AEI Committee Recommends Strategy For Fed’s MBS Holdings

As the Federal Reserve discusses strategies for reducing its approximately $1.2 trillion of mortgage-backed securities (MBS) acquired from Freddie Mac, Fannie Mae and Ginnie Mae, one policy group recommends that the central bank place the housing debt back on the books of Fannie and Freddie.

The policy suggestion comes from the American Enterprise Institute's (AEI) Shadow Financial Regulatory Committee, which the AEI describes as a ‘group of publicly recognized, independent experts on the financial services industry.’

The Fed's increase in MBS assets, together with the purchases of U.S. Treasury obligations, contributes to the "huge increase" in bank excess reserves currently being held by banks in their accounts with the Fed, the committee says. While the Fed's MBS acquisition program was terminated at the end of March, the associated reserves will ultimately have to be extinguished before they result in a potentially huge increase in bank credit and money supply, which could lead to a serious inflation problem, the committee adds.

As the Shadow Financial Regulatory Committee sees it, the Fed is faced with several options to address the reserve problems. It could engage in reverse repurchase agreements with primary dealers and other possible counterparties – a route the Fed has already begun experimenting with pilot programs to do just that. But such transactions would only temporarily, and not permanently, reduce the reserves, the committee says.

The Fed could simply let the securities run off as they mature, a strategy the Fed staff estimates would reduce holdings by about $200 billion per year.Â

A third option would be to sell the MBS into the marketplace. But as the market for these securities is relatively thin, sales would have to be gradual to avoid raising mortgage rates that might adversely affect the housing market or that result in losses to the Fed that might seriously deplete its book capital.

Alternatively, the committee recommends for consideration a fourth option, whereby the Treasury could issue Treasury debt to Freddie and Fannie with the offsetting accounting transaction being an IOU to the Treasury. Freddie and Fannie could then swap the acquired Treasury debt for MBS held by the Federal Reserve.

Such transactions would have several desirable features, the committee says, explaining that it would place housing debt on the books of Freddie and Fannie, "where it belongs," and remove the Fed from financing U.S. housing policy. The strategy would also help to re-establish Federal Reserve independence from the Treasury and fiscal policy. Additionally, it would free the Fed to devise strategies to reduce its balance sheet by engaging in more traditional asset sales in the much deeper Treasury market, where the pricing impacts would be smaller and would accommodate a more rapid reduction in excess reserves, the committee says.

SOURCE: American Enterprise Institute


Please enter your comment!
Please enter your name here