Federal Reserve QE2 Watch: Part 8

I usually do the “QE2 Watch” post in the first week of the new month, but in this coming month I will be a little tied up.  I am having hip replacement surgery on June 28 and will be a little preoccupied for a few days.  I will also write a post on the condition of the banking system that I will post tomorrow.  Then I go “on vacation” for a while.

Chairman Bernanke and the Federal Reserve have signaled that QE2 will definitely end on June 30 and they have indicated that QE3 is not in the works…at least at the present time. 

The stated plans for QE2 included the new purchase of $600 billion in Treasury securities and the purchase of a possible $300 billion more in Treasury securities to replace securities maturing in the Fed’s portfolio of Federal Agency issues and the Fed’s portfolio of mortgage-backed securities. 

From Wednesday, September 1, 2010 to Wednesday, June 22, 2011, the Federal Reserve’s holdings of United States Treasury issues have risen by roughly $816 billion.  During this time period, the dollar volume of Federal Agency issues on the Fed’s balance sheet has dropped by $38 billion and the dollar volume of mortgage-backed securities has declined by $189 billion…a combined total of $227 billion. 

The “net” increase in securities held outright by the Federal Reserve has been $589 billion, pretty close to the $600 billion “net” increase promised. 

Reserve balances at Federal Reserve banks, a proxy for excess reserves in the banking system, have increased by $584 billion to $1,594 billion over this time period.  Actual excess reserves in the banking system averaged $1,610 billion for the two-week period ending June 15, 2011.

Almost all the increase in excess reserves can be attributed to the Fed’s purchase of United States Treasury securities. 

Other factors affected reserve balances within this time period but they tended to be minimized over the period as a whole.  For example, in the first quarter of 2011, the United States Treasury Department reduce its “Supplemental Financing Account” at the Fed by $195 billion, a not inconsequential amount of funds.  This reduction added reserves to the banking system.  However, over time, this movement was offset by other factors and hardly had any net effect on the total amount of reserves being supplied to the banking system.

And, what was the total impact of QE2 on the commercial banking system?

All the reserves the Fed crammed into the banking system went into excess reserves!

Yet deposits in the banking system continued to increase. 

Demand deposits in particular rose at a very rapid pace.  From the second quarter of 2010 when demand deposits at commercial banks increased at a 6.3 percent rate year-over-year, these accounts rose by 8.5 percent in the third quarter and 14.3 percent in the fourth quarter.  But this rate of acceleration jumped to 20.4 percent year-over-year in the first quarter of 2011 and in the month of May was showing a rate of increase of almost 27 percent!

What is happening here?

Demand deposits at commercial banks are increasing at a very, very rapid pace, yet commercial banks do not seem to be lending much at all (more on this tomorrow) and everything the Federal Reserve is pushing into the system seems to be going into excess reserves.  What’s going on?

Basically, what’s going on is the same thing that has been going on for the last 18 months or so.  Because of the poor economic climate and because of the excessively low interest rates people and businesses are moving funds out of interest bearing accounts and into transactions accounts.  These latter accounts are where people are locating their “liquidity” these days so as to pay for necessities and other important things to keep on living. 

For example, Institutional money funds are still losing money…perhaps not as fast as they were a year ago, but they are still contracting by more than 5 percent, year-over-year.  Retail money funds are still declining at a rate in excess of 8 percent year-over-year and small time accounts are declining by more than 20 percent, year-over-year. 

All non-M1 money stock money included in the M2 money stock measure has risen only modestly over the past 12 months and most of this has come in the money market deposit account s included in the aggregate category titled savings deposits.

The result is that the M1 money stock measure is increasing rather rapidly at around a 12 percent year-over-year rate in the last three months.  The M2 money stock measure is increasing by less than 5 percent over the same time period.  The rate of growth of the M2 money stock measure has only increased modestly over the last four quarters. 

People are putting their money into accounts from which they can transact.  They are moving their money into these accounts because they need to stay liquid in order to pay for their daily needs. 

