While Federal Reserve officials are not ruling out future MBS purchases, there are some good reasons why they decided in August to reinvest principal payments into Treasurys instead, and that may play into any quantitative easing plans going forward.

Elevated “fails” in the MBS market during the Fed’s MBS purchase program are one reason, according to Michael Gapen, director in U.S. economics research at Barclays Capital.

Fails, or fail-to-delivers, occurred because new originations couldn’t keep up with Fed purchases/forward deliveries into MBS. As Gapen said in an interview, the Fed was buying more mortgages than were being created. This made it difficult for the Fed to conclude its purchase program because it had to clean up those fails, he said.

Also when the Fed was in the agency/government MBS market, its heavy buying drove other investors into riskier, higher-yielding assets like corporates.

It also did meet the quantitative easing measure’s goal of providing stimulus — at least to the extent tight primary market loan underwriting standards allowed. Treasurys, while not as directly tied to mortgage rates as MBS, can do that, too.

The Fed “holds the view that the degree of accommodation is determined mainly by the stock of securities it holds rather than by the flow of purchases,” Gapen’s report said.

The Fed’s portfolio is likely going to continue to be heavily weighted toward MBS until the end of 2011, at which point Treasury purchases should balance it somewhat, Gapen said. He found recently that about 29%, or a little over $1 trillion, of the Fed’s portfolio is in 30-year agency MBS, while roughly 12%, or about $760 billion, is in long-term Treasurys.

Among reasons why the Fed might want a better balance between Treasurys and MBS is that Treasuries don’t have the negative convexity risk the MBS market has in terms of possibly getting stuck with lower-yielding assets that extend their duration during a rate rise — or higher-yielding assets that will have their duration shortened by prepayments when rates fall.

Gapen’s recent reports suggest quantitative easing strategies the Fed could pursue going forward could either be a “shock and awe” strategy involving a big investment to jump-start the economy or perhaps more likely an incremental one than in the past to minimize market disruption.

Were the Fed to pursue a “shock and awe” strategy with quantitative easing in the future, Gapen said it could buy in a range of up to $500 billion to $1 trillion over a six- to 12-month period that he thinks could meet its easing goals.

Another $500 billion in long-term Treasury purchases would put the Fed’s stock of agency MBS at about 19% by the end of 2011 compared to roughly 20% in Treasurys.

That’s all well and good. But in the mean time, the fact that stimulus from lower rates — no matter what’s driving them—is only going to have a limited effect due to aforementioned tight underwriting remains a dilemma.

Gapen suggested in an interview that there could be surgical targeting of structural impediments to lower interest rates such as perhaps a careful lifting of credit scores at Fannie Mae and Freddie Mac to benefit average borrowers in some circumstances.

When asked if even a slight loosening of underwriting standards might still be a tough political sell given the persistence of the recent downturn, Gapen noted that given government officials’ willingness to subsidize losses at corporates, giving more breaks to average homeowners could be seen as reasonable at some point.

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