The Fed's MBS Conundrum
As the Fed’s Open Market Committee approaches its April 27 – 28 meeting, it faces a conundrum regarding how to dispose of the $1.1 trillion in mortgage-backed securities that it bought during the last year in order to tamp down mortgage rates and prop up the sickly U.S. housing market. At this point in time, these securities are almost solely responsible for bloating the Fed’s balance sheet up to almost $2.4 trillion, from about $800 billion before the onset of the financial crisis in 2008.
Most discussions about implications of this portfolio relate to rises in mortgage interest rates that undoubtedly will accompany any announcement of intentions to sell of the securities. What isn’t being discussed is the impact on the Fed’s own portfolio. This portfolio is composed largely of 30-year fixed-rate mortgages; what portion we do not know because the Fed has not revealed this information. Such a portfolio carries with it a tremendous amount of interest-rate risk: when interest rates go up, the price of rate-sensitive bonds go down.
Financial economists have developed tools for measuring the price impact of interest changes on such securities that collectively go under the name of “duration.” In general, duration is a measure of the percentage price change for a one-percentage point change in the interest rate. For the sake of argument, let us assume that the duration of the Fed’s $1.1 trillion portfolio is 10, meaning that it has the same interest-rate sensitivity as a portfolio of 10-year zero coupon bonds, then the value of the portfolio will fall by 10 percent for each one percentage point increase in interest rates. In other words, if mortgage interest rates rise by one percentage point, the Fed’s portfolio will fall in value by an astonishing $110 billion dollars! Even if the duration is only 5, then the decline in value would be $55 billion dollars. In other words, the Fed’s reckless actions taken to provide yet another subsidy to the housing market (don’t forget the $500 billion per year subsidy provided by the mortgage-interest tax deduction or the $20 billion first-time home-buyer tax credits), has exposed the Fed, and, therefore, U.S. taxpayers, to huge potential losses should rates rise.
Worse yet, these securities have compromised the Fed’s ability to shape monetary policy in a way that is in the best interests of the economy because, if that means raising rates, it hits the Fed’s own pocketbook. This stacks the deck in favor of continuing the easy money policy that largely helped to create the housing bubble, and that risks stoking inflationary fires that are not easily extinguished.
What is the easy way out of this conundrum? Look back to Christmas Eve, when the Obama administration quietly removed the $400 billion limit on Treasury’s credit line to Fannie and Freddie. Look for the administration to direct Fannie and Freddie to purchase the Fed’s mortgage-backed securities with cash borrowed from Treasury. This will unfetter the Fed’s ability to conduct monetary policy, but will put the future losses on this mortgage portfolio squarely on the taxpayer’s shoulders.