The other indicator of this behavior is the rapid increases that have been made in the demand for coin and currency.  In the second quarter of 2010, the currency in circulation was rising by only about 3.5 percent, year-over-year.  This steadily increased through 2010 until it reached a total of over 7.0 percent in the first quarter of 2011.  That is, the coin and currency in circulation more than doubled its growth rate over this time period.  In May 2011, the year-over-year rate of increase in the currency component of the money stock was rising at almost 9.0 percent year-over-year. 

In the slow economic growth climate we are in, people do not increase their holdings of coin and currency in order to generate new spending.  They increase their holdings because they need these funds to buy necessities in the face of unemployment, foreclosure, and bankruptcy!

The information from the financial system is not very encouraging.  The Fed has tried to push all the funds it can into the banking system.  The banking system is not lending it…both because the banking system is still not in that good of a shape…and because people are not in very good financial condition and are not borrowing.  Thus, reserves pile up at commercial banks. 

If QE2 was supposed to get the economy growing faster, it has failed miserably.  If QE2 served other purposes, like allowing the FDIC to close banks in an orderly fashion, then it has succeeded.  If the Fed used the economy as an excuse to explain QE2 while it was assisting the FDIC in its efforts to close banks in an orderly fashion then it was duplicitous.  It might have done this to avoid people getting overly worried about the condition of the banking system.

But, the more I think about this last statement the more I chuckle because I don’t think that the Fed is that good.

Housing Still in Cumulative Downward Cycle?

Why would financial institutions want to put home mortgages on their balance sheets right now?

Answer: they really don’t want to add mortgages to their balance sheets.

The consequence is that very tight credit standards exist for mortgages at the present time, a time when credit standards have usually been increasing as the economy comes out of a recession. A Federal Reserve report covering the third quarter of 2010 showed that 13 percent of bank loan officers stated that they were working with tighter requirements. Only 4 percent stated that they were working with easier ones.

Banks, of course, are not issuing non-governmental mortgage-backed securities. In fact, the amount of mortgage-backed securities outstanding has plummeted beginning in 2008. Federal Reserve statistics indicate that privately issued pools of home mortgages fell by $310 billion in 2008, by almost $340 billion in 2009 and have fallen by about $230 billion in 2010.

Agency- and GSE-backed mortgage pools are increasing but at a rate way below previous levels.
In 2008, home mortgages totaled over $11.1 trillion; at the end of the third quarter of 2010, there was only about $10.6 trillion in home mortgages outstanding in the United States, a 4.5 percent drop.

It is apparent that financial institutions do not want to hold mortgages on their own balance sheets and if they cannot securitize them and sell them then they just don’t originate them.

There appears to be two reasons contributing to this behavior. First, delinquencies and foreclosures are still increasing at near record rates. Trying to work out loans that are delinquent and carrying out the process of foreclosure takes time and human resources, resources that could be used to originate mortgages. Second, home owners do not seem to be borrowing if they don’t have to. Mortgage applications have fallen by more than a third from the levels reached in late 2008 and show an almost continuous decline in 2010. Why should home people move if they don’t have to and home prices continue to decline?

Furthermore, Fannie Mae and Freddie Mac have gotten very aggressive demanding that commercial banks buy back defaulted loans if it can be shown that the mortgages Fannie and Freddie acquired were not originated under stated underwriting guidelines. Financial institutions are scared due to the fact that if they have to buy back defaulted loans…it may put them out of business.

Why should the affected banks make any more loans if they might go out of business? Making loans under these circumstances is just a waste of time.

In terms of home prices, Zillow.com has reported that home prices will have dropped by about 7 percent in 2010. In 2011, Fitch Ratings has projected a further 10 percent decline in home prices.

The dynamics of the housing market, therefore, is that falling employment and incomes are still a problem in many sectors of the economy. Banks are not very willing to originate new home mortgages and have tightened requirements to obtain loans. Housing prices fall because the demand for homes has dropped and there is a large inventory of foreclosed properties on the market. This puts more homeowners “under water” with respect to the outstanding loan values they have. And the cycle continues…downward.

Given such a cycle, there is very little incentive for financial institutions to put home mortgages
on their balance sheets.

But, there is another possibility threatening the value of the home mortgages already on the balance sheets of commercial banks.

