Federal Reserve -- How to Sell Its Mortgage Securities？
The Federal Reserve has acquired more than $1 trillion worth of mortgage-backed securities in the past 15 months. At their policy meeting in the coming week, Fed officials will try to decide how and when to get rid of them without jarring financial markets and the nascent economic recovery.
The Fed's thinking on interest rates is straightforward. The recovery has gained traction but hasn't been vigorous or long lasting enough to warrant raising them soon; after its Tuesday and Wednesday meeting it is likely to repeat its signal that rates will stay low for an "extended period."
The more challenging issue will be agreeing on a long-term plan to shrink a balance sheet bloated to $2.38 trillion—more than double precrisis levels—according to Fed insiders.
Sales of mortgage-backed securities aren't likely soon. It is also possible that the Fed won't signal its intentions on the matter in its post-meeting statement Wednesday. But markets are on edge because its mortgage bonds holdings are so large. At $1.1 trillion in holdings of mortgage debt guaranteed by Fannie Mae, Freddie Mac and Ginnie Mae, the Fed owns roughly a fifth of all these outstanding instruments.
The sheer size of the portfolio makes these decisions so key. The Federal Reserve Bank of New York estimates Fed purchases of mortgage and Treasury bonds pushed long-term interest rates down about half a percentage point. The mere announcement of sales could have the opposite effect, as investors price in future sales.
Speculation about sales Friday morning knocked prices of longer-term Treasury bonds down, and helped push the 10-year note's yield up from 3.770% to 3.813%.
"If they sell the assets, it is clearly going to have a pretty big impact on the long end of the bond market, depending on how they do it, when they do it, and the speed at which they do it," said David Zervos, bond market strategist with Jefferies & Co.
Even if they reach a consensus, many officials want to stay flexible to avoid locking themselves into a course they might need to change later. "It seems to me neither necessary nor advisable to decide upon a single game plan that will be announced in advance and rigidly implemented," said Daniel Tarullo, a Fed governor, earlier this month.
Fed staff in the coming week will present models to forecast how different approaches to reducing the portfolio might play in markets. But some officials worry that they have little experience selling assets and can't rely exclusively on models to predict how markets will react. That—and a worry about disturbing the vulnerable housing market—has top officials inclined to proceed gradually and cautiously, at a predictable pace.
Though interest-rate increases and asset sales are still likely a ways off, the Fed is gearing up to take smaller, baby steps toward the exit. In coming weeks, it is likely to start testing a new program in which it will accept long-term deposits from banks called term deposits, a step meant to help drain money from the banking system when it wants to raise interest rates.
It also will broaden tests of "reverse repo" trades which are another way to drain money from the financial system to include not only banks, but also money-market mutual funds and possibly other financial institutions.
Fed officials will describe these as tests, and not the beginning of a tightening.
Some Fed officials are pushing for a more aggressive approach. In April, Narayana Kocherlakota, president of the Minneapolis Federal Reserve Bank, called for monthly sales of $15 billion to $25 billion to eliminate the Fed's mortgage holdings within five years. "It is likely the Fed will have to sell a nontrivial amount of its MBS holdings," he concluded. Some Fed policy makers—among them Charles Plosser of Philadelphia, Jeffrey Lacker of Richmond and Kevin Warsh at the Fed board—are sympathetic.
Fed Chairman Ben Bernanke made his preferences clear. "I currently do not anticipate that the Federal Reserve will sell any of its security holdings in the near term, at least until after policy tightening has gotten under way and the economy is clearly in a sustainable recovery," he said in February testimony before Congress.
As part of their debate, Fed officials will be weighing how to reach different objectives. Officials see sales of mortgage-backed securities as a way to accomplish two things at once—shrinking the balance sheet over time and returning to a portfolio dominated by government bonds.
Several top officials are wary of using sales to accomplish the third objective of eventually tightening credit when the economy is better healed. They believe the Fed has other tools to push interest rates higher and tighten financial conditions when that time comes. The Fed was mum on the asset-sale question after its March meeting, in part because officials wanted to see how markets reacted after the Fed stopped buying mortgage securities at the end of March. Officials are relieved that didn't unsettle markets. Rates on 30-year mortgages published by Freddie Mac were at 5.07% this week, little changed from where they've been all year.
Fed officials also need to make decisions about their holdings of Treasury securities. One way to shrink their balance sheet will be to allow some Treasury bonds to mature without purchasing new ones to replace them. The New York Fed has calculated the Fed could shrink its balance sheet by an additional $140 billion by 2011 by going this route. But that conflicts with the Fed's desire to hold only Treasury bonds so it could choose to roll over some Treasury holdings and let others mature without replacing them.
Meantime, the market for mortgage-backed securities has shown new signs of vigor. Bidding for a $222.4 million bond backed by private mortgages from Redwood Trust, which are different from the agency mortgage-backed bonds the Fed has bought, was so strong that investors were willing to accept a lower yield—3.75% instead of the original 4%. (Resource from BusinessWeek)
