09.19.2017 0

QE finally coming to an end, 9 years later, long overdue

By Robert Romano

Almost a decade after quantitative easing began in 2008 — where the U.S. Federal Reserve expanded its U.S. Treasuries holdings by over $1.9 trillion and acquired another $1.8 trillion of mortgage-backed securities, and then kept purchasing more as the bonds matured starting in 2014 — is finally coming to an end.

As reported the Wall Street Journal on Sept. 18, “The central bank is likely to announce Wednesday it will start slowly shrinking its $4.2 trillion portfolio of mortgage and Treasury bonds…”

It’s about time.

The Fed’s unprecedented program of national debt monetization and bailing out the mortgage industry continued long after the financial crisis of 2007 and 2008 was said to have ended — leaving markets to absorb the mixed signals from the government that on one hand said the recovery was underway and on the other kept many of the emergency policies, including near-zero percent interest rates, in effect.

On Oct. 29, 2014, the central bank stated, “the Committee continues to see sufficient underlying strength in the broader economy to support ongoing progress toward maximum employment in a context of price stability. Accordingly, the Committee decided to conclude its asset purchase program this month.” But the Fed maintained the policy of “reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction” in order to “help maintain accommodative financial conditions.”

If there was “sufficient underlying strength in the broader economy,” then why were the continued “reinvestments” back into treasuries and mortgage-backed securities still needed?

One indication might come from the rate of return by the Fed, in the form of its profits on bonds and other instruments that are then transmitted to the U.S. Treasury. Those earnings, which include mortgage interest payments, hit an all-time high of $115 billion in 2016, an increase of about $20 billion from 2015.

The mortgage-backed securities purchase program was thought to be taking non-performing assets off the books of banks and other investors, that the profits rose even as the principal balance remained the same and interest rates were dropping appears to indicate that conditions improved markedly on household balance sheets. The foreclosure wave was over. Or at least enough of it was so that the Fed no longer sees the need to take in new, non-performing assets. Now, it will just drawn down.

How fast?

In June, the Fed released advance guidance on what the drawdown would look like: “For payments of principal that the Federal Reserve receives from maturing Treasury securities, the Committee anticipates that the cap will be $6 billion per month initially and will increase in steps of $6 billion at three-month intervals over 12 months until it reaches $30 billion per month… [And] [f]or payments of principal that the Federal Reserve receives from its holdings of agency debt and mortgage-backed securities, the Committee anticipates that the cap will be $4 billion per month initially and will increase in steps of $4 billion at three-month intervals over 12 months until it reaches $20 billion per month.”

All of these purchases of U.S. treasuries and other agency debt were made possible by Section 14 of the Federal Reserve Act, a duty Congress established for the central bank to “To buy and sell in the open market, under the direction and regulations of the Federal Open Market Committee, any obligation which is a direct obligation of, or fully guaranteed as to principal and interest by, any agency of the United States.”

This was the implicit guarantee of the mortgages underwritten by the Congressionally created Fannie Mae and Freddie Mac, one of the root causes of the financial crisis. Those securities had been sold all over the world under the false premise that the value of real estate would keep going up forever. It didn’t.

Yet the assumption was that if anything went wrong with U.S. mortgage markets, the federal government would be there to honor the obligations. It was an assumption that proved to be correct.

Based on data released by the Federal Reserve from the 2010 audit, of the $1.25 trillion of MBS bought by the Fed, foreign entities sold some $442.7 billion at the time of the audit. According to the Federal Reserve, the securities were purchased at “Current face value of the securities, which is the remaining principal balance of the underlying mortgages.” These mortgage-backed securities purchases were not loans, but outright purchases. That’s a bailout.

That included $127.5 billion given to MBS Credit Suisse, $117.8 billion to Deutsche Bank, $63.1 billion to Barclays Capital, $55.5 billion to UBS Securities, $27 billion to BNP Paribas, $24.4 billion to the Royal Bank of Scotland, and $22.2 billion to Nomura Securities. Another $4.2 billion was given to the Royal Bank of Canada, and $917 million to Mizuho Securities.

Now that the Fed is finally ending its program, it is time for Congress to close the Fed’s implicit guarantee of U.S. agency debt, including that of Fannie and Freddie, once and for all. Markets can adjust to the reality that bailouts are forbidden, and engage in prudential lending practices.

Expanding housing markets via finance should be a consequence of real economic growth and development, not the construction of debt-fueled ghost towns without real jobs to support the communities being built. The last housing bubble was driven by a construction boom and a dangerous game of musical chairs ensued once there were no new customers to buy the homes as unemployment began rising.

Finally, the U.S. should not be responsible for bailing out the entire world financial system ever again.

Until then, we should not act surprised when the next financial bubble comes when the central bank is offering free money to anyone who behaves irresponsibly in investing in the U.S. housing market.

Robert Romano is the Vice President of Public Policy at Americans for Limited Government.

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