Fannie Mae and Freddie Mac are reported to be in discussions with people from the Obama administration seeking support for a program to write down loan balances on home mortgages where the borrowers mortgage is greater than the current market price of their homes.

Doing so would help these home owners by “forgiving” the amount of the loan that is underwater. This would reduce the probability of more foreclosures due to a mortgage being underwater and it would also have the effect of reducing loan payments. The “write down” would cost the American taxpayer as the government would have to pay for the amount written down.

Even more scary is the fact that if Fannie Mae and Freddie Mac start to reduce loan amounts to levels that are more consistent with current prices, what pressure would be put upon commercial banks to do exactly the same thing? And, this pressure would seemingly grow as the next Presidential election came nearer.

Commercial banks, both the largest 25 banks in the country and those smaller than these 25 banks, have slightly more than 14 percent of their assets in home mortgages. How much of a hit could these banks absorb and still remain solvent?

Even a little more “write down” in the face of all the other problems that reside on the balance sheets of the banking system would seem to be very troublesome. (See, for example, http://seekingalpha.com/article/241787-the-pending-2011-debt-refinancing-for-commercial-banks.)

The banking industry is fighting such a write down.

The problems existing banks are facing just seem to go on-and-on. Is it any wonder that the banking system, as a whole, is shrinking its loan portfolio? Is it any wonder that federal regulators are continuing to “prop up” the banking system so that these difficulties can be worked out as smoothly as possible? Is it any wonder that the banking system is not contributing to the economic recovery?

Even with some economic recovery taking place, there are still areas of the economy…housing and commercial real estate…that seem to be in on a cumulative downward cycle.

Federal Reserve Exit Watch: Part 13

In the summer of 2009, a great deal of concern was expressed about the Federal Reserve and the excessive amounts of Reserve Bank credit that had been pumped into the banking system. The Federal Reserve stated that it had an “exit” plan to withdraw these reserves from the banking system so as not to create an inflationary or hyper-inflationary environment once the economic recovery began to pick up speed.

Here we are 13 months into the “exit watch” and there has been “no exit” of reserves from the banking system. In fact, Reserve Bank credit is now $331 billion GREATER than it was one year ago; it has grown over the past 365 days by 16.7%, as of August 4, 2010.
The stated reason for this “no exit” performance: the economy has remained stagnant and as long as the economy stays very weak the Federal Reserve will keep its low target interest rates which means that the target Federal Funds rate will remain close to zero for an “extended period”.

As I have reported in my blog posts, my belief is that the Federal Reserve is excessively concerned about the solvency difficulties being experienced by the small banks in this county, a concern that I have recently summarized in my post of August 2, titled “No Banks, No Recovery,” http://seekingalpha.com/article/218027-no-banks-no-recovery. There are many small banks experiencing extreme problems and the Federal Reserve is not going to begin withdrawing reserves from the banking system until there is some indication that this solvency problem is over.

Commercial bank Reserve Balances with Federal Reserve Banks has risen by $334 billion over the past year, an increase of 46.6% since August 5, 2009. Note that Excess Reserves at depository institutions rose from a monthly average of $750 billion in June 2009 to $1,035 billion in June 2010, an increase of 38%.

This is a strange “exit.”

And, as the Federal Reserve has pumped these additional reserves into the banking system, the total assets of the commercial banks in the United States fell by 1.7% from almost $12.0 trillion to about $11.8 trillion from June 2009 through June 2010. Loans and leases at these commercial banks declined by 2.6%. Banks got out of a substantial amount of business loans during this time period, as commercial and industrial loans fell by 16.7%, June-over-June, and commercial real estate loans declined by 7.8%, year-over-year.

The reserves the Fed is pumping into the banking system are not going into “pumping up” the economy. The reserves the Fed is pumping into the banking system are just going into excess reserves!

Looking at a shorter period of time, over the past 13 weeks, the last quarter, Reserve balances with Federal Reserve banks rose by $8.0 billion. The primary swings in the Fed’s balance sheet over this time period were operational in nature. There was a $26 billion decrease in the General Account of the U. S. Treasury, a seasonal increase in currency in circulation of about $9 billion and a $7 billion rise in Foreign Reverse Repos. The offsetting transactions of the Fed to neutralize these changes was an increase in Securities Held Outright by the Fed of about $12 billion, the primary increase coming in the Fed’s purchase of Mortgage-backed securities.

