The Federal Reserve issued some updates to its balance sheet and payments data on Friday, and the long and short of the matter is that you are going to see why the Fed needs to start its $85 billion per month in bond-buying efforts. The latest minutes of the July 30-31 FOMC meeting indicated that tapering likely would start later in 2013 and end entirely by mid-2014. It is shocking how much the balance sheet has grown and how dominated it is by mortgage-backed securities. With Ben Bernanke due to have a formal replacement announcement later in 2013 or during the start of 2014, you really have to wonder about whether you want a continuation of the same quantitative easing policies or a new set of policies.

Total assets as of June 30, 2013, were $3.486 trillion, versus $2.917 trillion as of December 31, 2012. This translates to a gain in total assets of 19.5% in just six months. The growth in Treasury bills, notes and bonds was up to $2.097 trillion, versus $1.809 trillion, for growth of 15.9%.

Where the real balance sheet growth took place was in mortgage-backed securities (MBSs). The MBS assets are solely in government-sponsored entity MBSs, which means that they all fit into the conventional loan amount category and should not include the “jumbo loans” for prices above the conventional limit. The growth of MBSs was up to $1.246 trillion as of June 30, 2013, versus “only” $950.321 billion as of December 31, 2012. This was growth of 31.1%.

The real issue to consider is that from the start of May into July we saw roughly a 100 basis point rise (1 full percentage point) in 30-year mortgage rates. We cannot calculate what exactly the losses would be in this MBS portfolio without having their formal portfolio holdings, but we can tell readers is that this is just too much dominance in the mortgage-backed securities market. These loans should be safer than what we saw in 2003 to 2008, but the average weighted coupon will be so low that the losses would look horrendous to any major measurement.

If you want proof that the weighted average coupon has plummeted, the trailing six-months of income from the MBS pools was $15.988 billion for the first half of 2013, versus $16.581 billion for the first half of 2012. Translation: seriously lower coupons.

Now you have a compounding event taking place. Conventional mortgages and GSE MBS pertains to mortgages packaged by Fannie Mae and Freddie Mac. This is Federal National Mortgage Association (FNMA) and Federal Home Loan Mortgage Corp. (FMCC), respectively. The public has a disdain for these entities because of how much they contributed to the financial crisis, but of course they also make housing affordability better with lower interest rates due to that quasi-guarantee that investors assume is there.

Efforts are picking up to dismantle Fannie Mae and Freddie Mac in Congress, so what does this do to the Federal Reserve when it is already suffering severe losses?

If tapering begins as late as October or November, then we can assume that the September 30 balance sheet will be even more dominated by MBS assets. At least these either will have higher coupons or will be purchased at a lower prices. That being said, it looks like the Federal Reserve just proved that it bought up all the mortgage-backed securities effectively at the top of the market in prices and the lows in yields.

If you do not believe how bad things are in mortgage-backed securities and that this is not real, you might want to consider looking at the MBS REITS. Annaly Capital Management Inc. (NYSE: NLY) is supposed to be one of the kings of mortgage-backed securities in the REIT sector, yet its shares are down to $11.40, versus a 52-week range of $10.63 to $17.75. It still screens as a double-digit yield now that its price is down so much, but the May 1 adjusted closing price was $15.34. The government’s MBS pool will not be down anywhere close to this amount, but Annaly’s share price is down a whopping 25% since the start of May when the bear market in bonds started to take shape.

Now take a look at a closed-end mutual fund that is made up solely of investing in mortgage-backed securities. The BlackRock Income Trust Inc. (NYSE: BKT) indicates a 4.8% dividend yield and is at $6.35 against a 52-week range of $6.33 to $7.74. Its May 1 adjusted closing price was $7.17, which translates to a loss of about 11.5% as of now. This fund now trades at what appears to be a discount of more than 12% to its net asset value, and while this one seems to always trade at a discount to its net asset value, it is a much wider discount than its recent and normal trading history.

As we said this morning in our top analyst upgrades and downgrades on interest rates,

We have predicted that the rising interest rates are still coming, and the 10-year Treasury note is poised to challenge a 3% yield and the 30-year Treasury to challenge the 4% mark. Now Barclays is calling for the 10-year Treasury to reach 3.10% by the end of 2013 and perhaps 3.75% later in 2014. A Merrill Lynch technician on Thursday also showed a next stop on the 10-year yield at about 3.05%, with the first resistance level at about 2.95%. The Treasury yields are currently 2.90% on the 10-year and 3.89% on the 30-year.

If everyone else is avoiding mortgage-backed securities and the Federal Reserve is gobbling up almost the entire flow of conventional mortgage-backed securities at the top of the market price (lowest in yield), then how do you feel knowing that this money is being printed endlessly to the tune of $85 billion per month only to face immediate losses. Remember, at least theoretically, it is your taxpayer money.

The Federal Reserve has maintained that the purchase of MBS assets has been helpful to the economy. That is likely true. The question is whether that economic benefit and assistance should be with a risk of well over $1 trillion of your taxpayer dollars.

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