Home > Banks/Wall Street, Bond Market, Federal Reserve, Good One, New Products, TIPS > The Neatest Idea Ever for Reducing the Fed’s Balance Sheet

The Neatest Idea Ever for Reducing the Fed’s Balance Sheet


I mentioned a week and a half ago that I’d had a “really cool” idea that I had mentioned to a member of the Fed’s Open Market Desk, and I promised to write about it soon. “It’s an idea that would simultaneously be really helpful for investors and help the Fed reduce a balance sheet that they claim to be happy with but we all really know they wish they could reduce.” First, some background.

It is currently not possible to directly access any inflation index other than headline inflation (in any country that has inflation-linked bonds, aka ILBs). Yet, many of the concerns that people have do not involve general inflation, of the sort that describes increases in the cost of living and erodes real investment returns (hint – people should care, more than they do, about inflation), but about more precise exposures. For examples, many parents care greatly about the inflation in the price of college tuition, which is why we developed a college tuition inflation proxy hedge which S&P launched last year as the “S&P Target Tuition Inflation Index.” But so far, that’s really the only subcomponent you can easily access (or will, once someone launches an investment product tied to the index), and it is only an approximate hedge.

This lack has been apparent since literally the beginning. CPI inflation derivatives started trading in 2003 (I traded the first USCPI swap in the interbank broker market), and in February 2004 I gave a speech at a Barclays inflation conference promising that inflation components would be tradeable in five years.

I just didn’t say five years from when.

We’ve made little progress since then, although not for lack of trying. Wall Street can’t handle the “basis risks,” management of which are a bad use of capital for banks. Another possible approach involves mimicking the way that TIGRs (and CATS and LIONs), the precursors to the Treasury’s STRIPS program, allowed investors to access Treasury bonds in a zero coupon form even though the Treasury didn’t issue zero coupon bonds. With the TIGR program, Merrill Lynch would put normal Treasury bonds into a trust and then issue receipts that entitled the buyer to particular cash flows of that bond. The sum of all of the receipts equaled the bond, and the trust simply allowed Merrill to disperse the ownership of particular cash flows. In 1986, the Treasury wised up and realized that they could issue separate CUSIPs for each cash flow and make them naturally strippable, and TIGRs were no longer necessary.

A similar approach was used with CDOs (Collateralized Debt Obligations). A collection of corporate bonds was put into a trust[1], and certificates issued that entitled the buyer to the first X% of the cash flows, the next Y%, and so on until 100% of the cash flows were accounted for. Since the security at the top of the ‘waterfall’ got paid off first, it had a very good rating since even if some of the securities in the trust went bust, that wouldn’t affect the top tranche. The next tranche was lower-rated and higher-yielding, and so on. It turns out that with some (as it happens, somewhat heroic) assumptions about the lack of correlation of credit defaults, such a CDO would produce a very large AAA-rated piece, a somewhat smaller AA-rated piece, and only a small amount of sludge at the bottom.

So, in 2004 I thought “why don’t we do this for TIPS? Only the coupons would be tied to particular subcomponents. If I have 100% CPI, that’s really 42% housing, 3% Apparel, 9% Medical, and so on, adding up to 100%. We will call them ‘Barclays Real Accreting-Inflation Notes,’ or ‘BRAINs’, so that I can hear salespeople tell their clients that they need to get some BRAINs.” A chart of what that would look like appears below. Before reading onward, see if you can figure out why we never had BRAINs.

When I was discussing CDOs above, you may notice that the largest piece was the AAA piece, which was a really popular piece, and the sludge was a really small piece at the bottom. So the bank would find someone who would buy the sludge, and once they found someone who wanted that risk they could quickly put the rest of the structure together and sell the pieces that were in high-demand. But with BRAINs, the most valuable pieces were things like Education, and Medical Care…pretty small pieces, and the sludge was “Food and Beverages” or “Transportation” or, heaven forbid, “Other goods and services.” When you create this structure, you first need to find someone who wants to buy a bunch of big boring pieces so you can sell the small exciting pieces. That’s a lot harder. And if you don’t do that, the bank ends up holding Recreation inflation, and they don’t really enjoy eating BRAINs. Even the zombie banks.

Now we get to the really cool part.

So the Fed holds about $115.6 billion TIPS, along with trillions of other Treasury securities. And they really can’t sell these securities to reduce their balance sheet, because it would completely crater the market. Although the Fed makes brave noises about how they know they can sell these securities and it really wouldn’t hurt the market, they just have decided they don’t want to…we all know that’s baloney. The whole reason that no one really objected to QE2 and QE3 was that the Fed said it was only temporary, after all…

So here’s the idea. The Fed can’t sell $115bln of TIPS because it would crush the market. But they could easily sell $115bln of BRAINs (I guess Barclays wouldn’t be involved, which is sad, because the Fed as issuer makes this FRAINs, which makes no sense), and if they ended up holding “Other Goods and Services” would they really care? The basis risk that a bank hates is nothing to the Fed, and the Fed need hold no capital against the tracking error. But if they were able to distribute, say, 60% of these securities they would have shrunk the balance sheet by about $70 billion…and not only would this probably not affect the TIPS market – Apparel inflation isn’t really a good substitute for headline CPI – it would likely have the large positive effect of jump-starting a really important market: the market for inflation subcomponents.