In the past 4 weeks, the U. S. Treasury balance reversed itself, increasing by almost $28 billion and there were modest declines in currency in circulation and Foreign Reverse Repos. The Fed offset a portion of these by letting it holdings of Federal Agencies decline by a little more than $5 billion. The net effect of these operating transactions was a $19 billion decline in Reserve balances held at Federal Reserve banks.

Thus, over the past 4 weeks and over the past 13 weeks, Reserve Bank Credit barely changed. Both periods were dominated by operating transactions within the banking system offset by Federal Reserve balancing transactions.

As a consequence, excess reserves in the banking system stayed relatively constant over the last quarter of the year.

Loans and leases at commercial banks continued to decline over the last 4-week and 13 week periods as did commercial and industrial loans and commercial real estate loans.

In summary, the Exit Watch in the thirteenth month of its existence can report little or no action on the exit front over the past month or the past three months. “Exit” is still on hold until either the general condition of the small banks improves or the economic recovery really becomes an economic recovery…or both.

E-Mails, Investment Banking, and the Rating Agencies

Thank goodness for emails! Now we know what was really going on at Goldman Sachs and Moody’s and Standard & Poor’s. How about Congress including in their bill on financial reform the requirement that all financial institutions and rating agencies and all other organizations having to do with finance (say the Federal Reserve and the Treasury and Fannie Mae and Freddie Mac…and Congress…and the White House) release all of their e-mails a week after they were written.

This would really provide the financial markets with transparency!

The thing that strikes me so much about the release of these e-mails over the past week or so is their humanity. These Wall Street villains talk like human beings, like you and me.

Gillian Tett, in my mind, has a terrific opinion piece in the Financial Times this morning titled “E-Mails throw light on murky world of credit” (http://www.ft.com/cms/s/0/a9da1aa4-508b-11df-bc86-00144feab49a.html). Her reflection on the e-mails is captured in the following sentence: “It is fascinating, almost touching, stuff.”

But, even more important she states that “Reading these e-mails with the benefit of hindsight, there is little suggestion that rating officials were engaged in any deliberate malfeasance. Many appear conscientious and hard-working.” These people are just human beings trying to do their job.

The same can be said of those people that wrote the e-mails at Goldman. This is captured in an article by Kate Kelly in the Wall Street Journal titled “Goldman’s Take-No-Prisoners Attitude” (http://online.wsj.com/article/SB20001424052748703441404575206400921118356.html#mod=todays_us_money_and_investing.)
Kelly speaks of a world, which Tett describes as “so detached and rarefied”, in which betting applied to almost anything. The scene she presents in her article is one in which mortgage traders from Goldman Sachs “cast bets on a White Castle hamburger-eating contest” in December 2007. (Note that the problems in the subprime mortgage market were so severe at this time that the Federal Reserve announced the creation of a Term Auction Facility (TAF) on December 12, 2007 with the first auction being held on December 17, 2007.)

This behavior, Kelly reminisces, “resembled a scene out of ‘Liar’s Poker,’ a book (by Michael Lewis of the book ‘The Big Short’) depicting bawdy antics of (mortgage) bond traders at Salomon Brothers in the 1980s.” She argues that “It was a lower-stakes version of what went on ever day in the group: aggressive, take-no-prisoners trading.”

To Kelly, the world apparently didn’t change much between the 1980s and the 2000s!

Tett draws some conclusions from the picture present in the e-mails. She writes “by 2007 they (the bond raters), like the bankers, had become tiny cogs in a machine that was spinning out of control. Their world was also a strange, geeky silo, into which few non-bankers ever peered.”

And, Tett goes on, “Indeed, this world was so detached and rarefied it is, perhaps, little wonder that S&P struggled to deal with the press, or that Goldman traders felt free to celebrate the mortgage market collapse.”

