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The Financial Effects of Winding Down a $4.5 Trillion Balance Sheet

by Moises Ospina

Senior Advisor, Capital Markets

The Federal Reserve’s balance sheet (which is a standard balance sheet that consists of assets and liabilities) has grown to $4.5 trillion, including Treasuries and mortgage‑backed securities (MBS). Before the financial recession, the balance sheet held far less assets. In fact, the assets held by the Federal Reserve back in August 2007 totaled $869 billion.

The following chart from the Board of Governors of the Federal Reserve System reveals the rising trend we’ve seen in the last decade.

Federal Reserve Banks: total assets

A common narrative in the market today includes the concerns investors have regarding the likelihood of the Federal Reserve (the Fed) deciding to “roll off” or unwind assets from the existing balance sheet. Remember, the path from less than 1 trillion to north of 4 trillion was paved by fiscal policy that caused the Fed to be a huge buyer of MBS and Treasuries as a means to create liquidity in the market and fuel stabilization and growth in the housing and lending business. Now, as these securities mature, the Fed has the option to “cash out” and not continue to be the largest buyer of MBS. Some investors express fears directed at the potential lack of liquidity in these marketplaces, which leads to questions regarding possible implications of future Fed policy on the real estate industry and its ancillary markets, such as banking, lending and retail.

It’s almost unrealistic to think that the balance sheet held by the Fed will return to pre-crisis levels of $869 billion anytime soon. Unwinding the balance sheet by more than 75 percent will introduce a large amount of uncertainty in the markets. But what about unwinding the size of the balance sheet to $2–2.5 trillion?

The record amount of assets held by the Fed and other central banks around the world (e.g., the European Central Bank, the Bank of Japan and the People’s Bank of China) likely has a strong correlation to higher valuations in the stock market. At the beginning of 2009, the global market capitalization was around $30 trillion, and central banks held assets of just more than $8 trillion. Today, the global market is valued around $70 trillion, and the central banks have amassed more than $18 trillion in assets.1, 2

Through the Treasury, the Fed has been providing liquidity to markets, and the MBS market is certainly not the exception. Liquidity means lower yields and higher levels of cash circulating the economy, which, in many ways, propelled multiple industries, including the real estate market — a healthy U.S housing market backed by strong economic fundamentals will provide a good basis for the MBS market, as well.

The private sector will need to support the MBS market if the Fed finally reduces the amount of reinvestments within this particular sector. The banks may need to provide liquidity, but keep in mind that they will only do so if they can achieve decent profit margins.

Higher interest rates will increase the spreads on the MBS instruments due to the lower potential demand from the Fed — banks may find the MBS market appealing if the Fed rolls off future purchases of MBS paper. According to CNBC, more than $400 billion of Treasury debt alone is scheduled to mature in 2018, and possibly $200 billion in MBS could be paid off. If the decision is made to stop all reinvestments, the result could be the balance sheet moving in the direction of the “new normal” in merely a one-year period.3

However, going back to the question of Fed policy and the effect on the real estate market, what’s more of a concern is investors currently holding MBS paper due to future liquidity rather than investors participating directly in the real estate market.

To provide a common illustration, imagine kids selling lemonade on the corner of a neighborhood street in America. Usually there is a parent (i.e., the Fed) who is willing to buy most of the available lemonade to help the kids (i.e., the MBS market). In the absence of the “very nice” parent, the kids will sell the lemonade, but it will take the entire afternoon, and they may have some of the homemade beverage left at the end of the day.

It will be a similar process with the real estate market and the Fed unwinding the balance sheet — the market will still be there, but the velocity is not going to be the same. At the end of the day, what really matters is how strong the economy is, as the real estate momentum is closely tied to employment levels, GDP growth and the overall health of the economy.

Furthermore, what really could happen if unwinding the balance sheet ultimately affects the real estate market? It can be argued that the Fed has backed itself into a corner, holding the paper linked to assets requiring annual property taxes to pay to various federal, state and local government entities. In other words, disrupting the MBS and the real estate markets too much could potentially create a cash flow issue to the government, as well.

The Fed may still buy some lemonade (i.e., MBS instruments) in the near future to make sure that the markets are not dislocated. After all, it’s not the best situation to have unhappy kids in the neighborhood. The financial crisis propelled by the housing crash back in 2008 will always be a fresh reminder of market disruption.

Unwinding a $4.5 trillion balance sheet is certainly the equivalent to navigating uncharted financial waters, but having open discussions with your advisor about your concerns about the global economy sets the table for conversations about your personal economy.

 

1 Dr. Edward Yardeni and Mali Quintana. “Global Economic Briefing: Central Bank Balance Sheets.” Yardeni Research, Inc., July 2017.
2 Wallace Witkowski. “Global stock market cap has doubled since QE’s start.” MarketWatch, Feb. 12, 2015.
3 Steve Liesman. “Fed’s new normal balance sheet could be huge.” CNBC, May 15, 2017.

 

Moises Ospina is the senior advisor for the Capital Markets Group at 1st Global. In this role, he applies his years of market expertise as he works with affiliated advisors to perform account analysis as well as construct and manage fixed-income portfolios.

 

Disclosures

All opinions expressed and data provided are subject to change without notice.

Some of these opinions may not be appropriate to every investor.

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