Understanding QE3—The Federal Reserve’s Latest Policy

Bad weather outside, rainy, dark, dismal—I’m thinking about economics. A retired friend asked about QE3, the acronym for Quantitive Easing 3—the Federal Reserve’s (Fed’s) newest effort to boost the economy. There have been two related efforts in the past few years, hence this new one is number 3. “I don’t understand it—is there anything in it for me?” he asked.

The new policy means the Fed will buy about $40 billion worth of mortgage-backed securities each month. It has not historically bought these securities. The Fed hopes to lower mortgage interest rates and reduce the cost of buying a home. That should spur home buying and building, which translates into more construction workers, more lumber, shingles, sinks, paint, wire and so on, creating more demand across a wide swath of the economy. The Fed hopes that employment will pick up throughout the nation.

The Fed has several general responsibilities, but perhaps its main one is to conduct monetary policy, “in pursuit of maximum employment, stable prices, and moderate long-term interest rates.” Trying to boost employment, in other words, is a main responsibility. Historically, however, the Fed has paid more attention to maintaining stable prices and moderate interest rates. As best I can tell, QE3 is the first major Fed effort aimed specifically at employment.

My friend understood that lower mortgage rates would boost housing and maybe employment. But he didn’t understand mortgage-backed securities or why the Fed would want to buy them to lower mortgage interest rates.

Home Buying to Mortgage-Backed Securities

Most people need to borrow money from mortgage lenders to buy a home. Borrowers often get a conventional 30-year-fixed-rate loan, which means they will repay the loan with fixed monthly payments.

A lender may accumulate hundreds of mortgage loans from home buyers, then sell them to Fannie Mae and Freddie Mac, two government sponsored enterprises. They were established in 1938 and 1970, respectively, to buy mortgage loans from primary lenders. After getting paid, lenders have new money to loan home buyers.

Fannie Mae and Freddie Mac then sell mortgage-backed securities to investors. These securities are special contracts that give investors legal interests in the loans and mortgages. The payments that homeowners make to pay off their loans are channeled through intermediaries to the people/institutions who own the securities.

The money that Fannie Mae or Freddie Mac receive from investors is used to buy more mortgage loans from lenders. The whole process—consumers borrowing from lenders, who then sell the mortgage loans to Fannie Mae or Freddie Mac, who then sell securities backed by the mortgages—is a mechanism to make money available to finance housing. Mortgage-backed securities compete with stocks, bonds and other investments, so those securities give the housing lenders indirect access to huge amounts of investment capital.

Without mortgage-backed securities, investors who wanted to buy the payment streams from mortgage loans would have to buy individual mortgage-loans. That would be costly—finding banks that might sell them, checking the real estate and credit worthiness of homeowners and so on, would all require time and money. By creating investment securities backed by mortgages, Fannie Mae and Freddie Mac make mortgage-backed investments easily available to investors world wide.

The Policy Hook

Fed policy is related to the fact that most mortgage-loan payments may be viewed as a stream of constant payments. For conventional mortgage loans, when a home loan closes, the borrower’s payments are fixed.

With loan payments fixed, the interest rates earned by investors will vary with the purchase price of the securities. The fixed mortgage-loan payments act like a fulcrum for a seesaw, with security prices on one end and interest rates on the other. If security prices are bid up, the implicit interest rate on the security goes down.

An example may help: consider a security that pays $10 per year indefinitely—a fixed dollar payment every year. If interest rates on similar investments are about 10%, you would expect to pay about $100 to buy that security (the right to the $10 payments). If interest rates for similar investments are about 5%, then you would need to pay about $200 for the example security. If interest rates for similar investments drop to 2%, the example security would trade at $500. The $10 payments are 2% of $500.

Mortgage-backed securities are like the example except that the principal is eventually paid off—they don’t exist indefinitely. When the loans are paid off, the mortgages expire and the securities are worthless. That difference makes the math more complicated, but the the seesaw relationship between security prices and interest rates is the same.

Prospective buyers can learn current interest rates on all kinds of securities by looking in financial publications or online. When they prepare to buy mortgage-backed securities, they know what interest rates other investments are offering, and competition for investor capital forces the prices of mortgage-backed securities to a level that implies comparable interest rates.

When the Fed enters the market and buys these securities, prices should be bid up because the Fed is a new buyer with deep pockets. The interest rates implied by those higher security prices will be lower, and the money the Fed spends will find its way back to lenders.

The lenders earn fees on each mortgage, so they have an incentive to drum up more mortgage business. As lenders compete with one another to lend the new money that came from the Fed, mortgage rates are driven downward.

It is a complex story, but the Fed’s newest policy—buying mortgage-backed securities—may start a chain reaction that ends with more employment.

Effects

With new money available and lower interest rates, homeowners, including retirees, can refinance their existing mortgages and enjoy lower monthly payments.

Homeowners who own their homes outright will not benefit directly unless they decide to remortgage their homes.

For retirees who are living on investments, the news may be good or bad. Interest rates on home mortgages will trend downward, and competition among investments may cause other interest rates to move downward as well. For investors relying on interest-bearing securities, their incomes will likely decline slowly as old securities expire and are replaced by higher priced investments earning less interest.

Investors who may not want to compete with the Fed for mortgage-backed securities might bid up the prices of other investments, especially stocks. If stock investors think the Fed’s policy may work, then business should improve and profits should grow.

As stock prices move upward, retirees and other investors may feel wealthier and begin to spend more generally. That, too, may help boost employment.

The Federal Reserve Board is clearly worried about a prolonged stagnant economy such as we’ve had for four or more years. The long-term effects on millions of unemployed people amount to an incalculable cost that we see each day among friends and relatives.

The Fed is trying something new, and in an economy as large and complex as ours, where capital moves at electronic speed, there are no assurances that QE3 will work as wanted. As individuals, we can only watch and hope, and of course, we can continue to look for ways to help those most injured in our stagnant economy.

3 thoughts on “Understanding QE3—The Federal Reserve’s Latest Policy

  1. Read “Reckless Endangerment” by Gretchen Morenson. It will cause you to shake your head and wonder why more of these players are not in jail. Fannie May has been constrained since the Crash, but with these shenaigans the Fed may be setting us (USA) up again for another bout.

    I like your work. Thanks

  2. Pingback: Understanding QE3—The Federal Reserve's Latest Policy | Later … | Home Loans UK

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