Research On Large Scale Purchasing MBS Program By Federal Reserve System

The Federal Reserve System (‘Fed’) has been progressively changing itsmoneytary policy goals and tools over the past100years. To adjust stablility of assetprices and the financial system become the final goal of the Fed. With that goal, Fedhas become more and more capable of dealing with financial crisis. The moentarypolicies developed from the traditional tools, such as discount window, reserverequirement and open market operations, to irregualar monetary policy tools, such asquantitative easing, especially the key discussion of this dissertation, the large scalepurchase program of MBS. The Fed monetary policies today are more influentialthan the traditional monetary policies, some bypass the fiscal policies. Fed policiestoday can not only adjust the liquidity of the financial markets but also the structureof the financial markets. Meanwhile, it adjusts the structure of real U.S. economyand is influential to the global financial market.Shortly after the financial crisis, the Fed proposed and executed a sequence ofinnovations of moneytary policy tools, later it started quantitative easing (QE) policy.QE1and QE2provided over$1,000billion liquidities to the financial system yetdidn’t stimulate the banks to issue new loans to corporates and individuals.Operation twist (OT) followed next, but OT1and OT2only pressed the long termbond yield down and didn’t stimulate the banks to initiate loans either. The Fedstarted QE3and QE4with a different creative method, which is to purchase MBSevery month by$45billion. With the large scale MBS purchase program, the Fedreplaced MBS on commercial banks’ balance sheet by high quality liquid asset,which eventually released the lending ability and willingness of the commercialbanks. Then the economy was stimulated, jobs were created, long term bond yield was pressed lower so corporates can borrow from the bond market with lower cost,which improved the liquidity to the manufactures.The key to the success of the large scale MBS purchase program is the pricingand risk charateristics of MBS. During the process of securitization of mortgages,the separation of originator and SPV is critical to protect investors. Also, the creditrating and credit enhancement provide further protections to the investors. MBS canalmost be created as soon as the mortgage is issued, therefore it changes the lowliquidity and long duration characristics of mortgages. The structure of MBSbecomes more and more complicated as investors seeking different risk and reward,from simple pass-through MBS to CMO, SMBSs etc. Prepayment risk isdifferentiated further as contraction risk and extension risk. The embeddedprepayment option can be caculated by OAS. Effective duration and effectiveconvexity were derived on the basis of OAS which completes the theory of assetpricing and risk models of MBS. The large scale MBS purchase program is aninnovative monetary policy tool that will long influence and inspire other centralbanks’ moneytary policies.The large scale MBS purchase program stimulate the U.S. real estate market,stock market and bond market, turnover the commercial banks’ willingness andability to lend money to manufactures, corporates and individuals, whichconsequently increased employment rate and inflation. From global marketsperspective, the large scale MBS purchase program produced ‘USD carry trade’,which leads the global foreign exchange market, bond market, stock market andcommodities into a new US Dollar era. Weak USD decreased U.S. debt and othercountries’ foreign reserve, pushed other countries to import from the U.S. or investdirectly into the U.S. USD carry trade also has negative exogenous, it hit the capitalmarkets and currencies of all other countries. The large scale MBS purchase program made the US the only winner and USD became a powerful weapon to grab wealthfor the U.S. as part of its global financial strategies.USD carry trade, along with the political influence of the U.S., has equipped theU.S. with the ability to control the risk supply of the global financial markets. TheU.S. can trigger at any time when needed to lead the capital running back to ‘safeheaven’, the U.S. With the control of the derivatives market and rating agencies, therisk supply ability and monopoly of the U.S. has become means to defeat or weakenU.S. competitors such as European Union, China and Japan.The success of the large scale MBS purchase program should have inspiredChinese Central Bank with the following: adjust moneytary policty goals, create newmonetary policy tools and let the interest market be a market. Securitization ofmortgages is the way to resovle the real estate bubble in China, although there areonly few MBS and practically no qualified rating agencies in China.