Is Fed getting into the business of making money?

The following news caught my attention:


"The Federal Reserve will deliver a record $78.4 billion to the Treasury from its investments last year, a 65 percent increase from the $47.4 billion it transferred in 2009, according to preliminary estimates released Monday. "

So I was wondering from where the profit is coming and I found the biggest arbitrage business of the world! Fed is a big hedge fund and has found a great arbitrage opportunity in the name of saving the US.

The bank reserves with Fed have balloned over last two years!

* In 2008 Fed/US Government started paying interest (@ fed funds rate - 10 bp) on Bank Reserves with Fed so the reserves have ballooned from 40b to 1,040 billions!!!

* Besides the temptation of earning interest, other reason behind this jump is the hesitation by US banks in lending/investing this money. You, I and everyone have money in bank accounts which earn almost nothing. It seems that the banks are not lending this money to anyone either or they are not investing in mortgage or other higher interest instruments. Instead, seems like, banks are keeping these extra fund on demand deposits (I mean Reserves) with Fed.

See the following table that shows the jump in Reserves with Fed.

(see data here: http://www.federalreserve.gov/releases/h3/hist/h3hist1.txt


Month (Reserves with Fed in millions)

May 2008 45711
Jun 2008 45750
Jul 2008 45384
Aug 2008 46412
Sep 2008 103529
Oct 2008 315521
Nov 2008 609285
Dec 2008 820375
Jan 2009 857124
Feb 2009 700350
Mar 2009 779425
Apr 2009 880691
May 2009 900807
Jun 2009 809347
Jul 2009 795376
Aug 2009 828877
Sep 2009 922604
Oct 2009 1056642
Nov 2009 1140795
Dec 2009 1139002
Jan 2010 1108995
Feb 2010 1224790
Mar 2010 1185964
Apr 2010 1116368
May 2010 1109412
Jun 2010 1099258
Jul 2010 1087162
Aug 2010 1085607
Sep 2010 1048360
Oct 2010 1040217
Nov 2010 1038710

Fed announced few months back that they would be buying additional 600b dollars worth of mortgages. This is where yours, mine and everyone's money in our bank accounts is going. We are aware or we are not, but our money is used to hold our own mortgages!

Think of this situation: Your money in bank accounts earn no interest but you are probably paying 5-7% interest on home mortgage. Fed is exactly in the opposite- they have money that costs very little but they are earning interests in the range of 4-6% by investing in our mortgages!  - earning in my opinion 50-70 billion dollars!!

This arbitrage may not be the main objective of Fed, but I am sure, Fed, Treasure and deficit-ridden US goverment would be loving this additiona cashflow of 50 plus billions.

What is the cost/catch here?
1) If banks start withdrawing this excess reserve, Fed will have to sell the bonds (causing rates to go up sharply) or print money. If they start selling these bonds, the bond prices will tend to fall. Lower bond prices mean higher interest rates. Higher rates in the economy--- lower economical growth.
See some notes, taken from an article on NYTimes:

Interest income from its investment portfolio has produced record profits for the Fed for two consecutive years. But over time, when economic conditions improve, the portfolio could become a risk, because the investments could lose value when interest rates eventually rise.

“From the taxpayers’ view, I think it is a mistake to make much of this number either way,” said John H. Cochrane, an economist who has been critical of the central bank. “The Fed is acting like a huge hedge fund on our behalf. It is borrowing at very low short-term rates and investing in long-term government bonds, mortgages and other risky loans. It made a profit on those investments last year, but it is bearing a lot of risk.”

Mr. Cochrane, a University of Chicago finance professor, said the Fed was intentionally bearing those risks to support housing and other markets.

“But inevitably, with a big portfolio of long-term bonds, mortgages and risky securities, the day will come when the Fed loses money on those investments, at least on a mark-to-market basis,” Mr. Cochrane added, referring to the accounting the Fed uses to fairly value its balance sheet.

2) If Fed does not want to sell the bonds, they will probably have to resort to print money to pay back those reserves. I am sure none of us would like this...

3) Money spoils everyone. Though the Fed is entrusted with non-profit motives, it is very likely that their motives may be biased now. Directly or indirectly, the profit will keep coming in their economical decisions. Washington will also hate to lose this billions of dollars....so in the name of keeping the US vibrant, loweing unemployment, they would like to keep the game going! This is a perfect game- Fed gets an image of doing good for the nation, Washington looks good because they seem be very concerned about common good, and we also feel good and secured by having such a great Fed and Government lol
Mr. Bernanke is quoted, the Fed “is a profitable program, from the perspective of the federal deficit.”

4) We blamed Greenspan for causing housing bubble by keeping interest rates artificially lower... Current game is even bigger! The rates are artificially lower for long time...coupled with many benefits to troubled home-owners. If the home prices have to start booming, there will be even more players in the next housing boom because Real Estate investment now comes with a free Put option! If you get in losses, government is always there to bail you out! If you have profit in your real estate investments, it is yours to keep! Very advantageous proposition for investing in Real Estate compared to trading stocks or putting money in Cisco or Citibank!

Will appreciate your comments:
Jayesh Patel