The Federal Reserve reached a noteworthy milestone this week. For the first time in history, its balance sheet exceeded $3 trillion.
To be a bit more specific, as rounding errors matter when you're talking about trillions of dollars, the central bank's asset holdings increased to $3.013 trillion for the week ended Jan. 23 -- don't ask me why the Fed chooses Wednesday as the end of a week. This included $1.697 trillion of U.S. Treasury securities and $983 billion in mortgage-backed securities as well as a handful of other assets.
Source: The Federal Reserve Board of Governors.
Since the Fall of 2008, the Fed has increased its holdings in three distinct waves of quantitative easing, known colloquially as QE1 through QE3, under which it's purchased assets guaranteed by the full faith and credit of the United States.
In the most recent round, announced at the end of last year, the central bank committed to buying $40 billion in mortgage-backed securities a month until the unemployment situation improves significantly. By "significantly" it's possible that the bank means "down to 6.5%," which the Fed identified as a benchmark later in the year. If true, then we could very well see a $4-trillion balance sheet before all is said and done.
Who cares?
Beyond people alarmed by the hypothetical omnipresent menace of inflation, the most tangible impact of the Fed's aggressive monetary stance are financial institutions such as banks and mortgage REITs.
With respect to banks, the long-term interest rates that quantitative easing is designed to reduce are the very same rates that banks rely on to make money. For instance, after announcing third-quarter earnings last year, Wells Fargo (NYSE: WFC) saw its shares slammed after the bank reported a decrease in its net interest margin by 25 basis points; as a follow-up, this figure fell an additional 10 basis points in the fourth quarter.
Perhaps the greatest impact, however, has been felt by mortgage REITs like Annaly Capital Management (NYSE: NLY), American Capital Agency (NASDAQ: AGNC), and ARMOUR Residential (NYSE: ARR).
What makes these funds particularly susceptible to the Fed's moves, and particularly QE3, is the fact that they're vying for the very same assets, agency mortgage-backed securities. MBS prices have accordingly gone through the roof, and their yields, which mortgage REITs look to for income, have tanked, as MBS prices and yields are inversely related.
The stress this has put on the industry has been palatable. In November of last year, it led Annaly, the largest player in the space, to announce the proposed acquisition of CreXus Investment Corporation, a higher-yielding commercially focused REIT that Annaly had previously just managed.
NLY Price / Tangible Book Value data by YCharts.
Additionally, as you can see in the chart above and as I discuss here, it's caused valuations in the entire industry to drop. Since the middle of 2012 -- that is, before QE3 began -- Annaly's has fallen by 12%, American Capital's by 14%, and ARMOUR Residential's by 9%. And with valuations and income have gone dividends. In Annaly's case, the quarterly payout has fallen by 17% over the last 12 months alone.
Is there any end in sight?
At this point, the answer to this question is: No. For those of you concerned about inflation, my recommendation is to ease up a bit, as Japan's experience over the last two decades has shown that inflating prices are the last thing we need to be concerned about right now.
More generally, however, for investors with a stake in financial companies, it's likely that the Fed's easy monetary stance is bound to continue at least for the foreseeable future. But it won't last forever. Consequently, and particularly for those of you invested in mortgage REITs, you'll simply need to readjust your expectations for those wonderful, though slightly smaller, quarterly payouts.
