Recent Good News from the Federal Reserve is Actually Very Disturbing
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Federal Reserve reports of $6.6 billion in profits from selling mortgage securities it bought at a discount from AIG (NYSE: AIG) at the nadir of The Great Recession should have all investors concerned. While a profit is always nice, this was all but guaranteed by the actions of the Federal Reserve to maintain a low interest environment. Due to these actions, the Federal Reserve now has about $3 trillion in assets that it must dispose of sometime in the future before all become liabilities for the American taxpayer. That amount will only increase with the initiation of Quantitative Easing 3.
To recapitalize the global financial system the American taxpayer bailed out Wall Street Institutions such as Goldman Sachs (NYSE: GS), Citigroup (NYSE: C), Bank of America (NYSE: BAC) and Morgan Stanley (NYSE: MS). If this had not happened, each would most likely have ended up filing for bankruptcy like Lehman Brothers or being nationalized like Fannie Mae and Freddie Mac. For this to transpire, the Federal Reserve had to inflate its balance sheet to acquire trillions in mortgage backed securities and other assets. There was no way Congress could appropriate such amounts.
As a result, the balance sheet of the Federal Reserve increased from around $700 billion in mid-2007 to about $3 trillion, at present. Quantitative Easing 2, from November 2010 to June 2011, consisted of the Federal Reserve inflating its balance sheet to finance the budget deficit for the United States though the purchases of $700 billion in Treasury bonds.
The reason for this is that there are no investors, either foreign or domestic, to be found for US Treasury bonds at such low interest rates. The Federal Reserve is the buyer of last resort for US Treasury Bonds in the present low interest environment. Federal Reserve Chairman Ben Bernanke has openly pledged to maintain this low interest rate environment until at least 2014. If no buyers can be found for these securities in a timely manner, then the liabilities for the American taxpayer will total in the trillions.
What is so disturbing about the recent sale of the AIG mortgage assets, knows as Maiden Lane III, is that it required 4 months to sell about $24 billion of the high-yielding AIG mortgage asset securities in the most optimal conditions possible: a yield hungry world due to a low interest rate environment with bull stock market conditions and plenty of liquidity.
Before, it took ten months to dispose of $19.5 billion in Maiden Lane II bonds (Maiden Lane is the street in Manhattan where the New York Federal Reserve is located). From that, less than $3 billion in gains were booked. The period for the sale of Maiden Lane II securities was from April 2011 through February 2012.
Overall, in very favorable market conditions, it took the Federal Reserve about a year to sell around $35 billion in very desirable, high yield securities, a little under $3 billion a month.
If the Federal Reserve can only move less than $3 billion a month in very appealing securities in very attractive market conditions, then it seems highly unlikely that the $3 trillion on the Federal Reserve balance sheet can possibly be disposed of before it becomes a huge liability for the American taxpayer. What made the mortgage assets from AIG so attractive was the high yield. Much of the Federal Reserve balance sheet consists of low yield American Treasury bonds, for which there is no market.
If there were willing buyers, the Federal Reserve would not have been forced to purchase the Treasury Bonds. If there was a purchaser waiting, these Treasury bonds would have been moved off the Federal Reserve balance sheet and sold to the private sector, as were the mortgage assets from AIG in the Maiden Lane II and Maiden Lane III transactions.
At $3 billion per month, it will take almost 100 years to restore the Federal Reserve balance sheet to its previous position, based on current market conditions. This will likely get much worse and take longer as it appears as if the Federal Reserve will be initiating further economic stimulus measures soon, which will most likely entail the buying of hundreds of billions more in American Treasury bonds that no other investors wants at such low interest rates.
One of the most important reasons for the Federal Reserve bailing out AIG, Goldman Sachs, Bank of America, Morgan Stanley and Citigroup and then handing over billions in profits was so that each would be healthy enough to assist in financing the operations of the United States Government; and facilitating the achievement of its goals and objectives. That is one of the most important considerations in protecting, regulating and developing the private financial sector.
None of these institutions is in any shape to step in and purchase the assets off the Federal Reserve balance sheet. The need to continue augmenting the financial sector is a huge reason behind the Federal Reserve's decision for Quantitative Easing 3. That is evinced by the rise in the share price of each from the boost of Quantitative Easing 3. Citigroup is up 10.70% for the week. Morgan Stanley is higher by 10.17%. Bank of America has risen 12.57% for the same period; with Goldman Sachs jumping 6.28%.
The only reason every one is still around is the American taxpayer bailing each out and then subsidizing billions in trading profits by allowing the banks to borrow at basically zero from the Federal Reserve discount window. With these low costs funds, each was then able to buy securities with higher yields and then book the spread as profits, courtesy of the American taxpayer.
This is new territory for the Federal Reserve: having $3 trillion in assets on its balance sheet, about a 450% increase in five years. No one knows how it will turn out for the disposition of these trillions in low interest rate securities that no other investor wanted to buy. But, based on the Maiden II and Maiden III transactions, if less than $3 billion a month can be moved in high yield bonds in a low interest environment with a rising stock market, then it does not look as if this will turn out well for the American taxpayer in the long term.
jonathanyates13 has no positions in the stocks mentioned above. The Motley Fool owns shares of American International Group, Bank of America, and Citigroup Inc and has the following options: long JAN 2014 $25.00 calls on American International Group. Motley Fool newsletter services recommend American International Group and Goldman Sachs Group. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.