Chart Of The Day

How the Fed Will Force a Mispricing of Risk

By Walter Kurtz, Sober Look

Credit Suisse has made an important point with respect to the Fed’s purchases of MBS. As we know, a mortgage borrower is long an option to prepay. That means a mortgage lender is short this same prepayment option. Therefore a buyer of MBS is an options seller and the Fed is in effect selling vol into the market.

CS: – It is important, in our view, that the Fed continue to sell volatility – explicitly or implicitly – into the markets. This is at the heart of its quest to reduce term premiums and hence term interest rates. Buying mortgages results in a direct sale of volatility (prepayment risk) to the public. Extending the rate guidance to “mid 2015” represents an implicit sale of volatility – the Fed is giving up the option to hike (arguments about the Fed’s ability to renege notwithstanding).

Source: CS

Of course this is quite similar to the ECB’s implicit put option on periphery debt (discussed here). As we’ve learned the hard way from the so-called “Greenspan’s put”, artificially suppressing volatility creates a “moral hazard” by forcing markets (including individuals and businesses) to misprice (and learn to ignore) risk.

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