And all I ask is a single basis point for the idea!


[1] This was eventually done through derivatives with no explicit trust needed…and I mean that in the totally ironic way that you could read it.

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  1. Jan Robyns
    September 20, 2018 at 6:22 am

    Is the Fed balance sheet that much of a problem you think? % vs gdp it naturally goes down quite a bit every year. Could it be postulated it was way too small before the crisis? seems M0 vs GDP but especially vs total assets in a currency zone was tiny before the crisis. People always look in nominal terms and vs gdp but have a look vs total outstanding assets and vs total credit. Ain’t that big and will naturally fall. Wacky thought: just increase the reserve requirement ie cut fractional banking leverage….? Btw think multiple expansion/contraction theories since 2009 with higher inflation are now not that applicable anymore. Trust me I am bearish on equities but the former imply markets expect higher rates with higher inflation. Doubt that will be the case and real rates drop further. If push comes to shove CBs will happily let inflation run if the alternative is sovereign crisis. Especially in Europe and Japan…

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    • September 20, 2018 at 7:49 am

      Jan – funny you should say that. In my book I argued that the only real way out of the problem the Fed is in…that they don’t control the money supply since they don’t control the marginal reserves…is to change the reserve requirement. But there’s really no chance of that happening. It would be brilliant, because it would allow the Fed to immediately exercise control over reserves again rather than having the money supply completely out of their control. But the folks in the Fed don’t believe any more that money matters…there are no monetarists left! The balance sheet is not a problem per se; the problem is with excess reserves. The only way the Fed can solve this problem without changing the reserve requirement is…shrink the balance sheet and sop up those excess reserves.

  2. Brian Gidley
    September 20, 2018 at 8:10 am

    Michael, I enjoy your writings. You are able to take the complicated and simplify.

    My thought, on which I would enjoy learning your thoughts… Why do we start in nominal and attempt to ‘link up’ to the real? Why don’t we start in Real and calculate the equivalent nominal units to deliver a known/stable purchasing power?

    a) Would not this match the known real payment to the expected real income of a project?
    b )Would this not improve the free cash flow, balance sheet and income statement of the borrower? And lower the capital requirements and costs to the lender?
    c) Could not any index, or component of an index, be agreed upon by the borrower and lender?
    d) Would this not be a boon to a ‘inflation derivatives’ marketplace?
    e) Would this not be a viable choice to all market participants because the accretion and phantom income tax components of the TIIS and LINKER’s program would be eliminated?

    Would this not meet a model of simplification? Find the lowest, common ground and build up from there.

    Maybe our ability to know the current and future PRICE of any instrument should be moving to knowing the current and future VALUE ( in purchasing power ) of every instrument?

    Brian Gidley
    Jacksonville FL
    http://www.realreturnmethodologies.com

    • September 20, 2018 at 8:19 am

      Brian – you’re right on! My answers: (a) yes! (b) yes! (c) yes! and they actually are, in some cases – notably long-term contracts such as for utility construction or aircraft. but they’re not hedgeable (d) yes! (e) not really – all assets get taxed on inflation uplift. Stocks get taxed on nominal returns, nominal bonds get taxed on nominal returns, same as TIPS. There’s no phantom-tax problem…it’s just a record-keeping problem akin to the OID rules that make TIPS more of a pain at tax-time. But there are no more taxes for TIPS than for any other asset. Unless Congress allows us to inflation-adjust investment gains, this will continue to be a problem. But not merely for TIPS.

      • Brian Gidley
        September 20, 2018 at 11:14 am

        Michael,

        As per d) would there not be a fourth leg to the marketplace? A FIXED REAL leg which would offer the hedger more choices? Would this not double the available choices? And for e) current tax regime does not tax return of ‘principal’ and there would be no ‘OID’ in this structure.

        I am thinking of the recent comments by Secretary Mnuchin and Chairman Kudlow regarding finding the lowest cost of funding and indexing capital gains.

        May I answer your questions?

        Brian

      • September 25, 2018 at 1:34 pm

        Thanks Brian. There are already derivatives structures that create fixed real payments – it’s just another application of an inflation swap. We’ve been doing that since the beginning. 🙂 Unfortunately, current US tax law does not acknowledge that inflation uplift embedded in the return of principal is actually principal – it gets taxed as income. Now, if they index capital gains then inflation bonds look much better than nominal bonds because the latter will pay tax on the inflation compensation (which would be embedded in the coupon) and end up with a real loss on principal, while TIPS would pay real coupons and real principal allocated more efficiently for tax reasons. We can hope. I wouldn’t hold your breath though…that looks “expensive” to Treasury.

