The Fed and it's SOMA

It’s been a while since I last wrote an article about the central banks so since I am currently half way though an 800 pages book about the history of the Fed titled The Secret of the Temple; I am going to explain in this short article what are the problems facing the Fed’s SOMA, which stands for the System Open Market Account. This account is where the central bank holds the MBS, treasuries and agency securities which currently stands at approximately 2.25$ trillion, up 62% from the previous year due to the recent QE2 purchases. So, why is the size of this account so important for the economy?

Well first, for Bernanke, other than the inflation risk that such massive liquidity might spark, the interest rate risk of the holdings in the account is another one of his main concerns. As we hear about the increasing inflation expectation in the United States, the yields along the curve is climbing back up from its historical low so therefore the market value of this portfolio will decrease accordingly to the yield changes. These MBS carries the highest interest rate risk because of their lack of liquidity comparing to the other agency securities and if you remember from your CFA studies, these MBS also carries an additional problem called the prepayment risk. Not only is the structure of these securities a problem, but as prepayment slows down when interest rate rises, this will create larger losses to these MBS products that represents a 40% of the entire account. According to the Fed, their current holding of MBS in the SOMA is about 965$ billion with a duration of 7 years.

Well now, what is the second problem? When the Fed gets closer to the end of the QE2 purchases to expand their balance sheet and the SOMA portfolio, this is basically the end of the easy money game for the commercial banks as the Fed will discontinue the purchase of their assets. The large amount of cash which are held at the banks will begin to move around in search of higher yields, so with an imposed reserve requirement of 10% and the 1.04$ trillion of excess reserves that is currently stored at the central bank, the additional loans that will flood into the market will add fuel to the problem of inflation.

Last and not least, as I wrote about how Obama is getting near his debt limit and while the budget deficit is on pace to hit 1.48$ trillion for 2011, the private market will have to start absorbing the treasuries as the Fed is still currently the main buyer for over 90% of the daily issuance at about 5.5$ billion a day. As the Fed backs out from the huge daily funding, will the private market be able to pick up such a huge purchase on its own? I can already feel it coming, they are going to need the Chinese again but hey, then they are going to blame them for fixing their currency from buying their securites, just like how Donald Trump is publicly blaming the Chinese for the US economy all over TV. How sad is the country getting when you have Trump leading with 37% in a national poll as the primary republican candidate. What a nightmare…