Greek banks demonstrate how Fed can ultimately shrink its balance sheet

Bloomberg ran an interesting article on how the Fed's ongoing purchase of securities under quantitative easing is making it increasingly difficult to unwind the Fed's balance sheet.

A decision by the Federal Reserve to expand its bond buying next week is likely to prompt policy makers to rewrite their 18-month-old blueprint for an exit from record monetary stimulus. 

Under the exit strategy, the Fed would start selling bonds in mid-2015 in a bid to return its holdings to pre-crisis proportions in two to three years. An accelerated buildup of assets would also mean a faster pace of sales when the time comes to exit -- increasing the risk that a jump in interest rates would crush the economic recovery. 

“There is certainly an issue about unwinding the balance sheet” in a way that “is effective and continues to support the recovery without creating inflation,” St. Louis Fed Bank President James Bullard said in an interview in October. The central bank might have to “revisit” the 2011 strategy, he added. 

The Fed is already buying $40 billion a month in mortgage- backed securities to boost the economy, and policy makers meeting Dec. 11-12 will consider whether to purchase more assets. John Williams, president of the San Francisco Fed, has proposed adding $45 billion of Treasury securities a month. 

The bigger the balance sheet, “the riskier the exit becomes,” Richmond Fed President Jeffrey Lacker said during a Nov. 20 speech in New York. “That is something we need to think carefully about.” 

Krishna Memani, director of fixed income at OppenheimerFunds Inc., said a too-rapid sale of assets risks disrupting the $5.2 trillion market for agency mortgage debt.

Tyler Durden at ZeroHedge looks at the Fed's balance sheet problem and concludes in an excellent post that it simply cannot be done.

The reason that it cannot be done is that quantitative easing has effectively destroyed the long-term US treasury bond market ... the Fed is buying these securities at a far higher price than any investors would and has effectively driven investors out of the market.

“They have to find ways of unwinding the balance sheet without dumping all of it in the marketplace,” said Memani, who oversees a bond portfolio of about $70 billion, including about $6 billion of mortgage-backed securities.

Regular readers know that your humble blogger has proposed a way for the Fed to unwind its balance sheet that doesn't require dumping all of it in the marketplace.  This past week, with their participation in the Greek sovereign debt buyback, the Greek banks demonstrated how the Fed can unwind its balance sheet.

As reported by Reuters,

Greece's five biggest banks said they would take part in the country's debt buyback which expires on Friday, putting Athens on track to meet targets set by international lenders.... 

Athens has pressured its banks, which hold an estimated 17 billion euros (13 billion pounds) out of the 63 billion in eligible bonds, to sell and they had been expected to do so since they depend on bailout funds that a successful buyback would unlock.....

Banking sources earlier said the banks had asked their boards to approve selling back as much as their entire holdings. 

"The proposals by banks to their boards were positive on the buyback offer, asking for approval to participate by up to 100 percent," said one banker, who declined to be named....

Greek banks - already battered by the country's debt crisis - have been hit further by fears that they would be forced to book losses from the buyback. 

Finance Minister Yannis Stournaras, who has told banks it was their "patriotic duty" to ensure the scheme is a success...

The Greek banks are "selling" their government bond holdings and then, because they are subject to Basel III and its liquidity provisions, turning around and buying new government bonds.

A similar model can be used in the US to help the Fed unwind its balance sheet.

First, in recognition of how valuable the combination of deposit insurance and access to unlimited central bank liquidity is, the banks can set aside their excess reserves in an interest free account at the Federal Reserve.  The excess reserves are used to fund the Fed's balance sheet until the bonds on the balance sheet mature.

The benefits of this solution are many.

It dramatically shrinks the effective US government debt outstanding as all interest paid by the US Treasury on the bonds flows back to the US Treasury when the Federal Reserve turns over its earnings.

It puts all the excess reserves on the banks' balance sheets to use in a way that doesn't cause inflation.