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The Real Person's Guide to the Federal Reserve

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Yesterday at 2:15 PM EST the Federal Reserve released what to most of us normal people was a bunch of gibberish, including this:

"To help support the economic recovery in a context of price stability, the Committee will keep constant the Federal Reserve's holdings of securities at their current level by reinvesting principal payments from agency debt and agency mortgage-backed securities in longer-term Treasury securities."

In the aftermath of the financial crisis, most of us are now at least vaguely aware that the Federal Reserve has intervened in financial markets to "help support the economic recovery." But what, exactly does that mean, intervention? It's actually not that hard to understand, not as hard as you might think.

More than a year ago, the Federal Reserve announced it was beginning a program to purchase mortgage-backed securities. The Fed initially planned to purchase "just" $500 billion in mortgage-backed securities but last March expanded it to $1.25 trillion when it became clear that the initial purchase amount was not enough to stabilize the economy.

OK, let's back up. Two things: 1) What did the Fed buy and why? and 2) How does buying it stabilize the economy?

1) What and Why?

Between January 5, 2009 and March 31, 2010, the Fed bought agency mortgage-backed securities. These securities are backed by mortgage loans which are backed by actual property liens.

Now, here's where the financial crisis enters the picture. Think about a house for a moment. It's not a very liquid investment, is it? By that I mean, it's not like you can wake up one morning and sell your house that afternoon. A share of a widely-held and traded stock, on the other hand, such as General Electric (GE) is very liquid. You can buy and sell shares of GE, literally, hundreds of times a day if you so choose. Because mortgages are not very liquid, the government helped create three government-sponsored mortgage guarantors: Fannie Mae, Ginnie Mae and Freddie Mac. These are called "the agencies" and they guarantee the credit quality of mortgages in order to make them more liquid. If investors believe that the mortgages backing the mortgage-backed securities are guaranteed, then they are very happy to buy them. As we have seen, however, those guarantees are all well and good until they are not.

So, what happened is that as the housing bubble came apart, and as it became apparent that the credit quality of the mortgages that Fannie, Freddie had guaranteed was simply an illusion created by a burgeoning housing bubble, investors in mortgage-backed securities panicked. There were many issues at work, but the primary one the Federal Reserve was concerned with is that investors, including banks and hedge funds, now held securities that were no longer liquid. This lack of liquidity meant they were unable to sell these securities in the open market, at least not at prices that wouldn't create tremendous losses because.... ah, yes, leverage.

But let's hold on for a moment. As an aside, one of the fundamental questions at work throughout the crisis, even today, is one of the price at which the securities could be transferred away from the investors that held them. The major banks and Federal Reserve argued, and continue to argue, that the majority of these securities are worth more than the market is pricing them at, and as a result if they are held long enough the market will come back eventually and price them "fairly." That is a fundamental issue at stake and one of the chief reasons that some maintain that the Fed has bailed out their friends at the banks because, hey, wouldn't it be nice if every time we bought something that went down in value someone would take it off our hands at a higher price and then hold it until it increased in price again? It sure would. But Main Street doesn't get that deal. Only some on Wall Street do.

OK, leverage. See, investors in these mortgage-backed securities don't simply gather up, say, $25 million of cash from their vaults and hand it over to the seller. In many cases they paid, oh, $2.5 million of their own cash for $25 million worth of securities, and then borrowed the rest of the money. Why? Because they're guaranteed, right? What can possibly go wrong? And if you borrow money to buy something you believe is going up in price, you can dramatically increase your return on your investment.

If I pay $10 out of pocket for a $100 baseball card, and later sell that card for $120, my return is around 100 percent, depending on how much interest I had to pay my dad for the $90 he loaned me. I paid $10, borrowed $90, and after repaying the $90 have $20 in my pocket. But if I pay $100 out of pocket for the card and sell it for $120, my return is only 20 percent. Look, pal, you simply cannot make it in the baseball card investment world generating meager 20 percent returns! Anyone can do that. Investors demand more! This is the line of reasoning that was occurring in banks and hedge funds all over the country in 2006 and 2007.

2) How does buying it stabilize the economy?

Here's a problem: If we want to buy a house, and no one wants to invest in mortgages, then how can we buy the house? Well, we can save up the entire purchase price of the house and pay cash. That's not very liquid, is it? So, by purchasing mortgage-backed securities the Federal Reserve hoped to stabilize the market and lower borrowing costs for home mortgages. As well, buying these mortgage-backed securities from cash-strapped investors at generous prices, the hope was that the Fed would free up additional capital at these banks.

See, it's not quite as complicated as it looks is it? Let's fast forward to yesterday at 2:15 PM and revisit the main nugget from the Federal Reserve's statement:

 "To help support the economic recovery in a context of price stability, the Committee will keep constant the Federal Reserve's holdings of securities at their current level by reinvesting principal payments from agency debt and agency mortgage-backed securities in longer-term Treasury securities."

Reads a bit easier now, right? "In order to help support the economic recovery by maintaining price stability,the Committee will keep constant the Federal Reserve's holdings of securities at their current level." What that means is that the Fed understands that right now there still aren't enough buyers in the market willing to buy those securities at a "fair' price. D'oh! So, what to do? Well, remember one of the attractive features of mortgage-backed securities is that the investor pays a price and in return gets a flow of income from the mortgage payments backing the securities. The Fed is going to take those payments and... anyone?.... why, buy longer-term Treasury securities, of course.

OK, so the Federal Reserve owns $1.25 trillion in mortgage-backed securities. That's a large number and actually pretty meaningless out of context. What's $1.25 trillion anyway? What difference does it make? What does that even mean? For this it helps to get a visual, which, fortunately, we just happen to have courtesy of the Cleveland branch of the Federal Reserve. Below is a graphic image that shows what the Federal Reserve's typical securities portfolio looks like.

What do the colors on this chart represent? The orange are traditional security holdings, short-term purchases that help provide system liquidity. Uh, wha? Remember, the Fed is charged with "maintaining the stability of the financial system." One way they do that is to help provide liquidity within the system.

Think of it this way: suppose I'm in college, and it's late September, and I want to sell a book from that stupid Economics 101 class that I recently dropped. Used, the book sells for $100. I bought it for more, but that's what they sell for at the bookstore and that is going to have to serve as a benchmark for what is a "fair price." Now, imagine that the college bookstore is closed. Here's the problem: I need the $100 to go to an event that evening. Well, my choices are pretty limited. I can walk all over campus hoping to find someone to pay me a fair price for the book. Someone who doesn't need the book might take pity on me and offer me $50 just to stop talking about it. But more than likely there is nothing I can do with the book until the bookstore reopens. In the larger economy this doesn't make for a very efficient or workable system. It may even be the case that someone on my floor desperately needs the book, but doesn't have access to $100 until Monday morning. What the Fed would do in this case - and this is a very rough analogy (sorry!) is loan the guy who needs the book $100 until Monday morning. Then everyone is happy. I sell my book, I go to the event, the system has worked!

Now, here is a graphic image that shows what the Federal Reserve's portfolio looks like today.

Holy Mother of... I know, right? So, that's all a very long-winded way of saying why financial markets care very much about what the Federal Reserve says it's doing with all that stuff it bought last year. The Fed will be able to hold onto this stuff for far longer than anyone can imagine, but not permanently. After that, things will get interesting again.

POSITION:  No positions in stocks mentioned.