“Few expected external scrutiny or imagined their e-mails would ever be read.” They were just being human.

But, something was wrong! Something bigger than the traders or the raters had taken control and was driving the system.

And, this leads Tett to the first of two lessons she draws from the information in the e-mails: “what went wrong in finance was fundamentally structural, as an entire system spun out of control! It might seem tempting to lash out at a few colorful traders but that is a sideshow…”

She concludes: “what is needed is systemic reform that removes conflicts of interest.”

This is the only point on which I disagree with her. To me this whole “spinning out of control” was a result of the credit inflation that had been prevalent in the financial system for the past fifty years or so. The whole effort to inflate the American economy had resulted in the excessive creation of credit during this time period, the almost fanatical drive toward financial innovation (led by the federal government), and the assumption of more and more risk by the private sector in a search to sustain its returns.

The reference to the book “Liar’s Poker” is particularly relevant because the main story in that book is about the trading going on in mortgage-backed securities, something that did not exist until the early 1970s when the federal government created the instrument. Please note that the first mortgage-backed security was issued by the Government National Mortgage Association (Ginny Mae) in 1970. Before then mortgage-related issues were not traded on capital markets. By the time of the writing of “Liar’s Poker”, government-related mortgage-backed securities had become the largest component of capital markets.

As I have stated many times, the purchasing power of the United States dollar declined by roughly 85% between January 1961 and the present time. Although consumer price inflation was kept relatively low over the past decade or so, credit inflation permeated the asset markets as bubbles appeared in stocks and housing. House prices got so out of line with rental prices during this time that the collapse of the housing bubble became inevitable.

So, I agree with Tett in her statement that “what went wrong in finance was fundamentally structural, as an entire system spun out of control!”

But, human beings acted like human beings during this time. Again, to quote Tett: “they (the bond raters), like the bankers, had become tiny cogs in a machine that was spinning out of control.”

And, as Chuck Prince, former CEO of Citigroup, called it: as long as the music is playing, people must keep on dancing. This doesn’t excuse them, but it puts, I think, the behavior in perspective. This was not the well-thought-out plot of evil people.

Lesson: inflation creates incentives that can get out of hand. If the government wants to conduct economic policies with an inflationary bias then they must deal with the consequences at a later time.

I do agree with Tett on her second lesson learned: “the whole murky credit business must be taken out of the shadows. So few people spotted that finance was spinning out of control because the financial system was so separated into silos that its practitioners lost any common sense.”

Tett “welcomes the publication of these emails” but warns us to “keep braced for the next installment.” She “suspects that US regulators and politicians have not finished publishing all those damning e-mails yet.” I look forward to these revelations, as well.

Financial Reform Is No Silver Bullet

These days I find it very hard to be on the same side of arguments with Paul Krugman. I must admit that today I am mostly in agreement with what Krugman has written in the New York Times. (“Georgia on My Mind”, http://www.nytimes.com/2010/04/12/opinion/12krugman.html?hp.)

To begin with, Krugman asks the question: “What’s the matter with Georgia?” He raises this question because that Georgia has recorded 37 bank failures since the beginning of 2008 against 206 for the nation as a whole.

Why is Georgia different?

Georgia, he contends, was not a part of the housing bubble that saw home prices soar to the point that upon the collapse of prices, many home owners found themselves in a position of negative equity. Unlike many other states, Georgia had lots of land and few limits on expansion into empty spaces. As a consequence, Georgia, and especially Atlanta, did not see much of a rise in housing prices.

Still Georgia managed to create its own housing problem. Krugman states that “the share of mortgages with delinquent payments is higher in Georgia than in California” and “the percentage of Georgia homeowners with negative equity is well above the national average.”

The problem? “Georgia suffered from a proliferation of small banks.” And, these small banks were anything but conservative. “Actually, the worst offenders in the lending spree tended to be relatively small start-ups…”

These banks did not develop local deposit bases but relied on “hot money” from out-of-area investors. Their lending practices? New mortgage loans, subprime loans, and home-equity loans. Anything they could put on the books to generate fees and cash flows.

The prices of houses did not rise by as much in Georgia as they did in other states, yet the equity that people had in homes fell, and fell, and fell.

