The Fed Bought What?

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The Fed Bought What?

By John Paul Koning
Posted on 8/13/2007
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The US Federal Reserve injected The Mises Blog
$38 billion dollars into the economy Title
via temporary open market
operations this Friday. This is the Date
largest number of temporary Author
repurchase agreements (specifically,
one business day repos) entered into
by the Fed since September 11,
2001. Back in 2001, Fed purchases
of treasuries exceeded $30 billion for
the four consecutive days after the
collapse of the World Trade Towers,
total temporary injections into the
banking system amounting to a whopping $295 billion.

What is significant about Friday's repurchase agreements is not so much their size, but the
securities that the Fed exchanged for money: mortgage-backed securities (MBS). Indeed,
the entire $38 billion dollar injection went to MBS purchases, the largest open market Study Guide
purchase of this asset type ever conducted by the Fed, smashing the previous record of
$8.6 billion set back in September of 2005. See chart, above.[1] Authors
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The type of mortgage-backed securities the Fed bought are created when bundles of
Study Guide
individual mortgages originated by commercial banks are guaranteed by quasi-
governmental agencies such as the Federal Home Loan Mortgage Corporation (Freddie Human Action
Mac) and Federal National Mortgage Association (Fannie Mae), then split apart and sold to Man, Econ, & State
investors. Homeowners pay interest on these mortgages, interest payments flowing through
E-books
to the final holders of MBS.
The Core
For those who have gone through the Economics 101 treatment of the Fed, the sudden Mises's Books
appearance of MBS in Fed open market operations might seem odd. Professors have All authors
always taught that when the Fed expanded the money supply it did so by buying
Classroom
government bonds and bills. Indeed back in September 2001, the Fed provided liquidity by
buying what it has always traditionally bought; treasury securities. So why is the Fed buying In-House Library
MBS now, and when did it acquire the authority to do so? The Forum
Marketwatch
First a note on how open market purchases work. The Fed uses what are called open
market operations to control the Federal Funds rate, the rate at which large commercial Film List
banks lend cash to each other overnight to fulfil their reserve requirements to the Fed. The
Fed sets a target for the federal funds rate and defends it by either withdrawing or injecting
money according to the requirements of commercial banks. It injects by buying securities
from the banks with freshly created checking deposits, or money. This injection increases
the reserves commercial banks hold, allowing these banks to expand credit to businesses
and consumers. The Fed withdraws money by selling securities to commercial banks and
receiving money as payment, thereby reducing reserves and removing credit from the
system.

The Fed conducts both temporary open market operations and permanent ones.
Permanent, or outright operations, inject cash and remove securities from the banking
system forever. The Fed keeps the securities it has acquired outright in the System Open
Market Account, aptly initialed SOMA (in Aldous Huxley's Brave New World, the drug soma Mises Media
is produced to keep citizens in a steady state of happiness, much like the Fed's SOMA).
Temporary operations, the ones entered into this Friday, involve 1–14 day repurchase or Media Archive
reverse repurchase agreements whereby the Fed purchases (or sells) securities in return for Mises Radio
cash with an agreement that the commercial bank on the other side of the deal will buy back Live Webcasts
(or sell back) the securities after a period of days.
RSS and Podcasting
Temporary reverse repurchase operations, the short-term withdrawal of money from the
banking system, are rare. The Fed has only engaged in 16 reverse repos since late 2000,
versus 1247 repurchases. This imbalance means that the Fed is almost always augmenting
commercial bank reserves by buying securities, allowing the banks to use their larger
reserves to expand credit and borrowing. Thus the rate defended by the Fed is lower than
the rate at which the commercial banks would be willing to lend each other if the Fed did not
exist.

Back to Friday's MBS purchases. Historically, the Fed's open market operations have been
confined to US Treasuries. Clauses 3 to 6 of the Guidelines for the Conduct of System
Operations in Federal Agency Issues ensured that Federal Reserve operations could not
engage in temporary purchases of securities issued by federal agencies like Freddie Mac
and Fannie Mae.[2] Mises Blog
In an August 1999 Fed meeting officials temporarily suspended clauses 3 to 6, giving
themselves the authority to freely purchase Ginnie Mae–, Freddie Mac–, and Fannie Mae–
issued MBS on a provisional basis without hindrance on size and timing. The reason given:

http://www.mises.org/story/2676 9/2/2007
The Fed Bought What? - Mises Institute Page 2 of 3

it needed full reign to inject money into the banking system in preparation for the year 2000
crisis.[3] The period for which the temporary suspension was to extend was from October 1,
1999 through April 7, 2000.
Posts
The year 2000 crisis proved a dud. But rather than removing the temporary suspension on
buying MBS, the Fed renewed the suspension in 2000 and 2001 before permanently striking
Slashdot: Why Are So
off clauses 3 to 6 in 2002. In recent Fed documents, only clauses 1 and 2 are listed. This
Many Nerds
storyline may sound familiar to Fed watchers. The Fed was founded in response to the crisis
Libertarians? by Manuel
of 1907, and had its ability to increase the money supply dramatically increased during
Lora
another crisis, the Great Depression, where gold convertibility was suspended.
Hulsmann on Mises by
Since the Orwellian rewriting of the Jeffrey Tucker
Guidelines the Fed has been gradually Personalized Homepage
expanding its MBS purchases, which by Jeffrey Tucker
reached a crescendo this Friday. This
(relatively) new power of the Fed is Paid Spokesman for the
startling given the current liquidity crisis State Decides that
prevailing in the mortgage markets of Money isn't Good
late. By openly stating its willingness to Enough by Jeffrey
buy thousands of mortgages and Tucker
temporarily to expose itself to the Do Nuclear Weapons
financial health (or lack thereof) of the Deter? by Dmitry
homeowning public, and doing so when $26 Chernikov
the rest of the world is shunning them,
the Fed is propping up mortgage Let's Bring Back the
markets, and thereby the housing Good Old Days of
market. This despite the fact that open English Patents by
market operations are not supposed to Stephan Kinsella
support individual sectors of the market The Historical Setting of
or channel funds into issues of particular the Austrian School of
agenciess[4] Economics, by Ludwig
von Mises by Weekend
While the purchases are only temporary Edition
— the cash must be returned by Monday
— one wonders how long before the Fed No More Legislation by
grants itself the power to buy MBS permanently. Either way, the Fed's response shows that Gary Galles
it is worried about the growing mortgage crises and willing to do anything to buy its way out George Selgin on the
of it. Unfortunately, by buying up MBS and propping up the market the Fed will only cause Misesian-style cycle by
more harm than it already has. Jeffrey Tucker
We Need To Secede If
We Are Going To
Succeed by Justin Ptak
John Paul Koning writes for Pollitt & Co, a brokerage based in Toronto, Canada. Send him
mail. See his archive. Comment on the blog. The Party is Over -
Again by William
Anderson
Notes
Who owns the
[1] Data available at copyright to cut-up
http://www.newyorkfed.org/markets/omo/dmm/historical/tomo/search.cfm jeans or low-rise pants?
by Tim Swanson
[2] See Appendix B, http://www.newyorkfed.org/markets/omo/omo2002.pdf Chicken-Salad Chick
Shut Down by Jeffrey
[3] http://federalreserve.gov/FOMC/minutes/19990824.htm Tucker
Katrina and the Great
[4] Clause 2 of Guidelines for the Conduct of System Operations in Federal Agency Issues Flood of 1927 by Mark
Thornton
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