How Do the Fed's MBS Purchases Affect Credit Allocation?
It is sometimes said that the Federal Reserve should not engage in “credit allocation.” But what does credit allocation actually mean? And how do current Fed policies affect the allocation of credit? In this post, we describe two separate ideas often associated with credit allocation. The first idea is that the Fed should not take credit risk, which taxpayers would ultimately have to bear. The second idea is that the Fed’s actions should not influence the flow of credit to particular sectors. We consider whether the Fed’s holdings of agency mortgage-backed securities (MBS) could affect the allocation of credit. In a companion post, we discuss how the economic effects of the Fed’s MBS holdings compare with the economic effects of more traditional holdings.
Taking Credit Risk
The Federal Reserve would take on credit risk if it purchased and held assets that have a risk of default. Marvin Goodfriend calls this “credit policy.” He notes that “all central bank credit initiatives carry some credit risk and expose the central bank and ultimately, taxpayers to losses and controversial disputes involving credit allocation.”
Historically, the securities that the Fed has purchased, which include Treasury and agency securities—securities fully guaranteed by the U.S. Treasury or federal government agencies—are quite safe. More precisely, Ginnie Mae securities are now, and always have been, guaranteed by the full faith and credit of the U.S. government. Although securities issued by Fannie Mae and Freddie Mac are not guaranteed by the government to the same extent, they are regarded as posing very little credit risk to investors, including the Fed. As former New York Fed President William C. Dudley said in February, “The government’s interventions to support Fannie Mae and Freddie Mac have made it clear that there is no credit risk in the Federal Reserve’s purchase of such obligations.”
District Federal Reserve Banks take some credit risk when they lend to banks at the discount window, or through other lending facilities. They mitigate risk, however, by requiring collateral against all loans they make. In addition, Reserve Banks value collateral and set “haircuts” so that loans are overcollateralized. Despite the credit risk, Reserve Banks have never lost money on a discount-window loan.
A number of central banks have taken on credit risk with their asset purchase programs. The European Central Bank, the Bank of England (BoE), and the Bank of Japan (BoJ), for example, have purchased assets issued by the private sector. In some cases, such as the BoJ, the central bank has retained the credit risk. In other instances, such as with the BoE, the central bank obtained explicit indemnities from its fiscal authority to protect it against any credit risk that could result from these purchases. These indemnities have a similar effect as the Fed’s approach of purchasing only government or government agency-guaranteed securities—the fiscal authority, not the central bank, makes the decision about whether to expose taxpayers to credit risk, and it is the balance sheet of the fiscal authority rather than the central bank that is at risk.
Allocating Credit across Sectors
Although the Fed’s MBS purchases are not “credit allocation” in the sense of incurring credit risk, they may affect credit allocation by changing the prices of various securities. Purchasing MBS raises the price of those securities directly. Higher prices for MBS reduce mortgage interest rates, thus supporting the flow of mortgage credit to households. Higher MBS prices also indirectly affect the prices of other securities if private investors reallocate their portfolios toward MBS. So, MBS purchases likely influence private investors’ decisions, at least indirectly. Changing relative prices may influence the private allocation of credit across sectors even without taking credit risk.
To minimize allocation effects, central banks generally seek to avoid purchasing assets from a narrow sector or a class of borrower and can take steps to mitigate distortions to the market price of credit. For example, this article from the BoE’s quarterly bulletin details how its corporate bond purchase program “was designed to impart broad stimulus to the macroeconomy while also ensuring that it did not distort the sterling corporate bond market, or create any unfair bias towards particular issuers or sectors.”
It is worth emphasizing that influencing the market prices of credit via central bank large-scale securities purchases is fundamentally different from the central bank itself lending directly to particular borrowers. Even if securities purchases change relative prices in a way that affects private investors’ incentives, the decision to lend to a specific borrower ultimately remains with investors, not the central bank.
To Sum Up
We tried to resolve two, sometimes blurred, notions about credit allocation associated with central bank securities purchases: taking credit risk and influencing the price of credit. By purchasing agency MBS, the Fed did not take on credit risk, because the U.S. government or agency guarantee behind these securities makes them essentially risk-free. The Fed may have indirectly affected credit allocation by changing the relative prices of certain credit. Indeed, Fed policymakers have debated the extent to which the Fed’s MBS purchases provide broad-based economic stimulus versus supporting the housing sector specifically—see, for example, the comments of then Chairman Bernanke and President Lacker in this FOMC transcript from 2009. In our next post, we study in more detail how the Fed’s agency MBS purchases affect the U.S. economy.
The views expressed in this post are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York, the Federal Reserve Bank of Chicago, or the Federal Reserve System. Any errors or omissions are the responsibility of the authors.
Antoine Martin is a senior vice president in the Federal Reserve Bank of New York’s Research and Statistics Group.
Sam Schulhofer-Wohl is a senior economist and research advisor at the Federal Reserve Bank of Chicago.
How to cite this blog post:
Antoine Martin and Sam Schulhofer-Wohl, “How Do the Fed's MBS Purchases Affect Credit Allocation?,” Federal Reserve Bank of New York Liberty Street Economics (blog), August 6, 2018, http://libertystreeteconomics.newyorkfed.org/2018/08/how-do-fed-mbs-purchases-affect-credit-allocation.html.