Sunday, August 12, 2007

Fed repurchase agreements for high-quality mortgage-backed securities

There were numerous mentions in the press on Friday about the Fed engaging in repurchase agreements for mortgage-backed securities (MBS) from "dealers", but the details were scant. Not all mortgage-backed securities are of equal quality, so I have been anxious to know what the Fed was actually "buying" (for three days before the dealers would be obligated to buy them back) and from whom.

First, I believe that the term "dealers" refers to "designated Primary Dealers", which is a set of 21 banks and financial institutions which the Fed regularly works with for carrying out open market operations. According to the Federal Reserve Bank of New York web site:

The primary dealer system has been developed for the purpose of selecting trading counterparties for the Federal Reserve in its execution of market operations to carry out U.S. monetary policy.

Note: BNP Paribas is one of the 21 primary dealers.

Normally most Fed open market operations involve Treasury securities, but sometimes also the securities of government sponsored enterprises (GSE) such as Fannie Mae and Freddie Mac.

The first question that popped  into my head was whether the Fed repos involved MBS issued by the GSEs or MBS and CDOs issued by Wall Street firms. If the latter, then the question was whether the Fed action involved primarily the higher-quality tranches of MBS which are not subprime, or the the much lower-quality subprime MBS and CDO securities.

Initially, the most detail I could find was in the Financial Times:

It told dealers it would re-enter the market as often as necessary, and -- in a highly unusual move -- accepted high-quality mortgage-backed securities as collateral for the entire $38bn of funds.

I'm glad to hear that the Fed focused on "high-quality" MBS rather than bail out firms holding risky subprime mortgage securities. Alas, this still doesn't tell us whether the Fed repoed GSE MBS (super-high quality) or Wall Street MBS (less-clear quality.)

But, the real point is that the Fed was taking on the short-term risk of the markets irrationally undervaluing high-quality, low-risk MBS debt simply because it was "smeared" with the bad reputation of subprime MBS.

A repo is typically only for a few days, but the Fed can simply roll them over indefinitely, as long as the liquidity crisis persists. The liquidity crisis may in fact be nearly completely behind us, or we may experience a few aftershocks.

This article in Reuters seems to indicate that the Fed did in fact stick with GSE MBS:

As guarantee for repayment, banks could have also offered as collateral U.S. Treasuries or corporate agency debt of thegovernment-chartered housing finance companies Fannie Mae and Freddie Mac.

But they nixed those options, offering just mortgage-backed securities issued by Freddie Mac, Fannie Mae and government-owned Ginnie Mae.

That article also notes that:

Dealers did not submit Treasuries and agency debt in any of the three repo operations because they wanted to retain their best performing securities, analysts said. The Fed, which has the option to exclude certain collateral, opened the repos for all three security types for "operational simplicity."

"My impression is that there are some liquidity issues in (agency MBS) and that there's plenty of that collateral hanging around," said Ward McCarthy, a founder of financial research firm Stone & McCarthy Research Associates.

Note thate the GSEs ("agencies") issue both normal debt (borrowing money for their own needs) and MBS debt. This seems to affirm the idea that the Fed repos were for GSE MBS and not any of the Wall Street subprime MBS or CDOs, but the issue remains unclear.

Also note that the Fed statement on Friday says:

As always, the discount window is available as a source of funding.

In addition to inter-bank lending, which the Fed facilitates by managing the fed funds target rate, the Fed also has the capacity to directly loan money to banks via the "discount window." Normally banks never go near the discount window since it is a source of last resort and is considered by most players on Wall Street as an act of desperation. Nonetheless, it is a source of funds should a bank find itself in a genuine liquidity crisis.

However this all plays out, rest assured that the Fed is on the case.

-- Jack Krupansky

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