Sunday, September 16, 2012

Ben Bernanke: Fed Launches New QE3 Plan to Buy Mortgage Bonds and Stimulate Economy

How the economy has reacted each time the Fed announces a new QE effort
Ben Bernanke announced Friday that the Fed, beginning this month, is going to buy $40 Billion worth of mortgage bonds each month until the job market improves substantially.  This is the "QE3" program, which is short for "Quantitative Easing."  The number "3" comes from the fact that this is the third round of Quantitative Easing by the Fed.  (see pic above)

All of the articles out there on this topic assume that you received an MBA from Harvard School of Business, so we're going to break down how the Fed works and how buying mortgage bonds (ie. "mortgage-backed securities") can lower interest rates for home buyers and affect the overall economy.  So the goal of this post is to give you, the reader, all of the facts on this latest move by the Fed and then to let you make the call as to whether it is a good idea or not.

Now let's stop right here and unpack a few things.  First of all, what the heck is the Fed?  The Fed is a nickname for our Federal Reserve System.  It is America's Central Bank where the U.S. Treasury keeps all of its money much like you or I would keep our money in a checking account.  It has been here since 1913. In addition to being the place where the government keeps its money, it has also been charged with the obligation of regulating all other banks, keeping the banking system from collapsing, stabilizing our markets, and setting interest rates for the banks.  This last component -- setting interest rates -- is central to our discussion here.

But before we go there, let's break down another question that many people have about this announcement - what the heck are mortgage bonds and how will buying them help the job market?  Mortgage "bonds" are another way to say "mortgage-backed securities."  Wait, aren't those the things that sunk our economy in 2008?  No, not exactly.  You may be thinking of the subprime mortgage-backed securities which tanked our economy 4 years ago.  Those were a particular type of mortgage-backed securities comprised of mortgages which were targeted at low-income home owners.  For purposes of our discussion here, all you need to know about mortgage-backed securities (aka "mortgage bonds") is that they are securities (like stocks) that are "backed" by home loans.  And when we say "backed by home loans" what we mean is that the security/bond is guaranteed by somebody's ability to pay their home loan.  "Subprime" mortgage-backed securities failed because they were largely comprised of home loans that were marketed (often times illegally) towards poor people who couldn't pay their home loans.  Regular mortgage-backed securities/mortgage bonds, by contrast, are considerably more stable.  For a more in-depth explanation on how your personal home loan can be transformed into a security that is traded like a stock on the stock market, see THIS VIDEO

And so how does the Fed's act of buying these mortgage bonds affect the economy?  Well that is good question because it requires you to know a few basic principles that the media has failed to explain.

BASIC PRINCIPLE #1: Banks and other lenders are in competition for INVESTORS. (So what this means is that if Bank of America is able to offer home loans for 3.0%, then in order for Wells Fargo to attract more investors they have to lower their home loan interest rates to 2.9%...or maybe even lower their interest rates to 2.5% or 2.0% or 1%.  Obviously the banks don't want to go too low because then they won't make any money, but you get the picture.  The #1 goal is to get people (and their money) in the door.) 

BASIC PRINCIPLE #2: The final amount that a bond pays out upon maturity is FIXED.  (For example, imagine that you have a $100 dollar bond that pays $120 in 5 years when it "matures."  The $20 payment to you is what is called the "YIELD" because the bond "yields" 20 bucks at the end of its life.  The important thing to know here is that if you have a $100 dollar bond that yields $20 when it matures in 5 years, then it's going to pay $120 in 5 years regardless of whether you pay $99 dollars for it today or whether you pay $115 dollars for it today.  The only difference between the $99 dollar purchase and the $115 dollar purchase is the INTEREST RATE that each respective investor received on their investment.  Since they each get $120 when the bond matures no matter what, obviously the person who bought the bond at $99 bucks received a much better return on investment than the guy who bought it at $115...which takes us to the next principle...)

