Why an MBS-Treasury swap is better policy than the Treasury twist

Arvind Krishnamurthy and Annette Vissing-Jørgensen

July 24, 2012

Policy note in PDF version

This note compares the effect of an MBS-Treasury swap (a strategy of purchasing long-maturity agency MBS and selling long-maturity Treasury bonds) versus the Treasury twist (purchasing long-maturity Treasury bonds and selling short-maturity ones).

We make two main points:

1. Purchasing long MBS brings down long MBS yields by more than would an equal sized purchase of long Treasury bonds and thus is likely to create a larger stimulus to economic activity via a larger reduction in homeowner borrowing costs
2. Purchasing Treasury bonds brings down Treasury yields, but part of this decrease indicates a welfare cost rather than a benefit to the economy. Thus it would be better to sell rather than purchase long-term Treasury bonds.

These points lead us to conclude that a superior large-scale asset purchase policy for the Fed is an MBS-Treasury swap where the Fed purchases long-maturity MBS, financed by a sale of long-maturity Treasury bonds.

MBS rates fall more when the Fed purchases MBS than when it purchases Treasuries

Krishnamurthy and Vissing-Jørgensen (Brookings Papers on Economic Activity, 2011) document that purchasing long-term MBS is more effective at lowering long-term MBS yields than purchasing long-term Treasuries, and discuss evidence provided by other researchers that such reductions in secondary market rates reduce primary market rates.

First, we argue that one cannot reconcile the impact of QE1 on Treasury, agency, agency MBS, and corporate rates without ascribing the majority of the reduction in MBS rates to the purchases of MBS (with a smaller role played by a signaling channel i.e. that QE made markets expect that the Fed would hold short-rates down for longer than previously anticipated, thus lowering long yields via the expectations hypothesis). A central part of the argument is that CDS-adjusted rates on lower-grade corporate bonds did not fall by more than what can be accounted for by the signaling channel and long CDS-adjusted corporate bonds yields did not fall by more than intermediate ones. Therefore, yield reductions cannot be driven simply by a reduction in duration risk premium, leaving changes in the price of pre-payment risk due to QE1’s MBS purchases as a more likely channel for explaining the large reductions in MBS yields seen on the main QE1 announcement dates. Second, in QE2 (which unlike QE1 focused its purchases on Treasuries), MBS rates fell only by what can be explained by the signaling channel, consistent with the argument above that the MBS purchases in QE1 in fact were crucial for lowering MBS yields in QE1. Third, the policy changes on September 21, 2011 provide an ideal setting for comparing the effects of equal-sized purchases of Treasuries and MBS. The statement read:

“To support a stronger economic recovery and to help ensure that inflation, over time, is at levels consistent with the dual mandate, the Committee decided today to extend the average maturity of its holdings of securities. The Committee intends to purchase, by the end of June 2012, $400 billion of Treasury securities with remaining maturities of 6 years to 30 years and to sell an equal amount of Treasury securities with remaining maturities of 3 years or less. …”

The Fed’s intention to do a Treasury twist was widely anticipated by markets, although the size of the purchase was still a surprise.  However, the next part of the statement was a surprise:

“To help support conditions in mortgage markets, the Committee will now reinvest principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities.”

Prior to this announcement, principal payments from the Fed’s holdings of agency debt and agency MBS had been invested in Treasuries, amounting to purchases of around $200B per year. Market participants had not anticipated that the twist would also involve purchases of long-maturity MBS so this announcement provides a unique setting for comparing the effect of MBS purchases to the effects of an equal-sized purchase of Treasuries holding the purchase of duration fixed, but increasing the amount of MBS-specific risk purchased.

The table above gives the one-day change in yields (from end of day on September 20 to end of day on September 21) on Treasury bonds and Agency MBS bonds.  The numbers indicate that the Treasury twist component lowered long-maturity yields and raised short-maturity yields, as one would expect.  We interpret the fall in the 10-year Treasury yield as being through an increase in the scarcity price premium on long-term Treasury bonds (discussed more below).

The table also indicates that the largest move in yields was for the 30-year MBS, which fell by 23 basis points.  The 30-year MBS has duration of roughly 7 years, so that if one thought of the Fed’s purchase simply in terms of purchasing duration (as is common among many commentators, but which we argue against in our other writings), then the 30-year MBS and the 7-year Treasury should fall by the same amount.  The fact that the MBS falls 20 basis points more indicates that the announcement must have worked through taking out mortgage-specific risk such as prepayment risk via additional purchases of MBS (relative to expectations prior to this announcement).

