by Calculated Risk on 9/03/2013 02:58:00 PM

From housing economist Tom Lawler:

In a controversial paper presented at the Federal Reserve Bank of Kansas City’s Economic Symposium at Jackson Hole, authors Arvind Krishnamurthy and Annette Vissing-Jorgensen argued that Fed “large scale asset purchases” (LSAP) of agency MBS are “more economically beneficial” than Fed LSAP of Treasury securities. Here is an excerpt from their “conclusion” section.

“We have presented theory and evidence that LSAPs work through narrow channels in which asset purchases affect the prices of the assets that are purchased. The primary channels for the operation of LSAPs in the US, and likely around the world, are the capital constraints and scarcity channels. We find that MBS LSAPs are more economically beneficial than Treasury LSAPs. There is little evidence for the operation of a broad channel through which LSAPs lower the yield on all long-term bonds.”

While I won’t go into the details of the paper, essentially the authors argue that (1) Fed purchases of a particular type of security lower that security’s yield relative to other yields; (2) purchases of agency MBS, by lowering MBS yields relative to other yields, encourages/allows mortgage lenders to originate agency-eligible mortgages to home buyers and home owners at lower interest rates; (3) lower rates on agency-eligible mortgages benefit the housing market; and (4) benefiting the housing market relative to other markets is a “good thing.”

While the authors don’t explicitly state their “findings” this way, that effectively is what their “findings” imply.

There are, however, several things missing from the paper. First, of course, is the issue of whether monetary policy should be conducted in a fashion that alters the allocation of credit to one sector of the economy relative to other sectors of the economy. Last year, for example, Philadelphia Federal Reserve Bank President Charles Plosser suggested that Fed purchases of MBS might be an “inappropriate foray” into fiscal policy. Here is a quote:

“When the Fed engages in targeted credit programs that seek to alter the allocation of credit across markets, I believe it is engaging in fiscal policy and has breached the traditional boundaries established between the fiscal authorities and the central bank,”

Richmond Federal Reserve Bank President Jeffrey Lacker this spring said that the Fed should “get out of the credit allocation business” and stop buying agency MBS.

Dallas Federal Reserve Bank President Richard Fisher also believes the Fed should dramatically scale back MBS purchases, arguing that “the housing market is on a self-sustaining path and does not need the same impetus we (the Fed) have been giving it.”

There is a long history on the appropriate “line” between the Treasury’s fiscal policy objectives and the Fed’s monetary and credit policy policies, and folks interested should get a copy of the Federal Reserve Bank of Richmond’s “Economic Quarterly Special Issue,” Winter 2001, commemorating the 50th anniversary of the 1951 Treasury Fed Accord.

The fiscal/monetary “line” came to the forefront during the height of the financial crisis, and to “clarify” things the Department of the Treasury and the Federal Reserve issued a joint statement on the role of the Federal Reserve in preserving financial and monetary stability on March 23, 2009. In that statement there were four “broad points” that the Treasury and the Federal Reserve agreed on.

1. Treasury-Federal Reserve cooperation in improving the functioning of credit markets and fostering financial stability
The Federal Reserve's expertise and powers are indispensable for preventing and managing financial crises. The programs it has initiated since the onset of this crisis have played a critical role in helping to contain the damage to the broader economy. As long as unusual and exigent circumstances persist, the Federal Reserve will continue to use all its tools working closely and cooperatively with the Treasury and other agencies as needed to improve the functioning of credit markets, help prevent the failure of institutions that could cause systemic damage, and to foster the stabilization and repair of the financial system.

2. The Federal Reserve to avoid credit risk and credit allocation
The Federal Reserve's lender-of-last-resort responsibilities involve lending against collateral, secured to the satisfaction of the responsible Federal Reserve Bank.
Actions taken by the Federal Reserve should also aim to improve financial or credit conditions broadly, not to allocate credit to narrowly-defined sectors or classes of borrowers. Government decisions to influence the allocation of credit are the province of the fiscal authorities.

3. Need to preserve monetary stability
Actions that the Federal Reserve takes, during this period of unusual and exigent circumstances, in the pursuit of financial stability, such as loans or securities purchases that influence the size of its balance sheet, must not constrain the exercise of monetary policy as needed to foster maximum sustainable employment and price stability. Treasury has in place a special financing mechanism called the Supplementary Financing Program, which helps the Federal Reserve manage its balance sheet. In addition, the Treasury and the Federal Reserve are seeking legislative action to provide additional tools the Federal Reserve can use to sterilize the effects of its lending or securities purchases on the supply of bank reserves.

4. Need for a comprehensive resolution regime for systemically critical financial institutions
The Treasury and the Federal Reserve remain fully committed to preventing the disorderly failure of systemically critical financial institutions. To reduce the risk of future crises, the Treasury and the Federal Reserve will work with the Congress to develop a regime that will allow the U.S. government to address effectively at an early stage the potential failure of any systemically critical financial institution. ...
emphasis added

Going back to the Krishnamuthy/Vissing-Jorgensen’s (KVJ) paper, their findings, if valid, suggest that the Fed’s LSAP of agency MBS has benefited a narrowly-defined sector (housing) and class of borrowers (mortgagors). Now read point 2 above.

Any questions?
Another shocking thing missing from the paper is that actions by other government entities and Congress have worked in the opposite direction of the Fed’s LSAP of agency MBS. FHA, for example, has raised its mortgage insurance premiums a boatload since 2010, both the bolster its depleted reserves and to encourage “private capital” to return to the mortgage market. Both Fannie Mae and Freddie Mac, to a large extent at the direction of its regulator (FHFA), have increased significantly the guarantee fees they charge on new SF mortgage acquisitions, both to bolster their finances and to encourage private capital to return to the mortgage market. And finally, Congress passed (and the President signed) the Temporary Payroll Tax Continuation Act of 2011, which required both Fannie Mae and Freddie Mac to increase their guarantee fees on all SF residential mortgages delivered to them on or after April 1, 2012 by 10 basis points, with the incremental revenue being remitted to Treasury (effectively to fund the continuation of the payroll tax cut.)

So ... FHA, FHFA/the GSEs, and Congress have all acted to increase the rates on agency-eligible mortgages, with FHA’s and the GSEs’ increases in part designed to encourage other entities to enter the mortgage market. The Fed, in contrast, has engaged in LSAP on agency MBS, which, in the KVJ framework, would lower agency MBS yields relative to other yields, including (presumably) what mortgage lenders would charge on mortgages not intended to be delivered to/insured by FHA or the GSEs! The Fed’s LSAP of agency MBS, in short, act to increase the “government’s” share of the mortgage market!

Interestingly and/or amusingly, an implication of the KVJ paper is that the Fed’s LSAP of agency MBS has “enabled” the GSEs to increase guarantee fees without losing much if any market share, bolstering their profits – which, of course, go back to the Treasury!

Is this “wack,” or what?

CR Note: The above was from economist Tom Lawler.