Wednesday, November 26, 2008
On November 2, I wrote an article about the new-found relationship between the Fed and the Treasury. Here is a bit from the article:
At some point the Fed may choose to monetize new debt issued by the Treasury (let’s say in order to raise $700 billion to finance TARP), but I doubt it. There is already a new $1 trillion of new liquidity sloshing around in the banking system, posing huge inflationary risks.
Well, circumstances have changed. Twenty-four days later, and in a rather nontraditional manner, the Fed is now monetizing government debt.
The time has come to officially monetize government debt. Yesterday the Fed announced that it would purchase $100 billion in debt obligations from Fannie Mae, Freddie Mac and the Federal Home Loan Bank next week. And furthermore, it will purchase $500 billion in mortgage-backed securities (MBS) – I like to call this FARP (Fed Asset Relief Program).
The purchase of GSE debt is a direct attempt to reduce the spread on government agency (GSE) debt over comparable Treasury debt, the relative borrowing costs. Basically, the Fed is targeting a lower interest rate on GSE debt. Sound familiar? Yup, that’s monetizing government debt.
The chart illustrates the difference between newly issued Fannie Mae debt and a comparable U.S. Treasury through 11/24/08. This spread has widened from an average of 29 bps (0.29%) spanning 2006-2007 to 90 bps spanning 2007-2008. Fannie Mae must pay more in order to finance its mortgage obligations, which limits its ability to roll over current obligations, and tightens the terms on new mortgage loans.
By driving down the spreads on GSE debt now, and later on mortgage-backed securities, the Fed gives the GSEs more flexibility in the mortgage market, and they can offer lower rates and better terms for potential homebuyers. That’s the theory.
I am interested to hear why the Fed is supporting the GSE debt and securitized assets that derive their value from the mortgages (MBS) rather than the mortgages themselves. The Fed could allocate a similar stock of resources to mortgages directly, where the effect would be immediate (mitigating foreclosures or offering better terms directly). However, I assume that the Federal Reserve Act prevents the Fed from doing such a thing – that sort of action probably lies in the hands of Congress. Although the immediate effects do appear to be quite positive.
Expect the Fed’s balance sheet to rise by another $100 billion (at least) in two weeks. It is official: the Fed is monetizing government debt.