Welfare cost of Treasury purchase

As we have shown elsewhere (Krishnamurthy and Vissing-Jørgensen, Brookings Papers on Economic Activity, 2011) purchasing Treasuries lowers long Treasury yields. The effect occurs through two channels.  The signaling channel mentioned above leads markets to expect the Fed to hold short-rates down for longer than previously anticipated. This channel will also affect private market rates such as those on MBS or corporate bonds. The safety channel is that by purchasing long-term Treasury bonds the Fed shrinks the supply of extremely safe assets, which drives up a scarcity price-premium on such assets and lowers their yields. This latter channel is a welfare cost to the economy.

To be more precise, we have argued elsewhere that Treasury bonds trade at a price-premium because of the scarcity of assets with extremely low default risk and extremely high liquidity (see Krishnamurthy and Vissing-Jørgensen, Journal of Political Economy, 2012). The safety premium is driven by the economic benefit Treasuries provide as high-quality collateral and a long-term extremely safe (in nominal terms) store of value (something that may be particularly valued by pension funds and insurance companies to the extent these have liabilities that are fixed in nominal terms).  One way to think about investor willingness to pay extra for assets with very low default risk, and to distinguish our explanation from a conventional asset pricing relation between default risk and risk premia, is to plot an asset’s price against its expected default rate. We argue that this curve is very steep for low default rates, with a slope that flattens as the supply of Treasuries increases.

By reducing the supply of Treasury bonds, the economy is deprived of extremely safe and liquid assets and welfare is reduced. How much is welfare reduced? The answer depends on the current scarcity price premium (for extreme safety and liquidity) on long-term Treasury bonds. This premium is not directly observable, so we outline two rough ways to assess it, both based on data from 7/20/2012.

Our first approach is to take the yield on Barclays’ US corporate investment grade bond index which is 2.96%. Barclays state that the duration of this index is 7.14 years. The Markit index for investment grade CDS for 7 year tenor is 1.31%.  Thus, a credit-risk adjusted investment-grade bond yield is 1.65% (=2.96%-1.31%). This yield corresponds to an asset that via a derivative is a riskless bond. The 7-year constant maturity Treasury yield is 0.95%. Thus an estimate of the scarcity value of the Treasury is 70 basis points (=1.65%-0.95%).  Note that this number is likely a lower bound because implicit in our computation is the assumption that a derivative-hedged corporate bond does not satisfy investor’s demand for extremely safe/liquid long-term assets (due to e.g. counter-party risk on the CDS contract or lack of demand for corporate bonds from foreign central banks).

Our second approach is to calculate another lower bound based on the logic of Fleckenstein, Longstaff and Lustig (working paper, 2010). The 10-year constant maturity TIPS yield is -0.67%. The 10-year inflation swap yields 2.40%.  Thus purchasing the TIPS and received fixed on the swap, to eliminate variability in the inflation-linked payments, produces a yield of 1.73% (=2.40%-0.67%).  The 10-year constant maturity Treasury yield is 1.49%, implying a yield discount on (nominal) Treasuries of 24 basis points. Again this is a lower bound because the hedged-TIPS are likely a substitute for Treasuries for at least some investors.

We use the average estimate (average of 70 and 24) of 47 basis points as the Treasury yield discount. We translate this into units of a price premium on a 10-year bond based on modified duration of the 10-year bond of 9, giving a price premium of 4.23%. Consider a hypothetical purchase of $500 billion of 10-year Treasury bonds. Holding the scarcity premium fixed, the purchase reduces consumer surplus by 4.23%×500=$21 billion.

The yield discount is likely to rise with such a purchase.  The decrease in consumer surplus from the Treasury purchase is equal to the integral under the demand curve for Treasury bonds, based on a quantity reduction of $500 billion of Treasury bonds. In Krishnamurthy and Vissing-Jørgensen (Brookings Papers on Economic Activity, 2011, Section 5.c) we laid out a computation that estimated that a $511 billion purchase will increase the premium by between 8 and 20 basis points in terms of yields. We use the average increase of 14 basis points, which translates to a price premium increase of 1.26% on a 10 year bond. Taking a linear demand curve with slope of 1.26% per $511 billion gives a total decrease of surplus of   .

