Apart from its responsibility of directing monetary policy, the Federal Reserve also functions as the regulator of the U.S. Financial system. It is also a powerful direct and indirect intermediary between various participants in the wholesale money markets, working to ensure the smooth flow of liquidity in the system. Most recently, the Federal Reserve has also been assuming a much more direct role in the day-to-day functioning of the broader U.S. economy by assuming the duties of a buyer of last-resort for anything from questionable mortgage paper, to arguably risk-free commercial paper. As the subprime crisis gradually transforms from an ABS crisis, to a global financial, and banking crisis, and finally, as this article was being written, threatens to become a global solvency crisis for sovereign credit, the Federal Reserve will keep transforming itself to suit the rapidly changing market conditions.
As with any other financial institution, the Federal Reserve’s balance sheet can be broken down into assets and liabilities components, each of which can grow and shrink depending on the circumstances of the U.S. economy, and the stated goals of the institution. Let’s take a look at assets of the Federal Reserve first, as summarized in page H.4 at the Fed web site.
1. Reserve Bank Credit
This item summarizes the various kinds of credit extended by the Federal Reserve to different institutions all over the world.
Securities Held Outright
This item is typically the main section of the Fed’s balance sheet, comprised of U.S. Treasury bills, notes, and bonds. Since the financial crisis of 2007-2009, however this section also includes MBS on U.S. mortgages purchased through an announced program of the Fed along with securities of GSE’s, (Fannie Mae and Freddie Mac). The Fed utilizes these high quality, lowest risk securities to lend to financial institutions in order to create money, or expand M2, while holding the mortgage paper, and other low quality items to prevent a shutdown of the credit channels of the financial system.
Repurchase Agreements (Repos)
This is the main tool that the Federal Reserve uses to keep interbank lending rates, and by extensions interest rates in the wider economy close to its target. By selling Treasury securities to financial institutions, and removing liquidity from the system on a temporary basis, and then repurchasing the securities at a later date, (termed a repo or a repurchase agreement), the New York Fed maintains the stability and liquidity of the system. Since securities sold in a repo agreement remain the property of the Fed, they are accounted for under the asset section of the balance sheet.
Term Auction Credit
This item accounts for the actions of the Term Auction Facility (TAF) of the Federal Reserve, which periodically auctions highly liquid assets such as Treasuries to keep the interbank market liquid. This category was also created in the aftermath of the subprime crisis of 2007-2008. The Fed holds auctions for about $25 billion monthly, but the sums are frequently increased in response to tensions in the financial world.
The term auction facility was launched in December 2007, and is largely modelled on the refinancing operations of the ECB conducted through weekly, and monthly periods, and through longer term periods in response to fluctuations in overnight Euro libor rates (EONIA).
This item sums up the amounts credited to financial institutions under the Fed’s role as a lender of last resort, and the guarantor of financial stability. With the recent expansion of the balance sheet, we have the TSLF, lending high-grade Treasury securities, for ABS (asset-backed securities, such as various types of mortgage paper, and CDOs, or CMOs which is a kind of CDO where the collateral is a mortgage), the PDCF, extending the discount rate facility to a wider array of primary dealers, the AMLF, launched to liquefy the money market funds that purchase asset-backed commercial paper, and the CPFF, which directly buys corporate commercial paper from the issuers.
Net Portfolio Holdings of Commercial Funding Facility
This item provides an account of the assets of Commercial Paper Funding Facility, LLC, holding the commercial paper purchases of the Fed. As with the following special purpose vehicles, Maiden Lane (I-II-III), CPFF, LLC is an off-balance sheet institution.
Maiden Lane (I-II-III)
The three Maiden Lane entities were launched between Q1-Q4 2009, to account for the bailout of of the bankrupt brokerage house Bear Sterns. Fulfilling the avowed role of the Federal Reserve as a de-facto mortgage lender, and the waste collector of the U.S. Financial system, the three limited liability corporations hold the following on behalf of U.S. taxpayers.
