The Federal Reserve (“the Fed”) currently holds about $1.7 trillion in mortgage-backed securities.  Prior to 2009, the Fed owned zero mortgage-backed securities (MBS).  It began its accumulation in January 2009 in the wake of the great financial crisis that appeared in the fall of 2008.

The Fed went through three buying sprees of both U.S. government debt and MBS.  They were labeled quantitative easing (QE). There was QE1, QE2, and QE3. QE is nothing more than monetary inflation.  The Fed buys assets with money created out of thin air.  Most of this money is not created on a printing press.  It is digital.  That is why I often refer to digital money printing.

QE3 ended in October 2014.  For almost four years, the Fed has not been inflating the money supply directly.  The money supply can still change based on bank lending and bank reserves.

The Fed is actually reducing its balance sheet right now, although at a relatively slow pace. Still, month after month, those tens of billions of dollars in assets start to add up to some real money.

The Fed is currently reducing its balance sheet by $40 billion per month.  $16 billion of that is in mortgage-backed securities. The FOMC implementation note does not say that the Fed is to sell off these assets.  Rather, it is to not roll over maturing securities up to these amounts.  These reduction amounts are supposed to be increased again, but things can change.

The thing that is not clear is what happens with any assets (debt) that the Fed owns that are defaulted on.  This obviously is not an issue with U.S. Treasury bills and bonds, as the U.S. government does not default on its debt, unless you factor in the depreciating value of the currency.  The problem is with the MBS.

First we have to understand how the Fed collected these securities.  During the housing bubble, banks and other lending institutions made loans to people for houses (and other types of residential properties).  It was common for these loans to have low down payment amounts, such as 3%, instead of the more conventional 20%.  When the housing bust happened, somewhat in sync with the financial crisis, many people defaulted on their mortgages.  They either couldn’t pay, or they chose not to pay.  If you have a $200,000 mortgage and your house is now worth only $150,000, it is sometimes easier to hand your keys over to the bank and default.

The Fed’s buying of MBS from the banks was part of the bailout.  While the public complained to some extent about the bank (and other) bailouts, the bailouts kept happening for many years after 2008, as the Fed bought up these MBS.  The Fed was not paying market value for them.  They were buying these securities for what they were previously worth.

With these mortgage securities, some people would have continued to pay their mortgage, while others did not.  In many cases, there were negotiations to refinance or allow the homeowner (more of a renter, with the bank acting as landlord) to stay in the house with modified payments.

No matter what, we have to assume that a certain portion of the currently-held $1.7 trillion in MBS is bad debt.  We have no idea what percentage this is.  So what happens with the securities that are bad?

I don’t know what tricks the FOMC has up its sleeve, but I see no way to completely drain this portion of the balance sheet without somehow acknowledging that some of it is bad debt.  Therefore, you can’t actually reduce the balance sheet with a retraction in the money supply for all of these securities.

Is the Fed just reducing its balance sheet without actually deflating the money supply when it comes to these MBS?

We know this isn’t the case with the U.S. government debt.  The Treasury actually pays back the interest owed and the principal amount for maturing debt.  The Fed ends up returning most of this money to the Treasury after it funds its own expenses.  It is a tricky game, but at least the accounting works with the Treasury. When the Fed reduces its balance sheet of U.S. Treasury bills and bonds, then this money is sucked back up by the Fed.  There is monetary deflation.

With the MBS, it is unclear what is taking place or what will take place in the future.  The Fed could write off the bad debt, but this is ultimately inflationary.  The Fed printed money (digitally speaking) to buy this debt, and then it is letting the debt expire or be written off without reversing the original digital money printing.  If people aren’t paying these old mortgages any longer, then there is nobody to collect the money from to reverse the original monetary inflation.

There is no question that the Fed is currently engaged in a slightly deflationary policy.  But we don’t know for sure to what extent, and it is also tricky trying to figure out how banks will react to this in the near future.

The excess reserves held by commercial banks have been going down since 2014.  Part of this is in lockstep with the Fed’s tighter monetary policy, but it seems that excess reserves have gone down a bit faster than the Fed is reducing its balance sheet.  Therefore, the Fed’s policy is slightly deflationary, while the banks seem to be slightly inflationary.

There is a lot of confusion to sort through with the Fed’s balance sheet and bank reserves. That is another reason why a permanent portfolio setup is ideal at this stage of the game.  It is also why it is easier to follow the yield curve and let the bond market tell us what is happening.  If the yield curve inverts, then maybe I will speculate a little in shorting stocks.  Until the inversion happens, anything goes.