Treasury/MBS Swaps

Arvind Krishnamurthy and Annette Vissing-Jorgensen have written this note, which makes an argument that a useful quantitative easing (QE) operation by the Fed would be a swap of Treasury bonds for mortgage-backed securities (MBS). This summarizes the argument:

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.

Let's start with point #2 above. On page 3, Krishnamurthy and Vissing-Jorgensen state:

...by purchasing long-term Treasury bonds the Fed shrinks the supply of extremely safe assets, which drives up a scarcity price-premium on such assets and lowers their yields. This latter channel is a welfare cost to the economy.

I like that. It's exactly how an open market operation works in this paper. A swap of outside money for government debt, under the right conditions, makes liquidity more scarce in financial markets and increases its price - the real interest rate goes down. The price of government debt reflects a liquidity premium. But this kind of swap is not a good thing, as it makes financial trade less efficient.

The problem is that it doesn't work that way in a liquidity trap (positive excess reserves and the interest rate on reserves driving all short-term interest rates). For example, under current circumstances, if the Fed swaps reserves for Treasury bonds, that implies no change in financial market liquidity, as the private sector's ability to intermediate T-bonds implies that the Fed's swap just nets out.

Now, move to point #1. The claim here is that we would prefer that the Fed have a portfolio of MBS rather than Treasury bonds. But what is the Fed supposed to be accomplishing by purchasing MBS? The case that some people make to justify the existence of Fannie Mae and Freddie Mac (currently under government "conservatorship") is that they are a boon to the mortgage market. Otherwise illiquid mortgages are sold to Fannie Mae and Freddie Mac. These mortgages can be held on the balance sheets of the GSEs, financed by liabilities which are perfect substitutes for government debt. They can, and are, packaged as MBS, which are tradeable, liquid securities. Why is it necessary that we go through another step and have these MBS intermediated by the Fed? They're not liquid enough already?

Maybe there is some risk associated with MBS (prepayment and default risk) that we don't see in Treasury bonds, that we are transferring from the private sector to the Fed with a Fed MBS purchase. But how does that work? The risk has to be borne by someone, and if the Fed holds the MBS, taxpayers bear the risk. Why is the Treasury any better at allocating risk in the private sector than are private financial institutions?

Likely Krishnamurthy and Vissing-Jorgensen's ideas will be used to support what the FOMC seems intent on doing, which is executing another QE operation, this time with MBS (as with QE1).