Maiden Lane (I): This firm holds the largest part of the illiquid, and potentially worthless assets of Bear Sterns.
Maiden Lane (II): This company holds the residential mortgage MBS acquired from the mortgage lending reinvestment portfolio of AIG subsidiaries.
Maiden Lane (III): This firm holds the CDOs formerly insured through CDS underwritten by AIG. With the end of AIG, the Fed acquired the CDOs and consolidated them in this Maiden Lane III SPV (special purpose vehicle).
Central Bank Liquidity Swap
This sum includes the dollar swaps of the Fed with the central banks of the world, the composition of which changes from time to time, but generally includes the ECB, SNB (Swiss National Bank), and the Bank of England. Through these swaps the Fed lends dollars to overcome local dollar shortages, and control dollar libor overseas.
Other Federal Reserve Assets
This item mainly summarizes the emergency credit or loans granted by the Fed to various insolvent entities, including, for example, AIG. It may also
Drawing rights of the U.S. At the IMF, held as an asset by the Federal Reserve. Special Drawing Rights (SDR), is the currency of the IMF, and is allotted to each IMF member on the basis of their contributions to the IMF’s reserves. The unit was launched in the 1969, in order to overcome dollar shortages by substituting the SDR for the U.S. Currency in operations between central banks.When central banks settled transactions between them before the creation of the SDRs, dollar was the preferred currency, a fact that created shortages pressuring the pegs of the time. The SDR today serves many purposes, but the U.S. Dollar maintains its status as the currency of international prestige for the dominant economic power of the world.
This is the gold bullion held at the Federal Reserve Bank of New York’s faults on behalf of the Federal Reserve System.
2. Liabilities of the Federal Reserve
Against the assets above, the Federal Reserve holds reserve balances, cash in circulation, reverse repos, and other deposits of government entities on the liability side of its balance sheet.
Currency in Circulation
This is the currency component of M1, often termed M0, and estimated by the Federal Reserve. Currency is a form of borrowing by the public sector at zero interest, and is a part of liabilities. Originally, each currency bill was redeemable for gold or silver at face value, and was equivalent to a promissory note, which lies at the origin of currency in circulation as an item of liability.
This is the exact opposite of a repurchase agreement, by which the Fed can inflate the money supply when it chooses to. In this case the bank buys securities from various financial institutions that will resell them to it at a later date, in exchange for an interest payment received by the Fed. At ordinary times, this is the main channel that the Fed uses to expand money supply, and to goad rates in the wholesale interbank market towards its main lending rate. Reverse repo operations are performed when rates are too high, and there appears to be a liquidity shortage in the interbank market.
Treasury Cash Holdings
Treasury cash held by the Federal Reserve, frequently an insignificant and small item.
Deposits with Federal Reserve Banks excluding reserve balances
This item breaks down into the general account of the U.S. Treasury, and its supplementary financial account both of which are the main sources of Federal Reserve Operations (such as buying mortgage paper, actioning of funds and similar actions). The term “foreign official” is also called “Fed Custody Holdings”. This item is a kind of temporary safe keeping facility operated by the Fed on behalf of foreign central banks where their possessions are deposited until further use (for example, when U.S. Treasury bills are deposited by foreign banks).
On both sides of the Fed Balance Sheet, there also exists an item termed “float” and “adjustments to compensate for float”. These terms describe accounting errors during the clearing of checks and are not highly relevant for fundamental analysispurposes.
What is the meaning of the balance sheet statistics of the Fed?
There are a large number of ways in which the monthly statistics of the Fed can be exploited for a better understanding of the “big picture”. Statistics on currency in circulation give a good estimate of M1 (which includes overnight deposits and other short term instruments in addition to currency in circulation). Central bank liquidity swap statistics provide the best information on overseas dollar shortages, and can be helpful in predicting the behavior of central banks with respect to refinancing and liquidity operations. Federal Reserve custody holdings on behalf of foreign central banks give us information on short term trends (unlike central bank reserve accumulation statistics, which provide information on long term trends) in global reserve accumulation.