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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Corruption, in Short, Still Seems a Small Part of the Problem

Housing prices and securitization, and their collapses, are the central causes of the Great Recession, and the debate now rages over their deeper causes and, related and more forward-looking, how to reform the regulation of financial markets to avoid future meltdowns without killing the goose that lays the Goldman Eggs.  The latest news is the extent to which plain old securities fraud seems to have played a role. The headlines have recently been grabbed by the SEC’s indictment of Goldman Sachs and their role in selling Abacus 2007-AC1 (e.g. here). This deal was for one billion dollars. This is a lot of money, but far short of the amount of the financial crisis. Remember, the total losses on sub-prime and alt-A mortgages in early 2008 given pretty bad scenarios were around 500 billion, an amount much smaller than that lost in the stock market decline following the internet boom in the 1990’s. The problem was the location of the debt instruments – hidden in banks and being held by all sorts of institutions that should have been holding only very safe assets. That and the cast that synthetic CDO’s seem to have been created with adverse selection in mind – picked to consist of the worse MBS and then sold as if they were the average MBS (see Pro Publica on the Magnetar CDO’s here). Some buyers did not check whether or not the dice were loaded.

But the important fact to keep in mind as the legal saga unfolds is that, so far, while one should always and everywhere prosecute securities fraud, this is chump change relative to the real causes of the financial crisis and should not be the primary focus of the new financial architecture. Although there is an important caveat. There may be many more instances of fraudulent sales of MBS. If this is the case, do we need to try to protect large financial institutions that manage other people’s money?  Are they really so unsophisticated as to get up and dance just because everyone else is? I hope not.

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NPR’s Toxic Asset

To understand more about a  deadly bacteria, a researcher would try to isolate it in the lab, study it, dissect it, sequence its genome, etc.  The folks at NPR who have been covering the financial crisis wanted to learn more about toxic assets, so they took a similar tack. They bought one and have been studying it, dissecting it, and sequencing its genome. Their ongoing work nicely illustrates what a canonical toxic asset is. (They went very toxic, paying $1,000 for a mortgage-backed security of Countrywide mortgages!)

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NPR’s Giant Pool of Money

NPR had a very good program about the MBS meltdown that kicked off the financial crisis. It was just pointed out to me that the piece is on-line at: The Giant Pool of Money There is also a follow-up at: Return to the Giant Pool of Money

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Fundamental Value and the Swap Spread Anomaly

Many pundits and policymakers think that asset prices have deviated from “fundamental values” and that this deviation is part of the problem affecting financial institutions.  For example, if mortgage and credit assets, which banks hold in plenty, are currently priced below “fundamental values,” then banks will be assessed larger losses than they otherwise would. This in turn can lead to concerns of banks defaulting, etc. In other words, the dysfunctionality of asset markets is part of the problem in the current financial crisis.

But, what is fundamental value, and how can one make these sorts of statement? The notion that one can accurately assess “fundamental value” on the most toxic mortgage-backed securities should be rightly treated with some suspicion.  However, there is considerable evidence that arbitrage forces, which we normally take to be the key enforcer of fundamental value relationships, are not present in today’s environment. This is circumstantial evidence for fundamental value deviations.

Below I discuss two pricing relationships which reflect these distortions. The examples are somewhat involved; but bear with me because they are not as complicated as they sound, and they are illuminating.

Figure 1: Swap Spreads (source: Federal Reserve)

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