Financial Markets in Crisis: Details of Federal Reserve MBS Purchase Program

January 5, 2009

The Gibson, Dunn & Crutcher Financial Markets Crisis Group is tracking closely government responses to the turmoil that has catalyzed dramatic and rapid reshaping of our capital and credit markets.

We are providing updates on key regulatory and legislative issues, as well as information on legal issues that we believe could prove useful as firms and other entities navigate these challenging times.

This update focuses on the Federal Reserve Board’s announcement that it expects to begin purchasing mortgage-backed securities (MBS) in early January 2009.[1]

On November 25, 2008, the Federal Reserve announced three major new initiatives as follows: 

• The Term Asset-Backed Securities Loan Facility (TALF) — under which the Federal Reserve Bank of New York, with Treasury credit protection in form of $20 billion in TARP funds, will make up to $200 billion in loans to finance the issuance of asset-backed securities with underlying credit exposures consisting of auto loans, student loans, credit card loans, or SBA-guaranteed small business loans;
• The GSE Direct Obligation Purchase Program — a program to purchase up to $100 billion in direct obligations of government-sponsored enterprises; and
• The MBS Purchase Program — a program to purchase up to $500 billion in mortgage-backed securities backed by Fannie Mae, Freddie Mac, or Ginnie Mae.

Certain details of the TALF and the GSE Direct Obligation Purchase Program were announced by the Fed in early- and mid-December.  This past week, the Fed announced details of the MBS Purchase Program.  The Federal Open Market Committee (FOMC) will manage the program under the direction of the New York Fed. 

The New York Fed plans to coordinate purchases of MBS through four private investment managers, BlackRock Inc., Goldman Sachs Asset Management, PIMCO, and Wellington Management Company, LLP.  According to the New York Fed, these managers were chosen through a competitive Request for Proposals (RFP) process.  The Federal Reserve also plans to choose a custodian in the coming days.

The roles of the private investment managers have been revealed only in part.  It is clear that the managers will purchase MBS outright on behalf of the Federal Reserve and that they will do so quickly.  Fed guidance indicates that the managers will "initially" trade only with primary dealers eligible to transact directly with the New York Fed.  In addition, to prevent investment managers from acquiring an unfair market advantage in their advisory and trading activities, the Fed will require that the investment managers establish screens between the investment management team and the rest of the firm. 

But many details of the private investment managers’ roles are not known.  For example, the Federal Reserve has not indicated the extent to which it will empower the managers to purchase MBS without requiring transaction-specific approval.  In addition, it is not clear what roles the private asset managers will play in terms of determining how long to hold and when and how to dispose of MBS.

Under the program, the only securities eligible for purchase will be fixed rate MBS guaranteed by Fannie Mae, Freddie Mac, and Ginnie Mae, including 30-year, 20-year, and 15-year securities.  It does not include other mortgage derivatives or cash equivalents.  Eligible securities are fully guaranteed by the GSEs, so the Fed largely will be insulated from the risk of the underlying mortgages provided that the GSEs remain healthy. 

The Federal Reserve had originally set a goal of beginning MBS purchases by the end of 2008.  Though that goal slipped, the Fed announced today that it has begun purchasing securities under the program.  The Fed has indicated that it intends to purchase (through its investment managers) up to $500 billion in agency MBS by the end of the second quarter of 2009.

Commentators have noted that this will be an aggressive purchasing program and if it is successful, will reduce primary mortgage rates and increase home prices, which have dropped rapidly over the last few months.[2]