Should The Fed Extend Its MBS Program?

Yesterday, St. Louis Federal Reserve President James Bullard suggested that the Fed might want to rethink ending its mortgage-backed security purchase program in March. That's the deadline it set for the program, which is committed to buying $1.25 trillion of MBS. He worries that the market might not be healthy enough to function on its own at that time. I share his concern.

Here's what Bullard said, via Reuters:

"I would just like to keep them active at a very low level," St. Louis Federal Reserve bank James Bullard told reporters after giving a speech at an event organized by Princeton University students in New York.

Bullard, who will be a voter on the Fed's policy-setting panel in 2010, said with rates near zero, keeping the purchase program alive would enable the Fed to react should the economy take another turn for the worse.

"I'd hate to get the feeling that the Fed is saying our work is done," after the programs' end date, Bullard said.

First, I completely understand his worry. The securitization market is hardly back to business as usual, and there's little reason to believe that it will running on all cylinders in March. Yet, the credit markets need securitization in order to properly function. If you think banks aren't lending enough now, then you'd find a world with no securitization much worse.

Yet, that might be what you get if the Fed ends its program. Investors may continue to gravitate towards the equity markets throughout early 2010. They'll likely also still be a little hesitant to return to the securitization realm after having some of their MBS turn "toxic" over the past few years. Of course, there also may still be a lot of very cheap MBS in the secondary market that can be purchased for pretty cheap without even needing to look at more expensive new securities.

So Bullard's fear makes total sense: you don't want a situation where the credit crunch re-intensifies for consumers if the Fed steps back from the purchase programs it began during the financial crisis. At the same time, however, I just wonder when the right time for the Fed to slowly back away would be.

At some point, it has to take off the training wheels, and I worry that banks would always prefer to ride with them on. After all, if you know the Fed will just buy your bonds, then there's little need to bother much with the private market and get investors comfortable again with MBS. So in a sense, the Fed's involvement could unintentionally be perpetuating the problem by not forcing the private market to step up.

So considering all those factors, it's very hard to decide what the right move is for the Fed. You don't want to stunt recovery, but you also don't want banks to become overly reliant and private investors to remain out of the game for too long. But there's another consideration to think about: financial regulation.

I've said in the past that the regulatory proposals by both chambers of Congress could dramatically reshape the securitization industry. They could make it much smaller, as forcing investment banks or issuers to retain a significant portion of risk will make securitization much more expensive and less attractive. Under the current timetable, those new regulatory constraints might hit right around the time when the Fed program is set to end.

That could create a sort of perfect storm for the securitization market. No one, least of all consumers who need credit, should want to see that. The Fed should consider this broader picture that includes regulatory changes as part of the equation when determining whether to end the MBS program in March. It might be wise to wait until banks have become more comfortable with the strange new financial world Congress' upcoming regulation creates.