointed out to us on Dec. 12 that the Fed just reported it has $66 billion of mark-to-market losses on its balance sheet. Horror of horrors!

My reaction?

Well woop de doo. The Fed doesn't mark to market for a reason. It never sells anything. It will never be forced to sell anything.

The Fed does not need capital to operate. It can – and does – conjure money in and out of existence at will. And eventually, as its bond holdings mature, it always gets paid. Or at least so far, it has always gotten paid. So, marking to market is a nice philosophical exercise, but in practical terms, it's meaningless. It has no impact on the market. It never will have an impact on the market. It should play no role in your thinking about investing or trading.

But boy, are there plenty of reasons to pay attention to the Fed's balance sheet, which is what I do a large part of my work time. I do it so that you don't have to, and mostly because I have come to believe, over 55 years of following markets, that while it might not be the only thing that matters, it sure as hell beats whatever comes second.

First, let's look at this mark-to-market business. Here's what is critical for you to know.

The Fed doesn't mark its securities holdings to market. It carries them at cost all the time. And that's OK. The Fed never sells.

As we know, the Fed is shrinking its balance sheet, reducing the size of its bond portfolio. But the Fed isn't selling that paper. It's simply allowing it to mature and demanding that the Treasury pay off the paper it holds.

The Fed's Treasury holdings mature at a known, scheduled pace. The Fed also holds Federal Agency and mortgage-backed securities (MBS), which get paid off at a semi-predictable pace.

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In the past, when the Fed's Treasury holdings matured, it always rolled the paper over. The Fed bought new debt from the U.S. Treasury to extend the loan it had made to the Treasury under the original purchase bonds that were maturing. These transactions always took place at par. The Fed never lost a nickel on its Treasury holdings and never will, whether it rolls the paper over or demands repayment.

Trade Me or Pay Me!

While most of the bonds it bought in the past are now worth less than par if sold today, the Fed isn't selling, so it doesn't need to pretend that its portfolio is going to cost us taxpayers $66 billion. It won't. The Fed will do one of two things. It will simply wait for the bonds to mature and roll them over, relending the money to the government. Or under its balance sheet "normalization" program, it will tell the government, "Pay me back!" And the Treasury will have no choice but to do it.

They Fed has been doing that for a year already. The Treasury pays off the loan the Fed originally gave it in the form of bonds. The money to pay off the loan is withdrawn from the banking system and sent to money heaven.

Right now the Fed is redeeming its maturing Treasury note and bond holdings at the rate of roughly $30 billion per month.

It is also allowing $20 billion per month of MBS to roll off its balance sheet. In the normal course of business, borrowers pay off mortgages every day, either by making the final payment, selling their property, or refinancing the loan. The MBS pools holding those mortgages get paid down. The Fed held $1.65 trillion of those securities as of Dec. 12. That's down $124 billion since October 2017, when the Fed started paring down its bloated securities portfolio known as the System Open Market Account.

It hasn't lost a dime on any of that paper, despite much of its current holdings being under water – that is, worth less than the Fed paid.

We know it will never lose a dime on its holdings of Treasuries, regardless of how much they may be under water. And so far, the Fed has been doing just fine on getting its MBS holdings repaid.