The Fed has said the reason it is buying the MBS is to push down interest rates in order to prop up home prices, reduce the number of foreclosures, and enable more people to buy homes. This is being done in order to encourage more home construction and related employment.
Assume you acquire a new mortgage or refinance your existing mortgage at a rate close to 3 percent through your local bank. Chances are the bank will decide not to hold on to your mortgage because, after inflation and servicing costs, there is little or no profit — the bank made its money on the origination fees. The two large government-sponsored mortgage companies, Fannie Mae and Freddie Mac, buy many mortgages from banks and other financial institutions. IfFannie Mae buys your mortgage from your bank, it will then combine it with other mortgages to create a MBS and then sell these bonds to buyers around the world.
The Fed has become the largest single purchaser of MBS from Fannie and Freddie. The Fed pays for the MBS by creating money — that is, Fannie sells your mortgage and the others in the MBS and receives a credit on its account at the Fed for the amount of the MBS. The asset side of the Fed’s balance sheet is increased by the value of the MBS, and the liability side of the balance sheet is increased by the amount of new money the Fed issued to pay for the MBS.
Now remember that the Fed is a government institution, fully owned by citizen taxpayers. The dollars it creates only have value to the extent people believe that the Internal Revenue Service can extract real wealth from taxpayers to equal the value of the new dollars being created. Either Congress will have to vote for more taxes (or engage in less spending) to obtain the wealth to cover the new money, or the Fed’s printing of money will cause inflation, thereby reducing the value of the money that individuals and businesses have or receive in exchange for the government bonds they have purchased.