The Mother of All Balance Sheets

The Federal Reserve’s balance sheet has quietly ballooned back to near-record highs. The Fed announced yesterday that it’s balance sheet expanded to $2.22 trillion last week, it’s grossest level in nearly a year and just a hair from an all time high. Hmmm… if Mr. Bernanke assures us the recession is “very likely over,” then why is the Fed balance sheet in crisis mode? What are they worried about? Here’s the answer:

Mortgage Backed Madness

The Federal Reserve went from an essentially non-existent player in the mortgage backed security market a year ago to owning $904 billion of the stuff today. The “private” bank has clearly moved its aim from the financial sector to housing, loading up on MBS, debt spilling out of Fannie Mae and Freddie Mac and Treasury bonds (a handy way to suppress mortgage rates).

Coupled with the Treasury’s black check to Fannie and Freddie, we’re detecting a trend.

“The market will eventually adopt the view that Fannie Mae and Freddie Mac have been nationalized,” opines Dan Amoss of the Strategic Short Report. “Last week’s elimination of limits on Treasury’s capital infusion into Fannie and Freddie is a de facto nationalization. In other words, there’s no longer much chance of a re-privatization, but instead we’ll see a gradual transformation of these Frankensteins into new branches of government. They’ll implement the official government agenda for housing, without much regard for prudent lending.

“This will have huge consequences for the Treasury market. While the federal government will stick to its Enron-style accounting, and not officially consolidate Fannie/Freddie assets and liabilities onto the government balance sheet, the smarter foreign creditors will. These creditors will start viewing Fannie/Freddie liabilities as equal to Treasuries in terms of default risk. But this doesn’t mean that spreads on Fannie/Freddie liabilities will tighten down to Treasuries; rather, it will substantially increase the long-term default risk of Treasuries, and Treasury buyers will demand higher rates to compensate for this risk.

“In summary: the Treasury’s Christmas Eve announcement adds substantially to the case for higher Treasury yields in 2010.”