Over the past five years, the Federal Reserve has bought $1.2 trillion of mortgage-backed securities in an attempt to resuscitate the nation’s housing market. How it acquired that power is a lesson in the ways seemingly small changes in policy can have outsized impact generations later.
The year was 1966. America had reaped the spoils of the post-war boom and was beginning to see the buds of inflation. The economy was overheating: Banks were fighting for deposits to meet loan demand, pushing up interest rates. Higher rates on mortgages meant that the red-hot housing market was faltering. Congress wanted to act.
More specifically, it wanted the Fed to act. To keep interest rates down, Congress wanted the central bank to set limits on the interest rates that banks could pay to depositers. Lawmakers amended the Federal Reserve Act to give it those new powers -- along with one more that seemed little more than an afterthought at the time.
The 1966 amendment also gave the Fed the authority “to buy and sell in the open market … any obligation, which is a direction obligation of, or fully guaranteed as to principal and interest by, any agency of the United States.” In other words, the Fed could buy debt from agencies other than the U.S. Treasury, so long as it was otherwise guaranteed by the government.
Congress was trying to establish a new Federal Financing Bank to help ease tight credit markets. To boost lending, the government was starting to buy mortgage and other debt. It wanted the Fed to join the experiment. The Fed, however, was not immediately sold. The market for agency debt was small and untested; the central banks involvement could alter the dynamics, a monetary policy no-no. On the flip side, some officials thought there would be little actual benefit. It wasn’t until 1971 that the Fed purchased any agency debt.
Congress “felt that the [Fed’s policy-setting] Committee had demonstrated an uncooperative attitude in the matter,” read a memorandum from a central bank meeting at the time. “Congress as a whole was concerned about the housing problem, and ... the feeling was widespread in Congress that the [Federal Reserve] System had not been sufficiently sensitive to that problem.”
Lawmakers trying to cobble together their response housing crisis, and a central bank accused of ignoring the problem -- sound familiar? The Fed spent $485 million that year on agency debt issued by the Federal National Mortgage Association (known then colloquially, and now formally, as Fannie Mae). By 1977, it was buying $3.3 billion worth of securities from Fannie Mae. It also had smaller holdings of a hodge-podge of other agencies: the U.S. Postal Service, the Export-Import Bank and even $117 million in debt of the Washington Metropolitan Area Transit Authority. Yes, the D.C. Metro system was funded in part with dollars from the Fed.
It was the WMATA holding that crystallized the hesitancy several Fed officials had about dabbling in agency debt in the first place, including then-Chairman Arthur Burns.
“I’d love to see us get rid of that,” he said at one point, according to a transcript of a Fed meeting in 1977. The holding “is dug up by individual Congressmen, and they come forward with the argument: ‘Now you have supported and rendered financial assistance to the City of Washington. You bought their securities. Why don’t you buy the securities of New York City, and why are you discriminating against New York?’”
The Fed wound down those investments in the years that followed, shifting over time to a more “neutral” balance sheet in which it held plain vanilla Treasury bonds instead and thus not favor one segment of the economy -- like home mortgages or D.C. area subways -- over everything else.
The debate that Burns was having in 1977 is almost identical to one held by modern-day critics of the Fed: Purchasing mortgage backed securities, as it has in response to the current crisis, means that the Fed is effectively helping one sector of the economy, housing, over everything else, effectively picking winners and losers.
“If there’s any effect, it tilts the playing field,” current Richmond Fed President Jeffrey Lacker, a vocal opponent of the central bank’s purchases of mortgage-backed securities, said in an interview. “You’re doing fiscal policy in a very real sense.”
Most of the Fed’s top brass, including current Chairman Ben S. Bernanke, believe purchasing mortgage debt is an important tool boosting the recovery. It has helped push interest rates on 30-year fixed loans to historic lows, which is credited with spurring demand among buyers and raising real estate prices.
The ripple effects, however, could be felt for decades to come. Fannie Mae mortgages remained on the Fed’s balance sheet until 2002, 30 years after the central bank first began purchasing them. The Fed held no agency debt until the financial crisis hit six years later, and it transformed an obscure rule into a powerful new weapon.
And given how long ago the Fed helped fund the D.C. transit authority, it seems unfair to blame Ben Bernanke for broken escalators a generation later.