Krugman contends that the reason for this was the absence of consumer-protection regulation so that people could use their homes as “piggybanks” and almost continuously extract cash by increasing the size of their mortgages. He contrasts this behavior with Texas that also had lots of land and few limits on the expansion into empty spaces. Texas avoided the mess that Georgia found itself in because, according to Krugman, Texas had consumer-protection regulation.

This is where I differ slightly from Krugman in interpretation. To me the problem is that “Georgia suffered from a proliferation of small banks.” Too many banks were chartered to serve too limited a geographic area. The competition for loans was too great for the area. Real estate construction was expanding because it could get financed. People could continue to borrow because banks needed to push out money. The government was happy because more Americans were owning their own homes.

This was all a part of the general credit inflation of the past twenty years as more and more debt was created to support the movement of into housing. It came from an unlikely place: commercial banks.

If you would go back in history and ask bankers from the 1960s whether or not commercial
banks should hold more than 60% of their loan portfolios in real estate loans, you would have gotten an overwhelming vote of “NO!”

If one looks back at the 1960s, one finds that, for example, all domestically chartered banks held only 25% of their loan portfolios in mortgages or other real estate loans. Looking at the same figures for 2009 we find that all domestically chartered banks held 61% of their portfolio of loans and leases in mortgages or other real estate loans.

Commercial banks used to lend primarily to businesses. That is why they were called “commercial” banks.

Now domestically chartered commercial banks hold three-quarters of their loan portfolios in real estate loans and consumer loans.

We get a split according to size as well. Small commercial banks now hold almost 70% of their loans and leases in mortgages and real estate loans. The largest 25 domestically chartered commercial banks in the United States hold roughly 55%.

The largest banks hold 17% of their loan portfolio in consumer loans whereas the loan portfolios of smaller banks only contain about 9%. Adding the two numbers together results in both the big banks and the smaller banks holding around 75% of their loans in these categories.

Commercial banking has changed!

Since the 1960s, the mortgage market has become the place where commercial banks play. This is even more so for the smaller banks! And, Georgia represents our extreme example of this.

How did we get to where we are? A picture of this transition from the 1960s to now is presented by Michael Lewis in his book “Liar’s Poker”. The first mortgage pass-through security was issued in 1970. By the middle of the 1980s the mortgage market was the largest component of the capital markets worldwide. Lewis describes this part of the capital markets in his book.

I do agree with Krugman that some consumer-protection regulation is important in this world. But, it is not a panacea. And, along with other regulation of financial institutions it is not a “silver bullet” that will keep the United States from another financial crisis in the future.

We are hearing almost daily the things that the larger commercial banks are doing to avoid future regulation. Plus, it is my contention that these banks have moved well beyond what Congress is now working on to resolve financial crises. Furthermore, we are constantly bombarded by headlines like the one that appeared in the Financial Times this morning, “Banks seek to exploit new rules,” http://www.ft.com/cms/s/0/b6e57828-4588-11df-9e46-00144feab49a.html.

And, as Krugman argues, “The case of Georgia shows that bad behavior by many small banks can do as much damage as misbehavior by a few financial giants.” Of the 8,000 small- to medium-sized banks in United States, about one in eight is seriously in trouble. This certainly is not the major part of the pie as these 8,000 or so banks make-up only about a third of the assets of domestically chartered commercial banks in the United States. The largest 25 banks control two-thirds of the banking assets in the country.

Conventional regulation is not going to do the job in this information age. (See my comments on this beginning with http://seekingalpha.com/article/184153-financial-regulation-in-the-information-age-part-a.) I have found a regulatory scheme I believe will work better than the ones currently being proposed. I will write on this scheme later this week.

Federal Reserve Exit Watch: Part 6

Debate seems to be picking up about the Federal Reserve exiting its current policy stance. Last week Thomas Hoenig, President of the Federal Reserve Bank of Kansas City, and Charles Plosser, President of the Federal Reserve Bank of Philadelphia, spoke last week of the forthcoming need to wind down the Fed’s position. Hoenig said that the Fed should end its purchase program of mortgage-backed securities and Plosser talked about the recovery being sustainable even as existing fiscal and monetary stimulus programs recede.

