The Fed's 'out of control' balance sheet is a major threat

• The Federal Reserve announced on Wednesday that it would start to unwind its massive $4.6 trillion balance sheet.
• If the Fed were judged as a private financial institution, it would be considered insolvent.
• What it has now is chaos. It must get its balance sheet under control in order to maintain control over economic policy. Here's what's at stake if it can't right the ship.

Getty Images

Former Federal Reserve Board Chairwoman Janet Yellen speaks during a news conference following a meeting of the Federal Open Market Committee September 20, 2017 in Washington, DC.

The Federal Reserve announced on Wednesday that it would start to unwind its massive $4.6 trillion balance sheet, as it embarks on its long awaited plan to normalize monetary policy.

As the central bank of the United States, the Fed does not have to follow the normal rules generally applied to financial institutions and it is exempt from the requirements that virtually all other global central banks must adhere to. But what if it were required to act as a private financial institution and it was not immune to all normal rules of finance? How would it be evaluated?

My view is that it would be regarded as an insolvent savings and loan institution with a terribly mismatched balance sheet that was headed for meaningful trouble. The fact that this is ignored when reviewing the agency's policy initiatives is surprising and a serious mistake.

S&L characteristics

The savings and loan companies of old captured deposits from individuals and institutions. By law they could only invest this money in government backed securities and mortgages. By and large that is how the Fed's balance sheet is constructed. The latest numbers show that the FRB balance sheet has $4.5 trillion in assets. These assets are composed of $2.5 trillion in Treasury securities, $1.8 trillion in mortgage backed securities, and $0.2 trillion in other holdings like gold for example. This balance sheet in its broad form is very, very similar to an S&L.

Insolvent

One of the problems that the S&L's had was that they could not sell the mortgages that they held. Thus, they were insolvent. Well guess what? The Fed cannot sell it mortgage backed securities either.

If the report called the Financial Institutions of the United States, published by the Fed itself, is to be believed approximately 34 percent of the mortgage backed securities in the United States are already owned by the Fed. Plus, anecdotal data indicates that the Fed, along with Ginnie Mae, is the largest buyer of these securities. The Treasury Department prohibits Fannie Mae and Freddie Mac from buying them and the private sector has shown limited enthusiasm for the product.

One assumes that if the Fed cut the price enough it could rid itself of these securities but in so doing it could wipe out its estimated equity of $41 billion. You see the Fed, like the old S&Ls, does not mark the value of its securities to market, which means that their value could be meaningfully overstated.

Mismatched balance sheet

Prior to the financial crisis, the Fed operated a sound business model. Basically, 91 percent of its funding came from printing the dollar and no one was going to attempt to redeem this currency. Approximately 83 percent of the securities it bought were Treasurys. There were no mortgage backed securities and more than 50 percent of the securities the Fed held had maturities of less than one year.

The Fed was using long term funding to buy short term assets. The model could not have been better.

However, this model was blown apart when the financial crisis came along. Today, banks provide more than 50 percent of the FRB's funds and more than 50 percent of its assets have maturities that are over 10 years in duration. The Fed is now borrowing short to lend long. Of course, as everyone knows, this is what destroyed the S&L industry.

Current dilemma

Consider this. If the Fed moved short term interest rates higher, it would be forced to pay more for the funds it borrows from the banks and in the repo markets. The higher short rates would keep long rates from rising as much as the short rates do. Thus, the Fed would lose a great deal of money as its net interest income plummeted and its long-dated mortgage backed securities dropped in value.

The reality is that the Federal Reserve cannot ignore the problems that its balance sheet represents for much longer. It is not immune to the laws of finance, to the extent that they exist. The Fed must return its balance sheet to a liquid position. It must create a reasonable balance between funding and assets. It badly needs an ALCO (asset and liability committee) to make the appropriate adjustments. What it has now is chaos.

What's at stake

Why should we care? If the Fed does not gain control of its balance sheet it will lose control of monetary policy. It will be forced to make decisions to shore up the weaknesses in the balance sheet as a first priority and monetary policy will take second place.

It will not be able to react to events as needed. Inflation will get out of hand. While the economy will not suffer near term it will suffer long term. The Fed must be able to control it destiny. It cannot do so if its balance sheet is out of control.

Commentary by Richard X. Bove, an equity research analyst at the Vertical Group and the author of "Guardians of Prosperity: Why America Needs Big Banks" (2013).

For more insight from CNBC contributors, follow @CNBCopinion on Twitter.

WATCH: Bove says Goldman needs a shakeup