How does the Federal Reserve’s QE Work

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Quantitative Easing, or Money Printing has been the most commonly used term among Central Banks across the world. Currently, the US Federal Reserve, Bank of England, to name a few engage in QE or asset purchase program in an effort to give their respective economies a boost. The US Federal Reserve for example has embarked on its latest QE since September 2012 promising to buy (and buying) MBS or Mortgage Backed Securities. While it might seem straight forward understanding how this QE(3) works gives investors and traders alike better insights into how the Federal Reserve aims to boost the economy.

What is a Mortgage Backed Security

MBS for short, falls under the derivatives market and works similar to that of Bonds, stocks or mutual funds. The MBS is a pool of Mortgages backed up by the actual asset, in this case the house (commercial or residential) and is packaged and sold from institutions such as Freddie Mac (Federal Home Loan Mortgage Corporation) and Fannie Mae (Federal National Mortgage Association) and includes private banks as well.

The MBS is basically a pass-through security where in the principle and the interest is paid out to the buyer of the MBS while the loan is financed from the sale of these derivatives. Other forms include CMO (Collateralized Mortgage Obligations) or CDO (Collateralized Debt Obligations). Despite the name. MBS can also include housing or property loans, credit cards, auto loans, student loans to name a few.

How does MBS work

When you approach a bank for a loan to buy a home and you get the loan, the bank then sells that loan as an investment by simply pooling in various other loans with similar interest rates. This is packaged into a bond and sold to investors as well as semi-governmental agencies like Fannie Mae and Freddie Mac. Simply put, the banks pass on the risks of a loan in the form of a security to the investor while at the same time ensuring that the loaned amount is financed from these buyers of MBS.

How Mortgage Backed Securities Work
How Mortgage Backed Securities Work

The role of Federal Reserve in MBS

Since the announcement in September 2012, the Federal Reserve has been the biggest buyer of these MBS products. Because the Fed (or any Central bank for that matter) has the authority to create money out of thin air, by purchasing the MBS from the banks, they pump in money to encourage lending in the markets, while expanding their own balance sheets. MBS is not just limited to mortgages but also equipment loans, automobiles and so on. As an active buyer of the MBS, the Fed is thus able to keep the costs of borrowing lower, which indirectly affects the end consumer who wishes to take out a loan. Thus the Fed encourages banks to loan to the consumers who in turn help in creating new jobs, purchasing and so on.

The risks of MBS

Mortgage Backed Securities has its fair share of risks and a classic example was the financial crisis which was started by the Sub-Prime lending. Sub-prime lending is where the risks of default is much higher and carries a higher interest rate than regular mainstream loans. The lenders (banks in this case) however were lot less concerned as the risks were packaged as an MBS and sold to investors. To make things complicated, the very lenders would then purchase CDS (Credit Default Swaps) as an insurance for a default on the mortgages… (which eventually led to the bailout of AIG, the largest insurer of the mortgage loans).

Thus, should a loan default, the risk would be passed on to the MBS investor, which in this case would be the Federal Reserve. But given the clout of the Central Bank, the chances of a default on loans is more manageable as compared to a private institution purchasing the MBS.

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