The Federal Reserve and Mortgage Backed Securities II

So it turns out that what was unusual about the Friday open market operations of Federal Reserve was even more narrowly technical still. The Federal Reserve always accepts mortgage backed securities as collateral, but usually issues loans backed by this sort of collateral at a less favorable rate. What was unusual on Friday was that the Federal Reserve issues all loans at the most favorable rate, no matter the collateral.

Kevin Drum passes along an e-mail from Stephen Spear, a professor of economics at Carnegie Mellon University, in which the Professor relates a conversation with a Federal Reserve colleague about the operation (“Friday’s Liquidity Event,” Political Animal, The Washington Monthly, 12 August 2007):

Here’s what I’ve been told by a colleague at the Fed:

First a minor point: Most of the open market operations that the Fed does (including Friday’s) are short-term collateralized loans and not outright purchases of securities. Friday’s loans were all overnight (well, over the weekend, actually, maturing on Monday). So the Fed is technically not buying anything; it’s been making short-term loans of cash against collateral.

The Fed accepts three categories of collateral for these loans. One is Treasury securities, another is other government agency securities, and the third is mortgage-backed securities that are federally guaranteed. Because they are federally guaranteed, the mortgage-backed securities the Fed accepts are (obviously) the very best.

Typically the interest rate on these short-term loans varies slightly depending on the type of collateral offered by the borrower. Treasuries get the lowest rate; mortgage-backed securities the highest. (The details of the last 25 OMOs, including the rates for each type of security, are available here.)

What was unusual about Friday (other than the size of the operation) is that the Fed announced it would lend against all three types of collateral at the same rate.

To quote my Fed colleague on this: “I’m not sure why we did this. I think the idea was that given the size of the operation we did not want to risk disrupting the Treasuries markets, but there may have been other motivations. The expectation was that borrowers would primarily use mortgage-backed securities, since these have the lowest opportunity cost to the borrower.”

On the web page above, you will see that for Friday’s operations, under collateral type it just says “mortgage-backed.” What this means is that mortgage-backed securities or any better securities were allowed as collateral — in other words, all three types were acceptable. Apparently, the media misinterpreted this as saying that the Fed was only accepting mortgage-backed securities, which led to the headlines about the Fed buying these things up.

So, the bottom line is that the Fed’s actions on Friday were unusual, but not tremendously so. It did three OMOs instead of the usual one. The quantity of reserves lent out was larger than normal, and the way collateral was handled was slightly unusual. But the general operating procedure, including the type of collateral accepted, was completely standard. It would seem that the media is trying to make the story a lot more sensational than it truly is.

Given the extraordinary amounts of money here along with tweaks to the usual policy, obviously the Federal Reserve sees a problem requiring extra-ordinary measures, but obviously not the panic initially reported by the press.