By Howard Schneider
AMELIA ISLAND, Fla. (Reuters) - If the Federal Reserve sells any of its holdings of mortgage backed securities it may have to do so at a loss, Cleveland Federal Reserve bank President Loretta Mester said Tuesday, a potentially difficult problem for the central bank, at least politically, since it remits its annual profits to the U.S. Treasury.
"A potential drawback of sales is that, depending on the interest rate path, they could result in realized market-to-market losses," Mester said in comments to an Atlanta Fed conference. "Such losses would not entail any operational challenges for the Fed in setting monetary policy. However, they would pose communication challenges that would need to be appropriately addressed."
The Fed has faced persistent questions from some members of Congress on the risks it was taking in amassing its giant stockpile of bonds and mortgage securities. The assets were purchased to stabilizing key financial markets during the onset of the pandemic in 2020, but part of the Fed's current fight against inflation involves lowering its presence in those same markets.
Assets that are held to maturity pose no risk of loss, but sales would depend on the market prices and interest rates of the day.
An ICE (NYSE:ICE) index of mortgage backed securities is down about 9% on the year.
Mester's comments do not reflect the likelihood of sales. But Fed officials do want their balance sheet to consist mainly of Treasury securities, and to get rid of most if not all of the $2.7 trillion in mortgage securities the central bank currently holds.
Fed officials plan to begin reducing their nearly $9 trillion balance sheet next month initially by taking the proceeds of maturing Treasury Securities or repaid mortgage securities and, instead of reinvesting the proceeds, pulling that much cash out of the financial system.
By this fall the reductions will be as much as $60 billion per month for Treasury securities, a limit the Fed expects to meet each month, and as much as $30 billion in mortgage securities.
Because of the slower repayments expected on home mortgages, the Fed does not expect to meet that cap each month, and has mentioned possible active sales of MBS to reach it.
Sales of MBS would "speed the return or our portfolio's composition" to mostly Treasury issued securities.
Because home mortgage interest rates have been rising, the sale price of those mortgage securities may well have fallen since buyers would demand a discount to accept mortgages based on a smaller stream of payments.
That "would lower the Fed's remittances to the Treasury," Mester said.
She said that in determining how far the balance sheet will shrink the Fed, as it did in a similar exercise from 2017 to 2019, will "be monitoring developments in money markets to determine the appropriate level."