Still, economists are pessimistic about when the Fed will begin to raise its target for the Federal Funds rate. The effective Federal Funds rate in recent months has averaged about 12 basis points. Bloomberg News conducted a survey of economists’ expectations and the median forecast was for the target rate to remain unchanged through September 2010 and then rise by a half of a point in December 2010.

Since the Federal Reserve finally realized in 2008 that there was a financial crisis and began to combat the unfolding chaos, the basic policy of the Fed has been to throw whatever it can at the wall so that a sufficient amount of what is thrown will stick so that a financial collapse can be avoided.

Can people who devised such a policy really be expected to move its target rate up until it is far past the time that a rise is needed? And, the Fed will then face a situation in which rising interest rates will put many holders of Treasury securities and mortgage-backed bonds underwater and the question will then be, “Can the Fed afford to raise interest rates too swiftly because of all the losses it will create?”

Right now, the Fed is subsidizing the profits of the large banks (and not the small- and medium-sized banks) by its interest rate policy (of course, the Obama administration has threatened to tax away a good deal of the profits). It is just amazing the contradictions in monetary and fiscal policy that are coming out of Washington, D. C. these days. Confusion reigns!

It is no wonder that businesses and banks don’t want to do much of anything these days. They don’t know what the economic policy and regulatory environment will be in three years, let alone three months.

Anyway, the Federal Reserve continues to add reserve balances to the banking system. In the past 13-week period ending Wednesday, January 13, 2010, the Fed has added about $84 billion in reserves to the banking system.

Remember in August 2008 when the total reserves of the whole banking system were only about $44 billion!

Of this $84 billion, $62 billion was put into the banking system in the latest 4-week period.

The major contributor to this increase was security purchases by the Federal Reserve in the open market. In the latest 4-week period, the Fed added almost $71 billion to its securities portfolio bringing the total new purchases for the last 13 weeks up to $233 billion.

A large portion of this increase went to offset the decline in several of the special facilities set up to handle the financial crisis. For example, the amount of funds supplied the banking system through the Term Auction Credit facility fell by about $80 billion over the 13-week period, by $10 billion over the last 4 weeks.

The swap facility with foreign central banks also continued to decline dramatically, falling by almost $38 billion in the latest 13-week period and by about $9 billion in the last four weeks.

In total, it appears as if the funds supplied the banking system through special financial crisis facilities fell by $42 billion over the past 13 weeks and by only $2 billion over the last two.

Thus, the Federal Reserve continues to let these special facilities wind down, replacing them in the banking system through open market purchases.

In terms of preparing for the Fed’s exit, there has recently been trading in reverse repurchase agreements with dealers, but there was no “practice” activity in the past four weeks presumably because of the seasonal Thanksgiving/Christmas churning in the banking system.

As of Wednesday, January 13, 2010, the Federal Reserve held $969 billion in mortgage-backed securities in its portfolio. The central bank has authorized purchases of up to $1.25 trillion going into March of this year. As mentioned earlier, there seems to be substantial debate within the Fed as to whether or not this program should reach the maximum total. We shall see.

The Fed now holds $777 billion in Treasury securities and $161 in the securities of Federal Agencies.

So, the Fed Exit watch continues. So far, the Federal Reserve has honored the path that it started out on: purchasing securities to add to its portfolio thereby replacing the funds draining away from the special facilities created to combat the financial crisis.

Obviously, the real test has not begun. Within the next month or two, if the recovery continues, the Fed is going to come under more and more pressure to start raising its target rate of interest. Until then, big banks will continue to arbitrage the Treasury market and the carry trade will continue to prosper. This behavior is based on the assumption that the Fed is not going to let short term rates rise for a while.

When this assumption is broken, expectations will have to be reset and there will be a re-adjustment in the financial markets as investors exit their arbitrage positions.

What the Fed does then remains to be seen.

However, by maintaining its current policy stance, if the economy doesn’t recover or goes into a double dip recession, the Federal Reserve cannot be accused of aborting the upswing by raising its target interest rate too soon.