The Fed’s ‘temporary’ mortgage-backed security experiment will last decades

Published in The Hill with Paul Kupiec. Also published in RealClear Markets.

It has been nearly 14 years since Federal Reserve Chairman Ben Bernanke told Congress that the Fed’s emergency quantitative-easing policy, of which the most radical part was buying mortgage-backed securities, was “temporary” and would be “reversed.”  

The Fed made huge mortgage-backed securities purchases. The purchases pushed mortgage interest rates to artificially low levels, stoked the second great house price bubble of the 21st century and made houses unaffordable for many. 

In addition, these mortgage-backed securities investments unintentionally caused massive Fed losses. They are costing the Fed and taxpayers billions of dollars a month and will for years to come, as there is no practical way for the Fed to reverse its very large, deeply underwater mortgage-backed securities investment. 

The Fed created a giant, loss-making mortgage-backed securities portfolio. It currently owns $2.3 trillion in mortgage-backed securities mostly bought at the top of the market when mortgage yields were artificially low. 

Today, these mortgage-backed securities are worth far less than the Fed paid for them. The June 30 Fed financial statement shows an unrealized market value loss of $423 billion on the Fed’s mortgage-backed securities investments. This loss is nearly 10 times the Fed’s financial statement reported capital of $43 billion. 

We say “reported capital” because the Fed has suffered $207 billion in realized cash operating losses that it has amazingly not deducted from its reported capital. Using standard accounting rules, per our estimate, the Fed’s actual capital as of Oct. 30, is $43 billion minus its accumulated cash operating loss of $207 billion; or negative $164 billion.  

In addition, the Fed has $423 billion in unrealized mortgage-backed securities market value losses because interest rates today are much higher than the rates the Fed earns on its mortgage-backed securities. 

The Fed invested in 30-year fixed-rate mortgage-backed securities, almost all of which have remaining maturities of more than 10 years. It earns about 2.2 percent interest on its mortgage-backed securities but pays a 4.9 percent interest rate to fund them. 

The Fed has a negative 2.7 percent spread on these mortgage-backed securities meaning that it costs the Fed an annualized $62 billion to own these securities. Remarkable asset-liability management!  

The Fed’s cash losses are also losses to the U.S. Treasury. So without any congressional approval, the Fed’s very large, very underwater mortgage-backed securities investment is imposing tens of billions of dollars of costs annually on taxpayers.   

According to a congressional testimony about the Fed’s emergency investments by Chairman Bernanke on June 12, 2014: 

“What we are doing here is a temporary measure which will be reversed so that at the end of the process, the money supply will be normalized, the Fed’s balance sheet will be normalized, and there will be no permanent increase … in the Fed’s balance sheet.”

It is now 2024. How long is “temporary”? Why doesn’t the Fed just sell its mortgage-backed securities and put the problem behind it?   

It is not practical for the Fed to sell all its mortgage-backed securities. If it sold them, the Fed would, under the unrealistic assumption that it could sell its mortgage-backed securities at their current estimated market value, realize $423 billion in new cash losses. We estimate that would make the Fed’s capital, measured using standard accounting rules, negative $587 billion. 

While the Fed would, we expect, continue to claim that it had $43 billion in capital, the $423 billion in market value losses would become actual cash losses and have to be reported in the Fed’s profit and loss statement. Reporting such a huge cash loss would not only be an embarrassment but could trigger congressional investigations and unwanted oversight. 

More realistically, the Fed would simply not be able to sell its mortgage-backed securities for its current fair value estimate. The Fed’s $2.3 trillion investment is a massive position. It is so big that in reality it can’t be sold. There are about $9.4 trillion in total mortgage-backed securities issued by Fannie Mae, Freddie Mac and Ginnie Mae of which, the Fed owns almost 25 percent. 

If the Fed tried to quickly sell its portfolio, the sale would crash the mortgage-backed securities market and result in a cash loss much larger than $423 billion. It could reduce the inevitable negative market price impact by liquidating its mortgage-backed securities gradually over time, but the mere announcement that the Fed planned to sell would lower prices in the mortgage-backed securities market. 

Moreover, either approach would push up mortgage interest rates — hardly a welcome political outcome. 

It seems likely the mortgage-backed securities will be on the Fed’s balance sheet until they finally mature. In the meantime, they will continue racking up billions of dollars in cash losses each month. 

It looks like the Fed is stuck with very large, losing “temporary” mortgage-backed securities investments for a long time to come. 

Alex J. Pollock is a senior fellow at the Mises Institute. Paul H. Kupiec is a senior fellow at the American Enterprise Institute.