Bill Gross Was Right: Fed Board Member Tarullo Calls For Restart Of MBS Monetization

When we first reported on Bill Gross' massive surge in duration and accelerated purchase of Mortgage Backed Securities a week ago, we said, "That's either what is called betting one's farm on Operation Twist, or, betting one's farm that the next thing to be purchased by the Fed in QE3 or QE4 depending on how one keeps count, will be Mortgage Backed Securities." It was the letter. Confirmation that Bill once again frontran the Fed comes courtesy of Daniel Tarullo who in a speech at Columbia University, talking about the labor market of all things, just said the following: "I believe we should move back up toward the top of the list of options the large-scale purchase of additional mortgage-backed securities (MBS), something the FOMC first did in November 2008 and then in greater amounts beginning in March 2009 in order to provide more support to mortgage lending and housing markets." And there you go: watch as the market rips on the expectation that the US will bail out China all over again. Oh wait, at this point China couldn't care less what happens to the GSEs stack. So unfortunately as can be expected, this is nothing but yet another bailout of US banks, which lately have been buying up MBS like crazy (Gross is not the only one with the hotline), and expecting to flip right back to Brian Sack: after all something has to be done to save the poor things from a total pancaking of the Treasury curve.

The relevant section from Tarullo's just released speech (full thing can be found here).

Within the FOMC and in the broader policy community, there has been considerable discussion of possible additional accommodative measures, from communication strategies such as forward guidance on the likely path of the federal funds rate to additional balance sheet operations. I believe we should move back up toward the top of the list of options the large-scale purchase of additional mortgage-backed securities (MBS), something the FOMC first did in November 2008 and then in greater amounts beginning in March 2009 in order to provide more support to mortgage lending and housing markets.

In November 2010, when the FOMC initiated another large-scale asset purchase program, only U.S. Treasury securities were involved, in large part because of a desire to return, once the recovery was well established, as quickly as possible to a Federal Reserve balance sheet that did not contain other kinds of assets. A related concern of some was that the purchase of MBS was a form of credit allocation, rather than simply monetary policy that lowered long-term rates for all borrowers. For similar reasons, the proceeds of agency securities accumulated pursuant to the first large-scale asset purchase program were reinvested in Treasury securities rather than in other agency securities.

At the September FOMC meeting, we changed our reinvestment policy so that the proceeds of maturing agency securities will now be reinvested in new MBS. Yields on longer-duration Treasury securities had trended down appreciably in the late summer in response to market demand, safe-haven flows, and diminishing expectations for growth. Even though nominal MBS rates had also declined somewhat, spreads to Treasury yields had, over the course of the year, widened noticeably. Since this announced change in reinvestment policy, spreads on lower-coupon MBS have narrowed, but they remain higher than they were early this year.

A large-scale MBS purchase program has many of the benefits associated with purchases of longer-duration Treasury securities, such as inducing investors to shift to other assets, including bonds and equities. [translated: everyone go into high beta stocks right now] But it could also have more direct effects on the housing market. By increasing demand for MBS, such a program should reduce the effective yield on those MBS, which in turn should put downward pressure on mortgage rates. The aggregate demand effect should be felt not just in new home purchases, but also in the added purchasing power of existing homeowners who are able to refinance. Indeed, homeowners who refinance get the equivalent of a permanent tax cut. Concerns about central banks making sectoral credit allocation decisions are understandable in general. But here we are talking about a widely traded instrument in a sector that appears, now more than ever, to be central to the slow pace of recovery.

Now, I should note that the mortgage market is quite segmented. One relatively small group of borrowers has extremely good credit and funds for sizable down payments. That group can readily obtain a mortgage. The other, much larger group lacks one or both advantages, and it faces much greater hurdles in the mortgage market. So there is some chance that the principal effect of renewed MBS purchases would be to allow those in the first group who have already refinanced to do so once again or to buy a new home at a somewhat lower mortgage rate. These outcomes would be helpful, but the effectiveness of an MBS purchase program would be amplified, perhaps significantly, if certain nonmonetary policies were changed.

Proposals for promoting refinancing have been made by many academics, policymakers, and policy analysts. Any proposals that could sensibly and effectively be implemented would increase the effect of an MBS purchase program. For example, action could be taken to bring the benefits of refinancing to underwater borrowers. In principle, borrowers with mortgages that are guaranteed by government-sponsored enterprises (GSEs) such as Fannie Mae and that have loan-to-value ratios of up to 125 percent can refinance through the Home Affordable Refinance Program. In practice, though, numerous obstacles have kept the program from helping many potentially eligible borrowers. Underwater borrowers whose loans are not guaranteed by GSEs are essentially unable to refinance at all. Policy changes directed at this last, larger group of homeowners would have to be carefully designed so as not to transfer credit risk from private investors to the government, and could well require legislation.

Needless to say, though, an MBS repurchase program will not cure all that ails the housing market, much less fill the whole aggregate demand shortfall. There is a host of other problems, including continuing issues in mortgage servicing, uncertainty as to when house prices will have bottomed out in local markets, ambiguity about the scope of putback risk for securitized mortgages, and the substantial part of the underwater mortgage problem that cannot be solved by refinancing. But I believe that MBS purchases are worth considering as a monetary policy option precisely because they carry the promise of addressing the feature of the current aggregate demand shortfall that differs from typical recessions and recoveries.


Look for Bill to have bought much more MBS when the October TRF update is released. The good thing out of all this: Jan Hatzius can finally shut up about Nominal GDP targetting, a topic so stupid we have been ignoring it on purpose. Instead, the Goldman economist can now redouble his efforts on pitching MBS monetization as the one greatest thing to save Goldman bonuses for 2012 (2011 is a screatch), er... we mean, tax-break for the middle class.


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