The Rescue of Fannie Mae and Freddie Mac–Module F: Federal Reserve’s Large-Scale Asset Purchase (LSAP)

Rosalind Z. Wiggins is Director of The Global Financial Crisis Project and Senior Editor at the Yale Program on Financial Stability, Yale School of Management. This post is based on a recent paper authored by Ms. Wiggins; Andrew Metrick, Janet L. Yellen Professor of Finance and Management at the Yale School of Management and the Director of the Yale Program on Financial Stability; and Yale Program on Financial Stability researchers Ben Henken, Adam Kulam, and Daniel Thompson.

In the Fall of 2008, the bursting of the US housing market and the subprime mortgage crisis that it spurred had sent shock waves throughout the financial system. For over a year, the Federal Reserve had been responding to tensions in the credit markets. Many markets had all but frozen in the wake of the unprecedented events of September—the government had taken the giant Fannie Mae and Freddie Mac into conservatorship to prevent their collapse and the collapse of the secondary mortgage market along with it, and the Fed had made one of its largest loans ever to the $ 1 trillion insurance company American International Group, to forestall it following in Lehman’s footsteps. Despite the intervening bankruptcy of the investment bank Lehman Brothers, the government and Fed had hoped that these extraordinary interventions would stabilize the system and keep credit flowing; but it wasn’t happening. The secondary mortgage markets continued to suffer high rates of default, causing mortgage lending to slow, and the value of mortgage-backed securities (MBS), widely held on the balance sheets of financial institutions, to plummet. Credit remained tight and rates remained high, especially mortgage and other long-term rates.

During the year, the Federal Open Market Committee (FOMC) had lowered the federal funds rate substantially and the rate stood near zero. With interest rates so low, the Fed did not have this traditional monetary policy tool at its disposal. Instead, as the FOMC debated what its next steps would be it turned to purchasing large amounts of assets as a way to get credit flowing and reduce spreads, thereby spurring the economy. The FOMC knew it had to do something big if the intervention was going to be effective. The Treasury had just concluded a program purchasing $220 billion in agency securities, which did not appear to have had an impact on rates.

Despite concern that the program might be seen as credit allocation or steering funds to the GSEs, on November 25, 2008, the FOMC announced the Large-Scale Asset Purchase (LSAP) program— it would purchase up to $500 billion in MBS and $100 billion in debt from Fannie Mae, Freddie Mac, and the other housing GSEs, the Federal Home Loan Banks, and the Government National Mortgage Association (Ginnie Mae). (It ultimately did not purchase any securities from FHLB bonds.)

Transcripts from FOMC meetings reveal that officials had deliberated between purchasing agency debt and MBS alone or in conjunction with purchasing long-term Treasury securities before deciding on the mix of GSE debt and bonds. The Fed stated— “This action is being taken to reduce the cost and increase the availability of credit for the purchase of houses, which in turn should support housing markets and foster improved conditions in financial markets more generally.”

Under the Large-Scale Asset Purchase (LSAP) program, which came to be known as quantative easing, the FRBNY ultimately purchased $172 billion in agency debt and $1.25 trillion in agency MBS through March 2010. The FRBNY also purchased $300 billion in longer-term Treasury securities as part of the program.

The theory of QE is that it will “increase the money supply and lower interest rates by injecting money into banks so that they can extend credit to businesses and consumers at a more attractive interest rate,” incentivizing parties to spend more and stimulating the economy. Several weeks after the LSAP program’s inception, the spreads between conforming mortgages and Treasuries, substantially narrowed causing conforming mortgage rates to fall substantially. The academic community generally concurs that the LSAP program succeeded in lowering interest rates, but they disagree about which interest rates were impacted by these programs, and to what extent. Additionally, central bankers and economists have argued that the size of the program’s commitments played an integral role in lowering Fannie Mae and Freddie Mac’s debt spreads and in lowering interest rates—particularly long-term interest rates—more broadly.

Reflecting on the LSAP program, Chairman Bernanke later noted that the LSAP was “[p]robably the most controversial form of unconventional policy adopted in recent years.” (Bernanke 2017). He also commented on the fact that while other central banks have broad authority to purchase a range of private securities including corporate bonds and equity, which the Fed cannot. Nevertheless, he stated—”The limits on the Fed did not seem to prevent its version of QE from being effective, although it was perhaps fortunate that, following a crisis centered on housing finance, the law did permit Fed purchases of mortgage-related securities.”

Thirteen years later, Fannie and Freddie are still in conservatorship and their future remains uncertain. However, QE has become a useful tool in the Fed’s bailiwick even though according to Stephen Williamson, a former Fed economist, it remains “controversial” and “muddy”. The Fed used QE repeatedly from 2020-2014, and did not hesitate to deploy QE in March 2020 to increase the liquidity of U.S. banks as the economy shut down due to the COVID-19 pandemic. It announced that it would purchase at least $500 billion of Treasury securities and at least $200 billion of agency MBS, markets “that are central to the flow of credit to households and businesses.” Since then, the Fed’s balance sheet increased by more than $4 trillion to $8.56 trillion (as of October 26, 2021). It has only recently announced that it will consider tapering its purchases, as critics debate whether it has deployed the measure long enough. As the country struggles to emerge from the COVID recession and address its effects fears of inflation and stock market distortions from the enlarged money supply are being discussed.

The FOMC’s reasoning on adopting the LSAP and its impact are further discussed in The Rescue of Fannie and Freddie, Module F: The Federal Reserve’s Large-Scale Asset Purchase (LSAP) Program, one of seven Yale Program on Financial Stability (YPFS) case studies that examine in detail the various elements of the government’s rescue of the GSEs. The cases may be accessed here.

The complete paper is available for download here.

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