This is the fourth month that I have posted something about the performance of the Federal Reserve with respect to their exit strategy, the strategy it is following to remove the massive amount of reserves it put into the banking system in 2008 and beyond. On November 11, 2009, the Fed was supplying $2,176 billion in reserve funds to the banking system. (This is from the Federal Reserve release H.4.1, Factors Affecting Reserve Balances of Depository Institutions and Condition Statement of Federal Reserve Banks.)

This was down slightly from the $2,233 billion total on October 14, 2009, but up from the $2,055 billion on August 12, 2009.

Commercial banks had $1,041 billion in Reserve Balances at Federal Reserve Banks on November 11 and the banking system averaged $1,059 in Excess Reserves for the two week period ending November 4, 2009. On October 14, Reserve Balances were $1,049 billion, but on August 12 this number was only $772 billion. Excess Reserves in the banking system averaged $918 billion in the two weeks ending October 7, and averaged $766 in the month of August.

Thus over the last 13-week period and over the past 4-week period total assets remained form around $2.1 trillion and $2.2 trillion.

However, Total Reserves in the banking system rose from $829 billion in August to $981 in the two week period ending October 7, to $1,124 billion in the two week period ending November 4.

This is an increase of over 35% in the total reserves of the banking system!

Of this $295 billion increase in total reserves, a total of $293 billion went into excess reserves!

Just a side note, Required Reserves rose by only $2 billion over the same time period!

No lending going on here!

The composition of the Fed’s balance sheet is changing, however. Securities held outright by the Federal Reserve has risen from $1,556 on August 12, 2009 to $1,673 billion on October 14 and $1,702 on November 11.

As reported in early editions of the Exit Watch, the Fed is letting the special assets it created run off as the need for them retreats and is replacing these reserves by marketable securities. Not all of these will run off in the near term as the credit and value issues surrounding assets at AIG and other institutions may take some time to disappear. However, these special assets have declined from somewhere in the neighborhood of $550-$500 billion on August 12, to $420-$380 on October 14 to around $340-$300 billion on November 11.

The largest decrease came from the reduction in the use of the Term Auction Credit which was instituted in December 2007 as a part of the dislocations in the financial markets that surrounded the problems at Bear Stearns. On August 12, this facility totaled $233 billion. The total dropped to $155 billion on October 14 and $109 billion on November 11.

Thus, the Fed is reducing the special assets portion of its balance sheet and is substituting for these asset, ownership of securities–Treasuries, Federal Agency issues, and Mortgage Backed securities.

In pursuing this path, the Fed is taking securities out of the open market, from banks and other financial institutions, but the funds it is using to pay for these securities is just going, so to speak, into bank vaults.

Commercial banks are basically saying, “If we don’t make any loans with this money, then the loans we don’t make cannot turn into bad loans!”

Another way of saying this is that the banks have enough bad assets on their books now and they don’t need to add any more. They’ll sell securities, but they won’t do anything with the money they receive back from the sale.

This seems to be creating a very uncomfortable situation. As the Fed reduced special facility assets over the last 13-week period and increased its holdings of open-market securities, it forced $300 billion reserves on the banking system.

Note that in August 2008, Total Reserves in the banking system amounted to $45 billion.

In 13 weeks the Fed forced 6.67 times more reserves into the banking system than the banking system had accumulated in all its history in the United States! And the banks did nothing with the reserves! And, the recession ended in the third quarter!

This is not a liquidity problem!

And the Federal Reserve says that it will continue to keep its target interest rates at its current level for an extended period of time. This is “QUANTATIVE EASING”!

Interest rates are going to start rising at some time. What is the Fed going to do with all the open-market securities it has on its balance sheet? What kinds of losses will the Fed have to take to eventually reduce reserves to reasonable levels once the economy begins to pick up steam?

Well, we really don’t need to worry about the Fed because the can just print money at a cost of zero in order to cover any losses they take.

But, what about those investors, what about the Chinese, what about anyone, who purchased United States Treasury securities during this summer and fall? How are they going to cover their losses when interest rates finally begin to rise?

The Federal Reserve got us here. There is no painless way to get us out of the situation they put us in…at least as far as I can see.

Thanks, Ben!