As the first quarter draws to a close, the Federal Reserve is expected to bring its $1.25 trillion mortgage-bond-buying spree to a close.
Here are some answers to basic questions about the U.S. central bank's unconventional and controversial initiative.
• What is a mortgage-backed security (MBS)?
A mortgage-backed security is a type of bond composed of a large pool of individual mortgage loans. MBS is a debt obligation that represents a claim on the cash flows from mortgage loans. These securities were at the heart of the global financial crisis that began in mid-2007.
As U.S. house prices began to fall, so did the value of debt backed by such home loans. Worse yet, the complexity with which these deals were devised made it very difficult to discern the exposure of financial institutions to risks. The result was a generalized panic and mistrust among bankers that forced the Fed to not only slash interest rates aggressively but also embark on a host of unconventional measures — such as direct purchases of MBS.
• Why did the Fed buy so much MBS?
At its core, the Fed's MBS buys had two key goals: to stabilize a swooning housing market by lowering borrowing costs for consumers, and to support banks that were under severe pressure from rising foreclosure rates.
As the financial crisis that began in the housing sector reached a fever pitch at the end of 2008, the U.S. Federal Reserve announced it would buy billions of dollars in mortgage-linked debt, and in 2009 it expanded the program to more than $1.4 trillion. Of that, $1.25 trillion were mortgage-backed bonds issued by government-sponsored Fannie Mae, Freddie Mac and government entity Ginnie Mae, while the rest was debt issued by Fannie, Freddie and the Federal Home Loan Bank System.
• What are the program's benefits? What are its risks?
Fed officials argue that the extreme measures they took were essential to preventing a bad recession from turning into an outright depression. They can claim some level of success, since the frantic selling that rattled markets has long subsided and the economy returned to growth in the third quarter.
Mortgage rates have also remained historically low, a central goal of the MBS purchases. However, the Fed's actions are not without their potential pitfalls. For one thing, they were perceived by many, including some senior Fed officials themselves, as veering too closely into fiscal policy. This, in turn, led to greater scrutiny of the central bank's behavior, which some observers feel has weakened its independence.
Skeptics of the Fed's bond-buying bonanza say that it has crippled its ability to tighten monetary policy, because the Fed is now saddled with securities that are much less liquid than the Treasury securities that usually make up the bulk of the central bank's balance sheet.
• What happens next?
That's the trillion-dollar question on the minds of investors. Financial markets are facing so many cross-currents these days that it becomes difficult to discern the impact of one event from another. But yields on U.S. Treasury debt have been rising sharply in recent weeks, a trend that could be due in part to hedging practices associated with rising mortgage rates. Home loan costs, for their part, are closely linked to Treasury rates, making some economists worried about the possible impact of this circularity on economic activity.
In the worst-case scenario, higher borrowing costs derail the mortgage market's tentative stabilization, forcing another leg down in housing activity and driving yet greater losses on banks' balance sheets.
Fed officials argue that the impact from the end of its MBS will be minor, although Fed Chairman Ben Bernanke says the central bank would keep the door open to renewed purchases if conditions were to deteriorate significantly.
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