Simon M Potter: The implementation of current asset purchases
Remarks by Mr Simon M Potter, Executive Vice President of the Markets Group of the
Federal Reserve Bank of New York, at the Annual Meeting with Primary Dealers, New York
City, 1 March 2013.
* * *
Thank you all for attending today's annual primary dealer meeting. Primary dealers play an
important role in financial markets and an integral role as counterparties for operations to
implement monetary policy. You are also an important source of market intelligence for the
Desk, providing insight into market developments, structure, and functioning dynamics. A
meeting like this provides a valuable opportunity to communicate our counterparty
expectations, as well as strengthen our ongoing relationship. Given your important role in the
implementation of monetary policy, I thought I would take this opportunity to discuss the
Federal Reserve's ongoing purchases of Treasury and agency mortgage-backed securities
(MBS).
As you are well aware, at the September 2012 Federal Open Market Committee (FOMC)
meeting, the FOMC decided to increase policy accommodation by purchasing $40 billion per
month of agency MBS and continue the Maturity Extension Program (MEP). Then at its
December meeting, the Committee chose to continue buying $45 billion per month in
longerterm Treasury securities following the completion of the MEP. As a result of these decisions,
the Federal Reserve is currently adding $85 billion in longer-term securities each month to its
holdings, in addition to reinvesting principal payments from its holdings of agency MBS and
agency debt securities into agency MBS.1 Under this program, we have bought about
$90 billion in Treasury securities since January and about $220 billion in agency MBS since
mid-September, bringing the total par value of the Federal Reserve's SOMA (System Open
Market Account) portfolio to over $2.8 trillion.2
In my comments today, I will describe the key differences and similarities between the recent
policy action and previous programs and discuss how the Desk implements these asset
purchases. As always, the views expressed here are my own and do not necessarily reflect
those of the Federal Reserve Bank of New York or the Federal Reserve System.3
Outcome-based purchases
The FOMC's current asset purchase program has some key differences from earlier policy
initiatives. When announcing previous programs to change the size or composition of its
balance sheet, the FOMC communicated an expected total size of each program and an
anticipated date by when it would be completed. Under the current asset purchase program,
the FOMC has announced only the monthly pace and composition of purchases and noted
that purchases will continue until there is a substantial improvement in the outlook for the
labor market in the context of price stability. The Committee has also indicated that it will take
appropriate account of the likely efficacy and costs of its purchases when adjusting their size,
pace, and composition. While noting that purchase activity will depend on these factors, the
Committee has not specified the time at which purchases will be complete or the total
expected size of the purchases. Instead, under this conditional, outcome-based approach,
the Committee has enacted a policy that will adjust to incoming information about labor
market conditions and the broader economy, as well as its ongoing assessment of the
efficacy and costs of purchases. Retaining the flexibility to adjust purchases is an important
feature of the program, given our relatively limited experience with the use of the balance
sheet as a monetary policy tool and the uncertainty about the policy's effects.
One of the potential costs of additional purchases is that they could disrupt functioning in
Treasury and MBS markets - a cost that the Desk carefully assesses when it implements the
FOMC's policy directive. As you know, there is a finite supply of Treasury and agency
securities available to purchase, in terms of both total amount and amounts available in the
market at any given time. If the Federal Reserve were to become too dominant a buyer or
holder, it could reduce the tradable supply of these securities and discourage trading among
market participants, leading to diminished liquidity and price discovery. A significant
deterioration in liquidity could lead investors to demand a premium for transacting in these
markets, ultimately raising borrowing costs and undermining the program's policy goal.4
However, as discussed later, the purchases have gone smoothly so far, and market liquidity
seems to be holding up well.
Although the current program is different in some respects from prior balance sheet
programs, its intended purpose and the ways the Committee anticipates it will impact the
economy are similar. The purchases are conducted to achieve the FOMC's dual mandate of
maximum employment and price stability. Asset purchases help achieve this mandate by
putting downward pressure on longer-term interest rates, supporting mortgage markets, and
helping to make broader financial conditions more accommodative.
The current purchases reduce interest rates and ease financial conditions through the same
transmission channels as previous balance sheet programs. As has been widely discussed
in the academic literature, one of the most important channels is the portfolio balance
channel.5 This theory relies on the premise that financial assets are imperfect substitutes in
investors' portfolios, and, as a result, a rise in the demand for a particular financial asset
relative to its supply - reflecting the Federal Reserve's asset purchase programs, for
example - will increase its price and reduce its yield. After selling that asset to the Federal
Reserve, investors may rebalance their portfolios by investing in other assets, raising the
prices of those assets, lowering their yields, and easing overall financial conditions.
