Embed Doc
Copy Link
Readcast
Collections

CommentGo Back

Download

e e oug a

By John Paul Koning

Posted on 8/13/2007

[

Tell Others

]

The US Federal Reserve injected$38 billion dollars into the economyvia temporary open marketoperations this Friday. This is thelargest number of temporaryrepurchase agreements (specifically,one business day repos) entered intoby the Fed since September 11,2001. Back in 2001, Fed purchasesof treasuries exceeded $30 billion forthe four consecutive days after thecollapse of the World Trade Towers,total temporary injections into thebanking system amounting to a whopping $295 billion.What is significant about Friday's repurchase agreements is not so much their size, but thesecurities that the Fed exchanged for money: mortgage-backed securities (MBS). Indeed,the entire $38 billion dollar injection went to MBS purchases, the largest open marketpurchase of this asset type ever conducted by the Fed, smashing the previous record of$8.6 billion set back in September of 2005. See chart, above.

[1]

The type of mortgage-backed securities the Fed bought are created when bundles ofindividual mortgages originated by commercial banks are guaranteed by quasi-governmental agencies such as the Federal Home Loan Mortgage Corporation (FreddieMac) and Federal National Mortgage Association (Fannie Mae), then split apart and sold toinvestors. Homeowners pay interest on these mortgages, interest payments flowing throughto the final holders of MBS.For those who have gone through the Economics 101 treatment of the Fed, the suddenappearance of MBS in Fed open market operations might seem odd. Professors havealways taught that when the Fed expanded the money supply it did so by buyinggovernment bonds and bills. Indeed back in September 2001, the Fed provided liquidity bybuying what it has always traditionally bought; treasury securities. So why is the Fed buyingMBS now, and when did it acquire the authority to do so?First a note on how open market purchases work. The Fed uses what are called openmarket operations to control the Federal Funds rate, the rate at which large commercialbanks lend cash to each other overnight to fulfil their reserve requirements to the Fed. TheFed sets a target for the federal funds rate and defends it by either withdrawing or injectingmoney according to the requirements of commercial banks. It injects by buying securitiesfrom the banks with freshly created checking deposits, or money. This injection increasesthe reserves commercial banks hold, allowing these banks to expand credit to businessesand consumers. The Fed withdraws money by selling securities to commercial banks andreceiving money as payment, thereby reducing reserves and removing credit from thesystem.The Fed conducts both temporary open market operations and permanent ones.Permanent, or outright operations, inject cash and remove securities from the bankingsystem forever. The Fed keeps the securities it has acquired outright in the System OpenMarket Account, aptly initialed SOMA (in Aldous Huxley's

Brave New World

, the drug somais produced to keep citizens in a steady state of happiness, much like the Fed's SOMA).Temporary operations, the ones entered into this Friday, involve 1–14 day repurchase orreverse repurchase agreements whereby the Fed purchases (or sells) securities in return forcash with an agreement that the commercial bank on the other side of the deal will buy back(or sell back) the securities after a period of days.Temporary reverse repurchase operations, the short-term withdrawal of money from thebanking system, are rare. The Fed has only engaged in 16 reverse repos since late 2000,versus 1247 repurchases. This imbalance means that the Fed is almost always augmentingcommercial bank reserves by buying securities, allowing the banks to use their largerreserves to expand credit and borrowing. Thus the rate defended by the Fed is lower thanthe rate at which the commercial banks would be willing to lend each other if the Fed did notexist.Back to Friday's MBS purchases. Historically, the Fed's open market operations have beenconfined to US Treasuries. Clauses 3 to 6 of the

Guidelines for the Conduct of System Operations in Federal Agency Issues

ensured that Federal Reserve operations could notengage in temporary purchases of securities issued by federal agencies like Freddie Macand Fannie Mae.

[2]

In an August 1999 Fed meeting officials temporarily suspended clauses 3 to 6, givingthemselves the authority to freely purchase Ginnie Mae–, Freddie Mac–, and Fannie Mae– issued MBS on a provisional basis without hindrance on size and timing. The reason given:

Daily Ar

ticles

Daily Article Archive

The Mises Blog

Title

Date

Author

Study Guid

Authors

Free Subscription

Study Guide

Human Action

Man, Econ, & State

E-books

The Core

Mises's Books

All authors

Classroom

In-House Library

The ForumMarketwatch

Film List

Mises Media

Media Archive

Mises Radio

Live Webcasts

RSS and Podcasting

Mises Blog

Page 1of 3The Fed Bought What? - Mises Institute9/2/2007http://www.mises.org/story/2676

it needed full reign to inject money into the banking system in preparation for the year 2000crisis.

[3]

The period for which the temporary suspension was to extend was from October 1,1999 through April 7, 2000.The year 2000 crisis proved a dud. But rather than removing the temporary suspension onbuying MBS, the Fed renewed the suspension in 2000 and 2001 before permanently strikingoff clauses 3 to 6 in 2002. In recent Fed documents, only clauses 1 and 2 are listed. Thisstoryline may sound familiar to Fed watchers. The Fed was founded in response to the crisisof 1907, and had its ability to increase the money supply dramatically increased duringanother crisis, the Great Depression, where gold convertibility was suspended.Since the Orwellian rewriting of the

Guidelines

the Fed has been graduallyexpanding its MBS purchases, whichreached a crescendo this Friday. This(relatively) new power of the Fed isstartling given the current liquidity crisisprevailing in the mortgage markets oflate. By openly stating its willingness tobuy thousands of mortgages andtemporarily to expose itself to thefinancial health (or lack thereof) of thehomeowning public, and doing so whenthe rest of the world is shunning them,the Fed is propping up mortgagemarkets, and thereby the housingmarket. This despite the fact that openmarket operations are not supposed tosupport individual sectors of the marketor channel funds into issues of particularagenciess

[4]

While the purchases are only temporary — the cash must be returned by Monday — one wonders how long before the Fedgrants itself the power to buy MBS permanently. Either way, the Fed's response shows thatit is worried about the growing mortgage crises and willing to do anything to buy its way outof it. Unfortunately, by buying up MBS and propping up the market the Fed will only causemore harm than it already has.John Paul Koning writes for

Pollitt & Co

, a brokerage based in Toronto, Canada. Send him

mail

. See his