May 2, 2011

Oh, the irony of it all! It’s easy to forget that our independent Federal Reserve has issues and worries of its own, apart from our shared economic destiny. But truth is stranger than fiction, as it were. So it should not surprise anyone that the very same Fed, whose monetary policies send ripples of interest rate risk right to your doorstep, has, well, interest rate risk of its own! That’s what happens when your bond portfolio gets to be a tad large. In total, the U.S. Federal Reserve now has $2.695 trillion with a “T” dollars worth of assets on its balance sheet, with nearly $2.5 trillion of this being fixed income assets sensitive to rate movements.

The overly simplistic view is that Fed assets will lose value as the economy recovers and interest rates rise. If you set aside the implications of the Fed’s dual mandate for just a moment, you may have wondered what it would look like to hedge the Fed’s balance sheet. Specifically, what could the Fed do to keep the value of its assets relatively constant so that it does not hemorrhage dollars before it begins an orderly unwind to a normal pre-crisis size? What would this hedge look like?

Back of the envelope. There are a number of ways the Fed can hedge this portfolio. For starters, they can short treasuries, or better yet short treasury futures contracts. They could simply re-invest principal from maturing securities into shorter dated T-bills, and reduce duration and IR exposure in the portfolio. Recall we are talking about the Fed’s balance sheet here, so lower yielding assets should not be the main concern anyways. A quicker calculation (right at my fingertips, I might add!) is for the Fed to enter into a pay-fixed swap, sized to match the duration of its fixed income portfolio. The swap would be an asset to the Fed if rates rise, and would be a liability to the Fed if rates fall, offsetting movements in its bond portfolio. If you will permit a simplifying assumption, that Fed assets include some level of credit risk beyond treasuries due to the composition (which includes agencies and MBS bonds, and all of the loans, etc.), then I will use a standard “semi-bond” swap structure to calculate the risk. Therefore, the Fed would pay fixed and receive 3mo LIBOR, with the swap essentially worth zero at inception (now you know it’s hypothetical, as clearly no one would do this for free!).

That’s one mighty big swap! Assuming a $2.5 trillion bullet notional to match the value of its securities and loans (as of Apr 27), and a 6yr average life to this portfolio (recall the Fed has shorter but also much longer dated assets), the resulting hedge has a staggering $1.385 billion dv01, or value of 1 basis point. That would mean a 1% (100bps) rise in interest rates (assuming a parallel shift) would generate roughly $138.5 billion dollars in value for the Fed, offsetting the same loss in value on its fixed income portfolio. This indication could be refined further with more precise duration and notional schedule assumptions, but you get the picture. The Fed’s assets would be protected against erosion in value due to changes in interest rates, and we would have successfully hedged the Fed.

Observations and implications. On the same Federal Reserve Statistical Release that shows the current balance sheet composition (H.4.1, dated April 28th), the Fed also advised that their total capital is just shy of $53 billion. That would mean without our hypothetical hedge, a rise in interest rates of only 38bps wipes out the Fed’s capital! As the Fed collects its interest coupons and receives principal on its maturing securities, the scenario gets a little better and affords the Fed a greater cushion, but it is a bewildering observation nonetheless. When you factor in the FOMC rate decisions, and how a tightening cycle might play out, the bond portfolio would take eye-popping losses without a hedge in place. Recall that we were in a 5.25% rate environment as recent as September 2007.

So, will the Fed hedge? “If an institution determines that its core earnings and capital are insufficient to support its level of interest rate risk, it should take steps to mitigate its exposure, increase its capital, or both.” So said the Fed in January 2010, in a warning to banks to implement sound risk-management practices to identify, measure, and control their exposures. Will the Fed take its own advice? It’s quite dramatic to contemplate a single $2.5 trillion swap, but the Fed could actually just leg into this position over time with multiple trades, just like it did with its asset purchases. The difficult thing would be to find enough counterparties to handle this much risk without imploding financial stability. And no doubt every trade (imagine billions in notional or larger, for every deal!) would be a monumental market mover, despite the depth of interest rate markets. And even though swap spreads would hedge some of the credit risk in the Fed’s portfolio, they would need to consider a more precise hedge if they wanted to fully mitigate their credit risk as well. Something like, I don’t know, maybe credit default swaps could work nicely, but of course that’s what got us into this mess in the first place! Despite some obvious benefits, it remains to be seen whether the Fed would ever hedge to such a degree.

If you have questions about your own hedging needs, give us a call! You don’t need to have Fed-size risk to know that rates could impact your bond portfolio, your borrowings, or your business. Chatham can help you structure the trade that’s right for you.