The Federal Reserve's asset purchase programs were designed to remove risk from the
portfolios of private investors. For example, Treasury and agency MBS purchases remove
duration risk, thereby lowering longer-term interest rates and reducing private sector
borrowing costs. Furthermore, agency MBS purchases also remove prepayment risk in the
market. Since homeowners can prepay their mortgage at any time, MBS investors do not
know when they will receive their cash flows. Investors generally demand an extra return to
bear this risk, which is incorporated into MBS yields and in part passed along to borrowers.
The removal of a considerable amount of this risk by the Fed's purchases would be expected
to lower MBS rates by lowering this extra return, thereby reducing primary mortgage rates,
stimulating demand for housing and prompting increased refinancing activity.
Even though the Committee is communicating a monthly pace and composition of
purchases, the predominant effect of those purchases on interest rates likely still comes from
the expectations of the total stock of risk that will be removed from private investors and the
length of time that the Federal Reserve will hold this risk. One feature of the current program
is that market participants' expectations of the total amount and composition of securities that
the Desk will purchase - and thus, the amount of monetary policy accommodation - will
evolve over time, along with incoming information about the economy, as well as
considerations about policy efficacy and costs.
The Desk's most recent Survey of Primary Dealers indicates that the median respondent
expects the FOMC to purchase about $1 trillion in securities, roughly equally split between
Treasuries and agency MBS, over the course of 2013 and early 2014. However, the
uncertainty around this expectation is large - at $500 billion it is almost as large as the entire
size of the large-scale asset purchases announced in November 2010 or the Maturity
Extension Program announced in September 2011.6 This likely reflects uncertainty about
how the economy will evolve and how the FOMC will adjust its purchases in response to
changes in the economic outlook or the costs and benefits of the policy.
Implementation of the current asset purchase program
In implementing the current purchase program, the Desk has operated in a similar manner as
in past programs. As always, outright purchases in Treasuries and agency MBS are
conducted through operations that seek to acquire securities at competitive prices while
minimizing any market disruptions.
There are some key differences between our Treasury and MBS operations that I would like
to discuss. As counterparties in our operations, you know that outright purchases of Treasury
securities are conducted through large-scale, multiple-security auctions via the Desk's
FedTrade platform, which allows all primary dealers to place multiple offers across all eligible
securities simultaneously. Purchases of MBS, on the other hand, are currently conducted
using TradeWeb, a commercial trading platform.7 The platform allows buyers to solicit offers
for one security at a time from up to four counterparties, so the Desk includes dealers in
operations on a rotating basis. As a result, the Desk purchases MBS in a series of
smallerscale, more frequent auctions. We are currently expanding the FedTrade platform, in order to
have more flexibility in conducting MBS auctions in the future.
In the Treasury market, purchases are distributed across securities with different maturities,
with the intent of removing a specified amount of duration risk from the market without
causing significant market disruption. For recent programs, this maturity distribution has been
announced at the outset, and a schedule of specific operations is released at the beginning
of each month.8 Such transparency is possible because the composition of Treasury coupon
securities available for purchase is reasonably predictable. Within this purchase distribution,
both newly issued (on-the-run) and more seasoned (off-the-run) securities are often
purchased.
Outright purchases of MBS are executed in the TBA (To-Be-Announced) market. The TBA
market is built around a trading convention that allows market participants to trade thousands
of different MBS backed by millions of individual mortgages using only a few standardized
contracts, which are grouped based on key characteristics such as the coupon of the security
that will be delivered. These factors help make the TBA market homogeneous and highly
liquid - useful characteristics given the scale of Desk operations.9 Mortgage originators sell
MBS backed by new loans into the TBA market because of the market's liquidity and
because the TBA market is a forward market, which allows originators to hedge the risk
associated with locking in loan rates with new borrowers.10 The Desk concentrates its TBA
purchases in "production coupons," since the yields and prices for production coupons are
directly related to the primary mortgage rate.
In general, the Desk purchases MBS in the TBA market across different agencies, maturities,
and coupons in amounts that are roughly proportional to anticipated issuance of those
securities. Issuance of new TBA securities varies over time, based on the level of refinancing
and home purchase activity. Moreover, because the coupon at which new MBS are
originated depends on the overall level of interest rates, the possibility of future fluctuations in
the primary mortgage rate makes it difficult to determine well in advance which coupons will
be issued. As a result, the Desk is not able to provide the same detailed guidance about the
composition of its MBS purchases as is possible with Treasury purchases. At times, we
adjust our purchases when certain market functioning indicators suggest that particular
securities are less readily available for settlement relative to other securities.11
As it has always done, the Desk closely monitors how its activities impact financial market
functioning. Good market functioning is integral for the successful implementation of the
FOMC's directive and for the effective transmission of monetary policy to the real economy.
