Mortgage Backed Security (MBS)
An MBS is a security whose cash flows are derived from a pool
of mortgages.
Two types of MBSs:
mortgage bonds (created from a pool of mortgages)
CDOs (created from a pool of mortgage bonds)
MBSs can get extremely complicated.
ABS (asset backed security) is same as MBS but cash flows are
from a pool of home equity loans, auto loans, student loans,
credit card receivables, . . .
Now over $1.2 trillion in student loans (but not all have been
securitized, i.e., made into ABSs).
1
Monetary Base Graph
2
M1 Graph
3
Money Supply Comments
• Money supply is believed to be important.
• While Fed is in entire control of the monetary base,
M1 and M2 are considered more useful in controlling
the real sector.
• Note that most of the money supply aggregates that
comprise M1 and M2 are determined by private
decisions which the Fed can’t precisely control (but
can influence via the monetary base).
• Thus, the Fed, via the monetary base, can only
imprecisely control M1 and M2.
4
Hedge Funds
Hedge -- an investment intended to offset adverse price
movements in another investment.
A basic hedging strategy is pair trading. Involves matching
a long position with a short position.
Funds use math and statistics to identify pairs with good
spread reversion characteristics. Done with stocks, options,
commodities, currencies, etc.
By law, hedge funds only offered to institutional investors or
individuals of substantial wealth. Government then doesn’t
regulate much.
5
Actual Fed Funds Rates 1954-2008
6
Fed Funds Rates 2004-2008
7
Target Rate vs. Actual Sep07 to Sep08
8
Monetarist Economists
• Monetarists believe
–
key explanatory variable is the money supply
–
people will buy more if feel they have “more
money,” and spend less if feel they have “less
money.”
–
idea is to use monetary policy to influence the
money supply.
–
in this way, adding reserves should promote
economic growth, reducing reserves should slow
the economy.
9
Keynesian Economists
• Keynesians believe
– key explanatory variable is the interest rate
– John
Maynard Keynes was influential British
economist of 1930s.
– money
supply does not make that much difference
– believe
economic growth is stimulated by falling
interest rates, and slowed by rising rates
10
Dates
stocks bonds
03/17/08 Bear Stearns (taken over by JP Morgan
Chase and government guarantees)
09/07/08 Fannie Mae / Freddie Mac
(conservatorship)
09/15/08 Lehman Brothers (bankruptcy)
09/16/08 AIG (kept alive by US government and
Federal Reserve)
09/21/08 Goldman Sachs & Morgan Stanley become
bank holding companies
09/25/08 Washington Mutual (receivership by FDIC
and then bankruptcy, formerly 6th largest
US bank)
12/31/08 Wachovia (taken over by Wells Fargo,
formerly 4th largest US bank)
01/01/09 Merrill Lynch (saved from failure by being
purchased by Bank of America)
-90%
-98%
safe
safe
-100% part loss
-95% safe
-100% part loss
-90%
safe
-60%
safe
11
Fed Balance Sheet (millions), April 2009
Assets
Liabilities & Capital
Gold & Coin
15,107
Federal Reserve Notes
Loans to depository institutions
-
Rev Repurchase agreements
Repurchase agreements
0
Deposits
US treasury securities
Agency securities
534,969
64,511
862,960
64,681
Depository inst balances
915,773
US Treasury
295,399
MBS
367,590
Other
13,456
Term Auction Facility (TAF)
455,799
Capital
46,000
CP Facility
242,431
Maiden Lane & related
72,163
Other loans
102,988
Foreign currency
282,863
Other
2,198,269
59,849
2,198,269
9/26
12
Term Auction Facility
As subprime problem arose in late 2007, banks began to
encounter liquidity problems. Overwhelmed discount
window.
In Dec 2007, Fed suspended traditional discount window
operations in favor of Term Auction Facility (TAF):
• rather than just overnight, made 28 and 84-day loans
• accepted other securities, rather than just Treasuries
and agency securities, as collateral.
• originally for depository institutions, extended to nonbank financial institutions.
• no new loans after March 2010
13
Commercial Paper
• Unsecured promissory notes that mature before nine
months (270 days).
• Proceeds can only be used for operating purposes
(inventories, receivables) and not for fixed assets (land,
buildings, machinery).
• Issued by 600 to 800 corporations.
• Sold at discount, mature at par.
• Some sold by direct placement, but most sold through
dealers .
• Dealers charge something like one-tenth to one-eighth
of a percent of face value to underwrite an issue for a
firm.
14
CP Backup Lines of Credit
• Except for a few highly-rated firms, usually not
possible for an issuer to sell CP without a backup line
of credit.
• Backup line of credit is agreement by which a bank
will lend an issuer, if needed, the money necessary to
redeem maturing paper.
• Makes purchasers feel more secure in the event issuer
is not able to “roll over” maturing CP (i.e., sell new CP
to pay off old CP).
• Banks charge 10 to 12.5 basis points (on an annual
basis) of par amount for backup lines of credit, then
market interest rate if money is actually borrowed.
• Average CP maturity is about 30 days
• In financial crisis, were difficult to roll over
15
CP
• Rated: prime, desirable, satisfactory. P-1, P-2, P-3
(Moody’s) A-1, A-2, A-3 (S&P’s)
• Virtually impossible to sell unrated commercial
paper
• Advantage of CP: low interest rates
• About 30 commercial paper dealers.
• There is a secondary market and issuers sometimes
buy back their commercial paper. Transaction costs
in range of about one-eighth of one percent per
annum.
• Normal US CP: up to $1 trillion outstanding at any
moment.
16
Asset-Backed Commercial Paper
• In addition to normal commercial paper, there is
asset-backed commercial paper (ABCP).
• Typical maturities of ABCP a little longer: 90 to 180
days
• In run up to financial crisis, issued by up to 1,000
special purpose vehicles to help buy pools of
mortgages, car loans, student loans, credit card
receivables, etc., but mostly mortgages.
• Before financial crisis struck, up to $1 trillion of US
ABCP outstanding.
• Then couldn’t roll over, so Fed had to step in.
17
Fed Balance Sheet, September 25, 2014
Assets
Gold & Coin
Loans to depository institutions
Repurchase agreements
US Treasury securities
Agency securities
MBS
Liabilities & Capital
11,041
330
0
2,447,066
40,006
1,708,147
Term Auction Facility (TAF)
-
CP Facility
-
Maiden Lane & related
Other loans
Foreign currency
Other
Federal Reserve Notes
Rev Repurchase agreements
1,288,293
270,542
Deposits
Depository inst balances
US Treasury
2,732,580
114,828
Other
32,766
Capital
63,656
4,502,665
1,664
22,560
271,851
4,502,665
18
Open Market Injection of $30 Billion
k = 10%
10/3
19
Technical Factors
Cash drains – increased cash holdings by public decrease
banking system reserves. Example:
 People take money out of their checking accounts in
advance of a big weekend.
 Reduces vault cash
 Banks have harder time meeting RRs
 Puts upward pressure on Fed Funds rate Fed does
Repurchase Agreement to increase temporarily
depository institution reserves
 Puts downward pressure on Fed Funds rate
US Treasury transactions -- many such transactions cause
shifts in reserves. Fed often offsets with carefully
calibrated open market transactions (typically with repos
and reverse repos)
20
Velocity of Money
• Velocity is annual money supply turnover rate.
•
Velocity * Money supply = GDP
• Velocity is difficult to predict.
• For given change in money supply, the Fed can expect
direction of change in economy, but cannot ensure the
degree.
21