BASIC PRINCIPLE #3: Buying up large quantities of mortgage bonds causes DEMAND for those securities to go UP. (Just like with anything else, if a lot of people go out today and start buying a lot of widgets, then the demand for widgets goes up.  And as you might recall from your Econ class, when demand goes up, price goes up.  Same principle applies to mortgage bonds.  The more bonds the Fed buys, the more the demand for those bonds will increase.  The more demand for mortgage bonds increases, the more the price for mortgage bonds will increase.)

BASIC PRINCIPLE #4: When demand for bonds goes UP, the YIELD on the bonds goes DOWN. (This may seem counter intuitive. If demand goes UP for mortgage bonds then why would the yield go DOWN?  The answer is because of Principles #2 and #3.  Remember our example of the $100 dollar bond up above?  Remember, when it matures in 5 years it is going to pay $120 no matter what.  This is guaranteed.  So when demand is LOW for this $100 bond, then you might be able to buy it for, let's say, $90 bucks.  In that case, the "YIELD" would still be $120 (what it's worth when it matures) minus $90 (what you paid for it today).  In that scenario, the "YIELD" is $30 bucks ($120 - $90).  Not a bad investment.  But when demand goes UP then everybody and their kid brother is out there buying up $100 bonds like they're going out of style.  That drives up the price (See Basic Principle #3).  So now, instead of buying that same bond for $90, demand has forced the price up to, let's say, $115.  The bond still pays $120 at maturity, but now the "YIELD" has decreased to only $5 bucks ($120 - $115).  By buying up $40 Billion dollars worth of these things each month, the Fed is creating a demand for mortgage bonds that (i) increases their price on the market and (ii) reduces the amount of yield that they will pay out at maturity.)

BASIC PRINCIPLE #5: When YIELDS go DOWN, then Banks do NOT need to offer INVESTORS higher returns and therefore they can LOWER interest rates to home loan borrowers.  (And so now we finally arrive at the end result - lower interest rates to you and me for buying a home.  So let's connect the dots.  Again, going back to Basic Principle #1 - banks compete with each other to get investors to deposit money.  If you've ever shopped around for a competitive savings account that pays you the highest interest rate possible then you may be familiar with this concept.  The same concept applies to mortgage bonds.  When mortgage bonds are not in demand, then they produce a nice yield for investors as we have discussed above.  When this happens, banks have to remain competitive by increasing the return on investment to mortgage bond investors.  Unfortunately for you and I, the primary way that banks are able to offer a larger return to mortgage bond investors is to INCREASE interest rates on people who take out home loans.  The money to pay for those higher yields has to come from somewhere, and so the most logical place to make up the difference (as far as the banks are concerned) is from the home loan borrower.  The Fed is trying to reverse this phenomenon.  By buying up large amounts of mortgage bonds, the demand prices for those bonds will rise, causing yields to go down.  In turn, banks are no longer forced to charge higher interest rates to borrowers in order to pay for higher yields.  The practical effect of this is that banks will LOWER interest rates to people buying a home and/or refinancing their home.)

(for a more in depth discussion about how mortgage bonds affect interest rates, see THIS VIDEO

So there you have it.  The Fed will buy $40 Billion worth of mortgage bonds each month which will ultimately cause the interest rates on home loans to go down, which will (in theory) allow more people to buy more homes and/or refinance their homes at better rates for more equity.  And since home ownership is seen as the cornerstone of wealth-building for most Americans, the expectation is that the more access people have to home ownership then the more the economy will improve.

Is QE3 a good idea?
How do you think this will affect the economy?
If you were in the market for a home right now, would this encourage you to buy a home?
If you already own a home, would this encourage you to refinance your home?
Since interest rates are already near all-time lows right now, will this cause more people to buy homes?
Assuming that QE3 does lower interest rates, will the banks play along and lock themselves into 30-year home loans at these extremely low interest rates when they know that interest rates will rise a few years down the road?  
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