Finally, the liquidity/safety premium on short-term Treasury bonds is quite small now (this is not the case historically). One way to see this is to compare the yield on the safest commercial paper to that on Treasury bills. This yield spread captures the lack of liquidity in the CP market as well as the differential credit risk of CP and T-bills. 3-month nonfinancial commercial paper based on the Fed’s 7/20 H15 release was 0.19%, while the yield on 3-month Treasury bills was 0.09%, implying that both the equilibrium price of liquidity and the equilibrium price of extreme safety for short durations must be small, adding up to at most 10 basis points (“at most’’ because we have neglected to adjust for any credit risk effects here to assess the extreme safety effect). Note that the low current price of liquidity for short-term bonds is likely at least in part to the large injections of reserves under QE1 and QE2.

Thus, it is not the case that by supplying more short-term Treasury bonds in a twist that the Fed undoes the welfare cost of purchasing long-term Treasury. This is because the higher scarcity premia on long-maturity Treasuries relative to short-maturity ones indicates that the scarcity at present is primarily on long-maturity Treasury bonds.

In sum

A policy of buying long-term MBS and selling long-term Treasuries would both (1) generate larger effects on MBS rates (and thus on household mortgage rates) than an equal-sized purchase of long-term Treasuries and (2) inject long-term Treasuries back into the economy thus generating a welfare increase from increasing the supply (to the private sector) of assets trading at low yields due to their extremely high safety.

References

Matthias Fleckenstein, Francis A. Longstaff, and Hanno Lustig. (September 2010). “Why Does the Treasury Issue TIPS? The TIPS-Treasury Bond Puzzle.” Working paper, UCLA.

Arvind Krishnamurthy and Annette Vissing-Jorgensen. (Fall 2011). “The Effects of Quantitative Easing on Interest Rates: Channels and Implications for Policy”, Brookings Papers on Economic Activity.

Arvind Krishnamurthy and Annette Vissing-Jorgensen. (April 2012). “The Aggregate Demand for Treasury Debt.” Journal of Political Economy.

Fearing some combination of the breakup of the Euro area, a European banking crisis, and a Europe-wide fiscal crisis, European investors are getting out of risky Euro-denominated assets, such as deposits in European banks or short-term European government debt, and into safer claims denominated in safer currencies, like claims on banks and governments that are denominated in Swiss Francs or Danish Krone.  Thus, capital is flowing into Switzerland and Denmark and pushing interest rates down in these countries.

Following the increase in demand for these currencies, the Swiss Franc has appreciated significantly against the Euro, but the Danish Krone is pegged to the Euro.  For Switzerland, the appreciation hurts exports and increases imports.  For Denmark, there is little immediate effect on exports and imports, but the pressure for the currency to appreciate is the same.  To stop the appreciation, the Danish central bank – Nationalbank — has to buy Euros and sell Krone.  This is what the peg means and how the value of the Krone is maintained against the Euro.  As it turns out, the central bank doesn’t actually sell Krone.  Instead, the central bank buys Euros from banks and pays for them by crediting their Krone accounts with the central bank, account balances which are called “reserves.”  Reserves are a lot like commercial bank’s bank accounts with the central bank.  These reserves can be withdrawn from the central bank as Krone, and some are as the bank’s customers make withdraws to buy safe assets like Danish government debt and the bank withdraws from the central bank to meet the withdrawals.  One upshot of all this is that the Danish central bank has roughly doubled its foreign reserve account balances and is becoming a long-short currency fund: long Euros and short Krone deposits (and Krone themselves – cash in circulation is a central bank liability).  But that is almost an aside, the interesting point is that the demand for Krone-denominated Danish assets has driven interest rates on short term government debt negative.  And Nationalbank has now reduced the interest rate it pays on reserves to negative 0.2 percent!  Yes, it is more expensive to hold reserves with the central bank than to hold cash in the vault.

And this is how we actually get negative nominal rates: the convenience and safety of deposits or short-term government debt relative to cash.  Holding a large amount of cash is inconvenient and risky.  As an individual, it is much easier to buy a house with a check than with cash (imagine how you would feel walking with the suitcase of money from the bank to the closing agent).  As a business, it is much easier to meet payroll with deposits than cash.  And even as a bank, vaults are only so big and so safe. So short term nominal rates in Denmark are solidly in the negative range.  The Zero Lower Bound is broken.  Expect an increase in vault construction and possibly an increase in bank robberies.  And a reconsideration of the Zero Lower Bound as an economic law.

What I think this bank jog is forcing, is a quiet but massive increase in the financial commitments of the ECB (Germany) to Spain and Greece.  The ECB is being forced to either lend to these banks or let them collapse; if they collapse, then Germany must decide to either lend to these countries or let them collapse/leave the Euro.  The loans are supposedly collateralized.  But the sheer size of the bank jog and the problems in these counties suggests that the collateral probably contains lots of bad collateral, like debt of sovereigns of questionable solvency and packaged highly-rated debt that should never have been highly rates.  That is, while we can call the current support loans, I suspect that many of them will be transfers (big transfers) in the case that these countries/banks do not grow and solve their fiscal imbalances.  How does it end?  It has to end when the banks run out of collateral that even the ECB in its most desperate hour cannot in good conscience lend against, and the banks start to collapse.  But it may end sooner, when some politicians have the good sense to finally pull the plug and default and devalue.

