Holding a mortgage investment portfolio bigger than Fannie Mae’s or Freddie Mac’s, along with a massively expanded government bond portfolio, puts the Federal Reserve into uncharted waters of interest rate risk.
The combined balance sheet of the Federal Reserve has $2.9 trillion in assets and $55 billion in equity, for leverage of a heady 52 times and a capital ratio of a paltry 1.9 percent. On top of this high leverage and little capital, the Fed runs massive interest rate risk, with investments in long-term mortgage-backed securities (MBS) of over $900 billion and longer-term Treasuries of $1.65 trillion.
“The huge and rising government bond holdings of Japanese banks leave them vulnerable to a spike in interest rates, the International Monetary Fund has warned,” the Financial Times reported recently. But somehow the IMF did not warn about the Fed’s huge and rising bond holdings, which leave the Fed vulnerable.
A rise in interest rates from their historic lows is inevitable at some point. How vulnerable is the Fed’s balance sheet to interest rate risk? We can estimate the market value impact of a 2 percent increase in interest rates, a common benchmark.
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