If you’ve been following reports of what might happen at next week’s FOMC’s meeting, you probably know that the Fed is contemplating further purchases of agency mortgage-backed securities.
And there are least two, somewhat obvious justifications for it:
1) Housing market activity continues to languish, and buying MBS will further shrink the spread of mortgage rates over US Treasuries. Hopefully more homeowners that currently pay above-market rates will refinance.
2) Buying MBS is a complement both to the earlier Operation Twist and to the Administration’s latest housing proposal, which is meant to help previously ineligible homeowners refinance and therefore could produce higher mortgage rates as prepayments lead MBS investors to drive them up. The Fed’s buying more agency MBS could act as an offset.
(It’s also just a straightforward way for the Fed to expand its balance sheet.)
Fine, and although we don’t know how effective this would be as economic stimulus, at least it’s a coherent rationale. But if the committee does proceed with QE3, here, from Credit Suisse economists, is an additional explanation for it that the Fed probably won’t mention (our emphasis):
The financial system is in a fragile state. Some institution, market or instrument seems always at the edge of breaking down – or just over that edge. Very low interest rates throughout the developed world pose a significant challenge to the profitability oftraditional financial business models by reducing the rewards of maturity transformation. New regulatory initiatives, including especially higher capital-to-asset ratio requirements on ever more strictly construed asset classifications, inhibit the volume and profitability of credit transformation. (No surprise there – that’s what deleveraging the developed economies is all about.)
Ultra-low interest rates tend to be more persistent than ultra-high ones. This partly reflects the asymmetry in the efficiency of monetary policy in stimulating versus restrainingeconomic activity. It also partly reflects the arithmetic of fiscal sustainability: low interest rates suppress the debt service cost entry for debtor governments while high interest rates contribute to explosive debt-to-GDP dynamics. Finally, the exit from ultra-low interest ratesis higher interest rates, that is, a bear market in bonds. Since bear markets tend to expose and magnify financial fragilities, human nature tends to incline the monetary authorities toa more cautious pace of raising interest rates. …
While ultra-low interest rates are still performing their corrosive role on the profitability ofthe financial sector business model, the sector is also trying to accommodate to an emergent regulatory environment.
One dimension of that regime is clear enough in outline. Banks and other financial intermediaries will be required to hold more capital per unit of assets, that is, to deleverage.There are two ways to raise a capital-asset ratio: add capital or subtract assets. Raising capital has the potentially undesirable feature of diluting existing shareholders. So banks will seek to accomplish at least some of their deleveraging by shedding assets.
But when all (or a large subset of all) financial intermediaries are seeking to disgorge assets, market prices will tend to weaken, bid-ask spreads to widen, liquidity to evaporate, perceived counter-party risk to rise, term funding to run for the hills – in sum, the syndrome that has manifested repeatedly since the summer of 2007. When this syndrome of financial fragility presents, the only balance sheet adequate to absorb the orphaned assets is the central bank’s. Hence, QE.
Such deleveraging, via the shedding of risk-weighted assets, is one of the lessons from bank recapitalisation history that FT Alphaville has been discussing in recent weeks, though normally in reference to European banks.
In his speech two weeks ago, Bernanke explained the evolving intellectual framework of central banking after the crisis, and specifically explained the increasing importance of monitoring financial stability along with its traditional responsibility for monetary policy. The details remain to be worked out, obviously, but buying MBS would seem a way to address both goals.
And speaking of those European banks….
Separately, anecdotes of European banks deleveraging dollar-denominated assets – such as mortgage securities – have proliferated. Should this trend continue, it would be most convenient to have the Federal Reserve positioned as a ready buyer of MBS, as well as Treasuries.
Convenient indeed, and too much of a coincidence not to at least mention. Just something to keep in mind next week…
Related links:
Lessons from bank recap history – FT Alphaville
The looming crunch de crédit – FT Alphaville
More on the looming crunch de credit – FT Alphaville
Building a better bank recap – FT Alphaville