      • Brian Gidley
        September 25, 2018 at 4:14 pm

        Reply Comments

        Mike,

        There is no derivative structure in our first level method. The derivatives in REAL terms are in the second level, the hedging of the known real payment you will be paying or receiving. No one is swapping anything. The structure matches/distributes the inflation exposure to both parties (borrower and lender) Because there is no swap, there is no third party expense incurred by either party.

        Disagree… attorneys and tax accounts we asked to look at this, no opinions written yet, for they need an “actual” red herring, comment that in our structure the return of principal is that and that alone, and if the IRS wanted to tax this return of principal a new tax rule/ruling would be needed. The inflation compensation ( the constant purchasing power) is embedded in the principal, so no real loss on principal. Current structures in the marketplace use accretion of the principal overtime and that accretion is paid out at the maturity. A special tax ruling was made to make that accretion a taxable event. We see our method as avoiding that ruling by paying P&I with each payment, be it yearly, semiannually, quarterly or monthly. *Monthly is the most efficient in our studies and it melds seamlessly into mortgages and leasing while reducing the risks associated with a structure of serials and terms (refinancing timing etc.)

        It is less expensive to the treasury…. The ‘inflation uncertainty premium’ is eliminated…. And the economic activity within of a sovereign (or any borrower) is matched to the principal and interest payment they make.

        Does the following assist your understanding of what we propose?

        You can fix either the nominal interest rate or the real interest rate, but not both.

        Nominal financing fixes the nominal interest rate and nominal payments of the financing. The nominal interest rate is set equal to the sum of three current economic variables:
        īNominal = ĩBusiness Risk + ĩReinflation + ĩRisk-Free Real

        This can be expressed in more detail as:
        īNominal = ĩBusiness Risk + ĩExpected Inflation + ĩInflation Risk Premium + ĩRisk-Free Real

        So, in fixing the nominal rate (on the left-hand-side) the risk-free real return is used to fix the nominal rate, but the realized real return becomes a variable that changes as the realized inflation rate changes:
        ĩRealized Real = īNominal – ĩRealized Inflation

        RRM financing fixes the real (purchasing power) interest rate and the real payments. The real interest rate is set equal to the sum of two economic variables:
        īReal = ĩBusiness Risk + ĩRisk-Free Real

        Fixing the real interest rate makes the realized nominal return a variable that changes as the realized inflation rate changes:
        ĩRealized Nominal = īReal + ĩRealized Inflation

        The nominal rate is now a variable, but this does not create a floating rate loan.

        The loan is still a fixed rate loan but with fixed payments that are now fixed in purchasing power. The fixed real payments are matched to the expected real income, reducing default risk and the business risk premium. Inflation risk is eliminated for everyone, except for possible effects of the agreed-upon adjustment period.

        This economic principle follows from simple algebra and it is true regardless of whether you are a borrower or a lender, and it holds in the market-clearing and pricing process.

        RRM is not just fixed real rate financing…. It is fixed real financing with three STABLE AND KNOWN interdependent components; namely, (1) the fixed real rate, (2) the fixed real payments, and (c) the fixed real amortization schedule. * Does not have to be amortizing.

        The RRM process calculates the nominal interest payments, nominal principal payments and remaining nominal balances that are required for purposes of financial reporting and the calculation of income tax liabilities.

      • September 26, 2018 at 7:11 am

        Most of this is what we’ve been doing and I’ve been writing about for a decade – certainly the idea of hedging real project exposures and stabilizing real returns rather than nominal returns is a relatively old idea. I can’t opine on your ‘new structure’ but was just pointing out that the accretion of inflation compensation in TIPS (explicitly, and every other asset, implicitly) has been taxable from day 1 and we have been doing real cash flow swaps since we started the CPI market. That is, swaps with real fixed rates, fixed real payments and fixed real amortization schedules. These are all stable and known in real space – that’s the whole point of hedging inflation, to put everything back in real space. You’ll notice when I run a risk/return securities market line, I do it in real terms. It’s silly to do it in nominal terms, when we care about real terms.

        But I can’t say anything about what you’re saying is your innovation, because I’m not aware of the particulars. I’m sure if it’s a better mousetrap that it’ll be eagerly adopted by Wall Street and other parties!

  3. Brian Gidley
    September 26, 2018 at 10:51 am

    You write… “to put everything back in real space.” That is the key and I believe you understand what we propose.

    We never have to put everything back in ‘real space’, because we start in ‘real space’ and put everything back in nominal space. This we suggest will enable every borrower to find their lowest cost of capital over time, lenders to improve their income and hedgers to have a much more efficient trading vehicle.

    I would like to forward a spreadsheet to you. Nothing hidden. No intellectual property. No trade secrets. You can see all the calculations, equations and formulas.

    It demonstrates a 10 year note. Comparing our structure which starts in Real and the current structures which start in nominal.

    May I send it to you?

    Brian

    • September 26, 2018 at 3:19 pm

      I’m interested to see. Of course, TIPS start in real, so I’m interested to see how your structure compares.

      • Brian Gidley
        September 27, 2018 at 12:52 pm

        Michael,

        I see your WordPress address, do you want the file delivered through this address?

        Brian

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