The Fed's Balance Sheet stands at $2.3 trillion - the bulk of which, $1.2 trillion, represents the purchase of mortgage backed securities issued by Fannie Mae and Freddie Mac, and $90 billion in AIG related securities.    Although the mortgages backing these bonds don't mature for 15 to 30 years, the Fed anticipates that many of them will be disappearing from their balance sheet in the near future as people "pay down, prepay, refinance, and sell homes".

(An interesting perspective based on a very optimistic view of an un-optimistic housing market...)

"An informed analyst might presume that some $200 billion of that portfolio will mature or be paid down by the end of 2011."

In a market of no jobs, I am curious how all these debt ridden homeowners are going to suddenly find the money to 'prepay' or 'pay down' their mortgages. 

Some feel that the Fed should sit back and allow maturities to run their natural course in order to de-leverage their holdings.  A far majority believe the Fed should sell off holdings into the market mix.  However, true to political form, disagreements over when the sales should begin and how quickly the assets should be sold abound. 

Of course, how, when, and where the Fed decides to sell these securities will have a direct impact not just on the markets - but on interest rates as well. 

The structure of the debt leaves the Fed little room for error:

"Currently, the maturity of the Fed's assets and liabilities are mismatched. The average maturity of their Treasuries (part of their assets) is near 7 years. Meanwhile, they are paying interest on the excess reserves (part of their liabilities), which has zero maturity and will go up as interest rates rise.  Therefore, when interest rates rise over the next few years, a large part of the Fed's income will remain steady while a large part of their expense will increase."

Before the financial crisis, the Fed did not have to pay interest on excess reserves so they did not have this massive liability.  To move interest rates, the Fed would change the amount of reserves banks held by borrowing and lending to them.

However, during the financial crisis, the Fed lent to banks great sums of money, and part of that money became excess reserves, which currently stands around $1 trillion.  Because of the staggering size of reserves, the Fed can no longer effectively manipulate interest rates by making changes (of their usual magnitude, which is now too small) to the size of the excess reserves.

To raise the interest rate, the Fed resorted to paying interest on excess reserves. To push up interest rates now, the Fed either has to massively reduce the size of excess reserves or pay more interest on excess reserves. If they choose the latter option, they would need money to pay that interest. However, if the income they derive from their assets remains constant and is based on rates from earlier periods, it may not be enough to cover the higher expense.

Ray Stone, Managing Director at Stone & McCarthy Research, suggests that the Fed reinvest maturing securities of longer maturity into short-term Treasuries; doing so would reduce the interest rate risk to the Fed's portfolio as the return on their assets would correspondingly increase with the cost of their liabilities.

Whether or not the Fed makes a political move now that would have tremendous ramifications on the future, remains an unknown.  Currently, the Fed remains enormously "profitable" as their income handily exceeds their expenses.  It is unfortunate that too often we are unable to properly see, account, and define the future despite the warnings. 

Planning for your future legacy, is no different.  Hindsight has some benefits, but hindsight of your estate when you are gone, is impossible to redefine.