During an IPO, a firm and its shareholders wish to sell shares. Generally they want the highest possible price for these shares. Investors, on the other hand, want to pay a low price. The underwriter’s job is to strike a balance. To understand what happened with Facebook, you need to appreciate the difficulty in striking this balance.

The investors who buy in an IPO offer to buy up to a particular number of shares. Suppose Joe Average subscribes to the IPO, offering to buy 1000 shares for the offering price ($38 in the case of Facebook). If demand for Facebook is weak, that is, if there are not many subscribers, then Joe will get the full 1000 shares. However, if demand is strong, there will not be enough shares to go around and Joe will get fewer than 1000 shares. This asymmetry is the key to understanding IPO pricing. Joe thinks: When I get the full 1000 shares, the price will go down, but when I get fewer shares the price will go up. In order for Joe to willingly participate, he must expect that on average, the price will go up at the offering. This positive average return compensates him for getting fewer than 1000 shares in good times. Although the price goes up on average, sometimes it will go down. You can understand why this occurs by thinking about the strategy of those investors who actually have information. They will bid for many shares when the offering is valuable, and for few shares when it is not. This is the flip side of Joe getting all his shares in bad times and fewer in good times.

So  investors lost money in the Facebook offering and we understand that sometimes this is going to happen. Did Facebook do anything obviously wrong? Surely Facebook management should have pushed for a high price and that’s apparently what they did. Does the IPO bode ill for Facebook? Why should it? Facebook is one of the most recognized names in the world. In the future, investors will judge Facebook by its financial success or lack thereof. Do you think that Facebook users will switch to Google+ because the stock fell at the IPO? If the offering price had been $32, Zuckerberg would have earned almost $200 million less in the offering. He looks to me like a smart guy.

The party on the hot seat is Morgan Stanley, the lead underwriter. Their institutional investors will want to know why Morgan Stanley agreed to a $38 price. These things happen: Morgan Stanley will make its mea culpas and be back the next time around.

Finally, what about the retail investors who participated? Were they treated fairly? Press reports made it sound like it should have been a sure thing: buy Facebook at $38 and flip the shares a few hours later at a higher price. Of course it could have happened that way. But anyone sure it was going to happen was expecting Mark Zuckerberg and Morgan Stanley to hand them free money. Here’s an Insider Tip: Zuckerberg and Morgan Stanley are not in business to give money to you. They make money from you.

Brokers and banks love to deal with investors who think otherwise.

I am glad the work is proceeding.  If, . . oops I mean . . . when we end up in the next financial crisis, we will at least have a plan.  And an ex ante plan may help reduce the frequency of crises.  As  Gruenberg said, “developing a credible capacity to place a systemically important financial institution into an orderly resolution process is essential to subjecting these companies to meaningful market discipline. “

A cash balance system that promises asset growth at a low rate, such as that of long-term Treasury bonds, and converts the balance to an annuity at prevailing rates in insurance markets, could be managed so that it generates no unfunded liabilities for the state. However, the very common temptation is to promise a higher rate of accrual on the plans, and just as with traditional DB plans in the public sector, to hope that those higher returns are achieved by setting aside risky assets.

The extent to which the state can avoid that temptation (to promise safe benefits and attempt to deliver them with risky assets) will determine how successful the plan would be in avoiding new unfunded liabilities.

The author of the article paraphrased the above passage as my indicating that a cash balance plan could eliminate the existing unfunded liability, which of course neither I nor Daniel Biss believe (see his own direct quote in the article).

Ben Bernanke gave a speech in New York, transcript here, on the pre-crisis vulnerabilities in the financial sector, on the triggers for the crisis, and on the policy responses – what and why.  Clearly reasoned from economic models and closely related to the canonical (Bernanke the academic) understanding of the first part of the Great Depression.  The Federal Reserve’s actions where Bagehot’s rule in practice and are ultimately defended by saying “ . . .the responses to the failure or near failure of a number of systemically critical firms reflected the best of bad options.”

A fun research article here , covered by the Wall Street Journal here , describes Keynes’ performance as an investor.  He was nearly wiped out by the crash of 1929, but did very well thereafter.