Thursday, July 26, 2012

Treasury/MBS Swaps

Arvind Krishnamurthy and Annette Vissing-Jorgensen have written this note, which makes an argument that a useful quantitative easing (QE) operation by the Fed would be a swap of Treasury bonds for mortgage-backed securities (MBS). This summarizes the argument:
We make two main points:
1. Purchasing long MBS brings down long MBS yields by more than would an equal sized purchase of long Treasury bonds and thus is likely to create a larger stimulus to economic activity via a larger reduction in homeowner borrowing costs.
2. Purchasing Treasury bonds brings down Treasury yields, but part of this decrease indicates a welfare cost rather than a benefit to the economy. Thus it would be better to sell rather than purchase long-term Treasury bonds.

Let's start with point #2 above. On page 3, Krishnamurthy and Vissing-Jorgensen state:
...by purchasing long-term Treasury bonds the Fed shrinks the supply of extremely safe assets, which drives up a scarcity price-premium on such assets and lowers their yields. This latter channel is a welfare cost to the economy.
I like that. It's exactly how an open market operation works in this paper. A swap of outside money for government debt, under the right conditions, makes liquidity more scarce in financial markets and increases its price - the real interest rate goes down. The price of government debt reflects a liquidity premium. But this kind of swap is not a good thing, as it makes financial trade less efficient.

The problem is that it doesn't work that way in a liquidity trap (positive excess reserves and the interest rate on reserves driving all short-term interest rates). For example, under current circumstances, if the Fed swaps reserves for Treasury bonds, that implies no change in financial market liquidity, as the private sector's ability to intermediate T-bonds implies that the Fed's swap just nets out.

Now, move to point #1. The claim here is that we would prefer that the Fed have a portfolio of MBS rather than Treasury bonds. But what is the Fed supposed to be accomplishing by purchasing MBS? The case that some people make to justify the existence of Fannie Mae and Freddie Mac (currently under government "conservatorship") is that they are a boon to the mortgage market. Otherwise illiquid mortgages are sold to Fannie Mae and Freddie Mac. These mortgages can be held on the balance sheets of the GSEs, financed by liabilities which are perfect substitutes for government debt. They can, and are, packaged as MBS, which are tradeable, liquid securities. Why is it necessary that we go through another step and have these MBS intermediated by the Fed? They're not liquid enough already?

Maybe there is some risk associated with MBS (prepayment and default risk) that we don't see in Treasury bonds, that we are transferring from the private sector to the Fed with a Fed MBS purchase. But how does that work? The risk has to be borne by someone, and if the Fed holds the MBS, taxpayers bear the risk. Why is the Treasury any better at allocating risk in the private sector than are private financial institutions?

Likely Krishnamurthy and Vissing-Jorgensen's ideas will be used to support what the FOMC seems intent on doing, which is executing another QE operation, this time with MBS (as with QE1).

21 comments:

  1. "The risk has to be borne by someone, and if the Fed holds the MBS, taxpayers bear the risk. Why is the Treasury any better at allocating risk in the private sector than are private financial institutions?"


    The private sector and the Treasury have different economic tools at their disposal for dealing with losses from risky assets. A bank (or any private sector entity) will anticipate the possibility of capital losses and may increase their reserve holdings against it. The treasury can just shrug and print money if they want to. Those two behaviors, when writ large, have very different implications for aggregate income.

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  2. "The treasury can just shrug and print money if they want to."

    No, losses on the MBS portfolio held by the Fed will sooner or later be reflected in less revenue turned over to the Treasury by the Fed, and the Treasury has to make it up somehow. When they make it up, it doesn't come out of thin air.

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    1. Treasury owns a printing press, yes? They may be unlikely to use it, but they can create money out of thin air, and the possibility of that affects economic outcomes.

      Besides which, Treasury losses could come from issuing more government debt, and the credit constraints for Treasury are very different from those for the private sector at the moment.

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    2. "Treasury owns a printing press, yes?"

      No, the Fed has the printing press.

      "...they can create money out of thin air."

      The Fed's liabilities - money - are not created out of thin air any more than anyone else's liabilities are. They issue liabilities, they buy assets, and the balance sheet balances.

      The Fed is different from a private bank. The Treasury is not the same as General Motors. The Fed can issue liabilities that a private bank cannot. But I would not trust the Fed to screen mortgage loans. The Treasury can make me pay my taxes, but I would not trust the Treasury to manufacture a car. The Fed has an advantage at doing some things, and it is not very good at other things. Given current circumstances, I don't think the Fed is any better at turning MBS into short term debt than the private sector is.

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    3. Hmm, the conclusion of ineffectiveness presumes that people are able to calculate an expected impact from the transfer of risk on their tax contributions and act on it. This requires a lot of foresight and economic training from their part. Empirical studies however suggest otherwise when future events are highly uncertain (Hsieh, 2003).

