MBS Purchases Transfer Risk from Lenders to Fed

MBS Purchases Transfer Risk from Lenders to Fed

Since the financial crisis, the balance sheet of the Federal Reserve expanded from around $900 billion in summer of 2008 to $2.2 trillion at the end of that year, and onward to its current amount  of around $4.2 trillion.

Additionally, the composition of the Fed’s balance sheet has changed. Ten years ago, it was made up almost exclusively of Treasuries. Now, about $1.7 trillion of the assets on the Fed’s books are mortgage backed securities (MBSs), the financial instruments made infamous by the financial crisis.

The primary tool the Federal Reserve uses to influence monetary policy is the purchase of securities, namely U.S. Treasury Bonds. When it buys Treasuries, it increases demand, lowers interest rates, and increasing inflation. When it sells them, the effects are reverse.

We see the same basic dynamic when the Fed buys and sells other securities, but such activities produce additional localized effects on markets related to the security in question.

This blog post from Liberty Street Economics focuses on these localized effects of the Fed holding more MBSs on the housing and mortgage lending market.

Unlike Treasuries, MBS also affect the price of a special risk known as “convexity” or “prepayment risk.” Homeowners with mortgages are allowed to pay off their mortgages early, for example to refinance to a lower-rate loan. This choice is more attractive if interest rates fall after the mortgage is issued. From the perspective of an MBS investor, prepayment risk is a lose-lose proposition. If rates fall, homeowners become more likely to prepay, and the investor does not receive the full stream of interest payments that were initially expected. On the other hand, if rates rise, homeowners become less likely to prepay, so the investor is now receiving below-market-rate interest payments and is stuck with this below-market-rate interest stream for a longer time than initially expected. Investors demand a risk premium to bear prepayment risk. But when the Fed holds MBS, it removes some prepayment risk from the market, reducing the prepayment risk premium. Because this risk premium is unique to mortgages, the Fed’s MBS holdings therefore help reduce mortgage rates even more than other rates. In this sense, MBS holdings provide more stimulus to the residential mortgage market than to other markets, affecting the cross-sectional allocation of credit and economic activity.

The expansion of the Fed’s balance sheet almost a decade ago was a response to the most serious economic downturn since the Great Depression, and the transfer of prepayment risk from the private market to the Fed may be a lower priority issue when determining balance sheet policy.

Interestingly, unlike countless other government policies that prop up the housing market and subsidize risky mortgage lending practices, this is an instance of investment risk that comes from homeowners not only not defaulting on their mortgages, but actually getting ahead of payments.

Nevertheless, this remains another example of post-crisis policymaking that leaves the public holding the bag for the private sector.

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By |2018-08-16T14:18:05-07:00August 16th, 2018|Blog, Financial Regulation|