When evaluating market functioning, we consider measures of market activity, such as
trading volumes, bid-ask spreads, trade sizes, quote sizes, financing costs, and settlement
fails, as well as other indicators. We also monitor the performance of our operations (for
example, the prices at which we can execute in comparison to prevailing market quotes or
the total amount of competitively priced propositions), the concentration of market
participants' holdings in securities with certain characteristics, the extent and concentration of
dealer participation in operations, and the pace of settlement of our MBS purchases. Based
on these types of measures, purchases of both Treasury securities and MBS have gone
smoothly so far, and market liquidity seems to be holding up well.
In addition to this monitoring, we have developed active policies to help prevent market
dysfunction as a result of our operations. In the Treasury market, the Desk ceases purchases
of a specific security once SOMA holdings of that security reach 70 percent of the
outstanding stock. In addition, when SOMA holdings of a specific issue exceed 30 percent of
outstanding securities, the Desk limits the rate at which it acquires new holdings of that issue
based on a predetermined, graduated schedule. The Desk also refrains from purchasing
certain Treasury securities in its operations if investors' demand for those specific securities
as collateral in the repurchase market or as deliverables into Treasury futures contracts is
relatively high. In the event of significant market demand for specific Treasury collateral held
by the SOMA, investors can borrow these holdings through competitive securities lending
operations.
In the MBS market, the Desk is supportive of market functioning in two main ways. First, as I
mentioned earlier, we adjust our purchase allocation as necessary to respond to concerns
about relative scarcity in particular contracts. Second, we use dollar roll transactions to
facilitate the orderly settlement of our unsettled purchases. Selling dollar roll contracts
essentially postpones the settlement of an outstanding purchase, while buying dollar roll
contracts brings it forward. The Desk actively monitors implied financing rates on dollar roll
contracts for the level of supply of the securities that the Desk expects to be delivered. When
implied financing rates reach levels notably below the general level of short-term interest
rates, thereby signaling supply concerns, the Desk sells dollar roll contracts to postpone
settlement of that outstanding purchase.12 Our dollar roll activity is consistent with the
guidelines laid out by the Treasury Market Practices Group (TMPG), an industry group
sponsored by the Federal Reserve Bank of New York. TMPG Best Practices encourage
market participants who have amassed a particularly large position in the agency MBS
market to manage that position mindful of the need to support market liquidity and to take
care that sudden changes in trading strategies do not adversely impact liquidity or
settlement.13 The Desk has consistently transacted in the dollar roll market when purchasing
MBS to facilitate the orderly settlement of its purchases and will continue to do so as
necessary to avoid deterioration in the liquidity of these contracts.14
So far, there seems to be little evidence that the current pace of purchases is straining the
market's ability to deliver securities to us. The current monthly pace is within the range seen
during the Federal Reserve's previous asset purchase programs, whether measured in par
terms or when adjusted for duration risk. Treasury purchases make up only about 25 percent
of monthly gross issuance of coupon securities, and current SOMA holdings are less than
20 percent of coupon Treasuries outstanding, although in some maturity sectors these
percentages are significantly larger.
The FOMC's capacity to purchase MBS is somewhat more difficult to gauge, given the
uncertainty around future mortgage origination discussed earlier. Since the beginning of the
current purchase program in 2012, we have purchased nearly $75 billion in MBS on average
per month, including reinvestments. This translates into about 50 percent of monthly gross
issuance, below the monthly purchase rate of roughly two-thirds during the first round of
large-scale MBS purchases in 2009. If refinancing activity declines, leading to a decrease in
gross issuance, our purchases could exceed these levels. Of course, the pace of asset
purchases is not strictly limited by the amount of new mortgage origination, as market
participants can also deliver older securities into TBA contracts. As the pace of MBS
issuance evolves, the Desk will continue to watch the market functioning indicators
discussed above, with a particular emphasis on the market's ability to settle further
purchases.
Conclusion
Overall, I believe the Desk has effectively and efficiently carried out the FOMC's directive to
purchase additional Treasury securities and agency MBS in a transparent fashion that
achieves the FOMC's policy objectives, supports orderly market functioning, and obtains
competitive market prices. I also believe that the Federal Reserve's balance sheet policies
have been effective in easing financial conditions, particularly with respect to making
historically low borrowing costs available to existing and prospective American homeowners,
as well as lowering interest rates to spur business investment and household spending. To
achieve our policy mandate, we rely on your continued ongoing and active participation in
our operations both for your own accounts and for the accounts of your customers,
consistent with your role as primary dealers. We will continue to implement the FOMC's
directive, with the goal of supporting a stronger economic recovery in the context of price
stability.
References
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Asset Purchases by the Federal Reserve: Did They Work?" Federal Reserve Bank of New
York Staff Reports, no. 441, March.
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Program Lower Mortgage Rates?" Journal of Monetary Economics, Vol. 58 (July):
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