Quantitative easing

Quantitative Easing (QE) is a euphemism that means printing and borrowing money by the Federal Reserve Bank. We have been through QE 1 and QE 2 and a few months ago we started QE 3 where the Fed would purchase 40 billion a month in mortgage backed securities. QE 4 has now joined QE 3 and the Fed will purchase 45 billion a month in long term government bonds. Recall that a mortgage backed security was a group of home mortgages usually about 100 in a bundle that were sold as securities on the open market. These individual mortgages were purchased by home owners through various financial institutions and then they were sold to other investors around the world. It was joked that the buyers of these securities had no way of knowing what they were worth. The only sure way to determine the value was to open them up and have each of the individual homes appraised and this was obviously too costly and too time consuming. Imagine what this means! Sophisticated buyers around the world were purchasing securities for a set price when they had no idea what they were worth. Now after thinking that through, understand that the Fed is currently buying these securities at the rate of 40 billion dollars a month and no one is the least bit concerned. Taking a closer look at a mortgage bundle we learn some things. First of all if there are 100 mortgages in the bundle and the average mortgage is $200,000 we are talking 20 million dollar which means that there are no small investors in this market. Second say the average mortgage in this bundle has a 6% rate so the return on your 20 million is 1.2 million per year. Understand that when these bundles were most popular interest rates on things like CD’s were 1 or 2 percent. Now let us say that the value of houses drops by 20% and another 20% of these go into default so the new value of the bundle is 12 million and the return is now 3.6%. The value of this bundle has decreased from 20 million to 12 million but no one knows this. People are now just buying and selling paper. If the houses were worth nothing it would not matter. To put this in the proper perspective assume that I bring out a large box wrapped in brown paper and I tell you there is a new car inside and ask you to bid on it. What is the first question you are going to ask?