Tuesday, June 19, 2012

MBS on Fed's balance sheet

A number of readers have asked about the declines from the peak of mortgage backed securities (MBS) holdings on Fed's balance sheet. Here is a quick overview.

MBS on Fed's balance sheet

Right after the financial crisis, the Fed initiated the first round of balance sheet expansion (QE1) which involved MBS. The Fed at the time was buying massive amounts of these securities, effectively consuming the bulk of agency new issue and then some. The balances went above 1.1 trillion before the program ended.

QE2 did not involve MBS and neither did the Operation Twist. Unlike treasuries however, MBS tend to prepay when mortgage holders refinance. It means that the principal of these bonds naturally declines, particularly as rates drop and refinancing gains momentum. That was the reason for the decline in balances after the peak in 2010.

Late last year, the Fed decided to start replacing the portion of MBS that pays down or matures. It was the fall of 2011 and things looked shaky in Europe. The Fed wanted to send a signal that it is ready to take action, and stabilizing the MBS holdings was one of them. That's when the balances stopped declining.

The central bank may end up revisiting MBS purchases as part of the next easing program (as discussed here), although outright purchases are still unlikely.

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