One question about the Federal Reserve’s new open-ended quantitative easing policy seems to keep popping up over and over among investors and commentators: How is the Fed buying mortgage-backed securities supposed to create jobs?
The Fed has not been most adept at explaining how the plan is supposed to work. And its previous large-scale asset purchase programs (like QE1 and QE2) don’t seem to have had much success in bringing down unemployment.
For you beginners, a mortgage-backed security (MBS) is a bundle of mortgages that is sold to investors.
Here is how the MBS purchases are supposed to translate into jobs for Americans (via KT ZMICO economist Isara Ordeedolchest):
Photo: KTZ Research
That’s how the transmission mechanism is supposed to work. Ordeedolchest isn’t sure how long it’s going to take or whether it will be sustainable. But “pushing down the mortgage rate,” a key link at the beginning of the chain, won’t do much to stimulate the housing market if banks are unwilling to lend.
BofA MBS strategist Chris Flanagan thinks banks are about to find that with QE3, the Fed has left them with no choice, though – and that realisation is about to cause a major sea change in the housing market and the economy.
Flanagan says that “the case is very strong right now for banks to significantly ramp up mortgage lending capabilities.” The reason for this is that the Fed, in bidding up prices on mortgage-backed securities (thereby simultaneously lowering yields and making them less attractive to hold from a value perspective), will force banks to look elsewhere for profits.
As a result, Flanagan thinks banks will return to lending to find those opportunities. And in order to find profitable lending opportunities, they are going to have to loosen mortgage underwriting standards and start making loans to less creditworthy clients. In a recent note to clients, Flanagan writes that “for banks deciding on their mortgage credit policies, we think the question for them will be whether they want to fight the Fed.”
If that proves to be the case, the diagram above illustrating how the purchases are supposed to eventually filter through to job creation may make a little more sense – and don’t forget the economic effects of the last great securitization wave in the United States.
QE3 is simply the Fed’s most forceful attempt since the crisis to get credit flowing again in the American economy.
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