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

Annette Vissing-Jørgensen and I wrote the short policy brief below. This afternoon, it was discussed in the Real Time Economics blog of the Wall Street Journal.

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.

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The Dallas Federal Reserve Bank on TBTF

Here is the Dallas Fed’s report that argues for breaking up the large banks in order to end “too big to fail.”  Very interesting reading.  My view (blogged about before) is that it is not enough to break up the large banks.  A sector that is critical and comprised of many small firms is not immune to the TBTF problem.  If banks all do a similar activity and are exposed to similar risks, then they all go under in response to the same losses in the same state of the world and the sector needs bailing out.  No firm is too big to fail, but if the sector just is too important to fail, then the concern is similar exposures as much as size.  That said, there is still an advantage to breakup, which is that the worst offenders can be allowed to fail, which may push the crowd back somewhat from the brink.

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Bernanke Teaches Again

 

When I first showed up at Princeton as an Assistant Professor, Ben Bernanke was teaching WWS 512b (Macroeconomics for the Master’s program at the Woodrow Wilson School of Public and International Affairs) and I was to teach WWS512c (same course, mathematical version).   As I figured out what and how to teach policy macroeconomics for master’s students, I leaned on Ben, who I quickly realized was an exceptionally clear teacher.  Professor Bernanke is now Chairman Bernanke, but he is back to teaching macroeconomics.  He is lecturing at GWU, but really for the world as the class is on-line here.  I highly endorse these lectures: Ben is a clear teacher with an intellectual (non-partisan) approach to central banking; he was an expert in banking crises and got the U.S. through this latest one; he not only believe in the benefits of central bank transparency, but has moved the Fed to being much more transparent in many dimensions.

 

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More Fed Translucency

The Dodd-Frank Act required that the Fed make readily available to the public information that is public.  So we now have a nice web page here that provides easy access to the latest reports on Fed lending authority and activity. It includes reports prepared by the Fed for the Senate Banking Committee and from the Comptroller General for example, as well as transaction data.

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Implementing the Volcker Rule

The Fed is asking for comments on their proposed phasing-in of the implementation of the Volcker rule that places tight restrictions on proprietary trading, link here http://www.federalreserve.gov/newsevents/press/bcreg/bcreg20101117a1.pdf .  Among other things, there are lots of interesting issues about how to handle “illiquid” securities.

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The FCIC meets Bernanke on Too Big To Fail

No, the FCIC is not reviewing the book.  Instead, its tackling the topic with its preliminary report on the question that many find Too Big To Answer: what do we do so that firms can fail or how do we stop them taking advantage of the fact that they can’t?  Here is the report.  Very interesting reading.  And I post it along with the link to Bernanke’s testimony before the FCIC yesterday, which, as always, is both clear and deep.  A nice quote:

Few governments will accept devastating economic costs if a rescue can be conducted at a lesser cost; even if one Administration refrained from rescuing a large, complex firm, market participants would believe that others might not refrain in the future. Thus, a promise not to intervene in and of itself will not solve the problem.

And on the new strategies to address TBTF: 1) new Basel capital and liquidity regulations, 2) improve the ability to rapidly resolve/liquidate a large firm, and 3) greater systemic resilience through for example  transparency (clearinghouses and exchanges instead of OTC, penalizing corporate complexity).

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Compensation Guidelines for Financial Institutions

How should financial institutions compensate their employees?  A complicated question for the owners, and their ‘agents,’ meaning boards and compensation committees.  Economic theory is not very helpful because it is based on optimal contracting and the answer very much depends on the what is known or knowable about the manager or pool of possible managers.  Empirical evidence is also sketchy.  But the financial crisis speaks clearly — we want to avoid the situation in which an informed financial institutions makes money by selling out of the money puts.  This is like selling insurance against rare correlated or macro events and not keeping a reserve to pay out when the event occurs.  For example, insuring MBS, booking profits and bonuses in the goods times, and failing spectacularly in the bad (hello AIG and, through off-balance sheet holdings, Lehman).

 The government agencies have now weighed in.  The Fed, the OCC, OTS, and the FDIC have issued guidelines for compensation practices.  From the document, the key principles of good practice are:

“. . . (1) incentive compensation arrangements at a banking organization should provide employees incentives that appropriately balance risk and financial results in a manner that does not encourage employees to expose their organizations to imprudent risk; (2) these arrangements should be compatible with effective controls and risk-management; and (3) these arrangements should be supported by strong corporate governance, including active and effective oversight by the organization’s board of directors.”

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The Economy Keeps The Fed on Its Toes

I was at the Fed last Friday giving a briefing for the staff about the effects of tax rebates, and happened to see my old colleague Ben Bernanke walking the halls.  With a few quick steps I risked getting tasered and we said a quick hello.  His life has been one long sprint for at least two years now. Thursday’s market chaos was being reviewed, and following stresses to the market for dollars in Europe in particular stemming from the Greek debt crisis, the Fed has re-opened swap lines with foreign central banks (release here).

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Making Derivatives Less Integral

The Senate Agriculture Committee just passed a bill regulating the derivatives market. Summary here. The legislation imposes clearing and trading requirements and real-time reporting of derivatives trades. It provides exceptions for some businesses like electric cooperatives which have argued that hedging business risks are important. It also tackles the moral hazard problem that the possibility of bailouts creates. (That is, if banks feel that the government will bail them out when they lose money, they take more risks since the downside is smaller for them). If the bill becomes law, the Federal Reserve Board and the Federal Deposit Insurance Corp. will be prohibited from providing any federal funds to businesses who are involved in derivative deals. This seems to imply that banks engaging in naked swaps transactions would have to spin off their swap dealer desks or be out in the cold in a crisis when others might be receiving bailouts. Of course, in a  crisis, laws change, and if no one spins off their desks, we are unlikely to let all banks go under (see Fall 2008).

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