      Also, I remember a remark by a senior economist (a U-Penn PhD who shall remain unnamed) when he was at the New York Fed, after working with bank executives on crash tests. He was shocked to see how little these guys knew about the true nature of risk and its management. So maybe there is something to be said about the Fed having an advantage. Besides, even before comparing credentials of economists working at an average Federal Reserve bank to those working at an average private bank, it seems to me that the Fed has access to a much broader pool of talent. This by itself gives it an advantage over private banks that rely on their own staff to manage risk, especially during crises. Or am I wrong?

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    4. Yes, but has to make it up somewhere when? And what else will have changed in the interrim?

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  3. Even Keynes didn't think a liquidity trap had ever existed. As Evan Soltas has pointed out, the zero lower bound is no barrier for central banks that decide to ignore it. People thought the Swiss franc was "trapped" at a high value relative to other currencies, but just by announcing their intentions the Swiss central bank changed that.

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    1. They have actually had to buy large quantities of Euro assets to maintain the peg. See http://ftalphaville.ft.com/blog/2012/07/31/1102241/the-changing-ingredients-of-that-swiss-cake/

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  4. "...just by announcing their intentions..."

    Sure, the liquidity trap only describes the effect of current actions, which leaves open future actions and what you say about them today. But you can't be assured that just saying stuff will matter. That has to be backed up by beliefs that you will actually do what you say.

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    1. Perhaps QE is ineffective under the current Fed policy regime (because the market does not believe that the fed will allow significant reflation); if so, that seems to imply that a new policy regime with a level target could make QE more effective, by giving more credibility to the belief that the fed will allow prices to reflate in the future.

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    2. "No, losses on the MBS portfolio held by the Fed will sooner or later be reflected in less revenue turned over to the Treasury by the Fed, and the Treasury has to make it up somehow. When they make it up, it doesn't come out of thin air."

      Right. And if the Fed raises interest rates in the future, the losses are likely to be bigger. So the commitment to lower interest rates in the future becomes more credible. This is the "signaling channel," which is more than just saying stuff.

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  5. I have a question about your methodology if you have time to address it: I think you would agree that if the Fed were allowed to purchase homes directly, that would have stimulative effects. Probably you would say the same if they were to purchase privately issued subprime mortgage securities. These are obviously more risky and illiquid than an agency MBS, which is in turn more risky and illiquid than a treasury bond. But liquidity and riskiness are not binary properties, they lie along a spectrum. My question is -- what properties do you use to judge that purchases of treasuries and MBS would have no effect, but direct purchases of riskier illiquid assets would? Or am I mistaken and you think that there is no asset the Fed could buy that would affect the price level?

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    1. He has at least once before suggested that Fed purchases of gold would not effect the price of gold, so maybe the premise of your question assumes an agreement that is not there.

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  6. What a farce.

    Could some list the names and addresses of the people at the fed who claim to be able to value these securities.

    I will go raise a few $$$, hire them away from the Fed, and start a hedge fund with the "Smartest People in the World"

    Seriously, how is it that ding a ling ideas like this even get talked about?

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    1. If anyone knows something about farcical ideas, I'm certain it is you, John D. What, you thought I'd forgotten about you? Nope, it will never happen -- I will rid the internet of your stupidity.

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  7. Here is a question that has always puzzled me:

    The CB cannot set two prices, or if it tries, it is creating an arbitrage opportunity, which is really fiscal policy. Arbitrage in the financial markets is hard to sustain.

    So given that the CB is already setting a policy rate of 0 for Fedfunds, why would an attempt to change any other rate (e.g. drive longer term MBS yields lower) not be fiscal policy? And would it not be hard to sustain, as the CB is telling the market that how they price longer term securities is wrong based on FF is wrong somehow?

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  8. The paper that this note is based on has already made it onto the reading list for Berkeley macro students. Vissing-Jorgensen presented it at the finance seminar at Haas too, and it really got a lot of people's attention. This paper is taught alongside Swanson's 2011 paper (also a high frequency event study) of Operation Twist, a somewhat similar program in 1961. By using a high frequency event study, Swanson found effects of QE that earlier studies did not detect, which is interesting. I wonder if older fashioned studies of QE1 and QE2 also wouldn't have found anything.

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  9. Actually it is the Treasury that has the printing press.

    The Treasury prints all Federal Reserve notes. Or rather the Bureau of Engraving and Printing (which is part of the Treasury) does. Then the notes are supplied to the Federal Reserve by the Treasury "subject to to order of the Secretary of the Treasury" (US Code).

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  10. Damned typos.

    "subject to the order of the Secretary of the Treasury".

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