I have mentioned that the Fed has actually targeted volatility, desiring to reduce it so that investors take more risk. Remember, taking risk is inflationary while avoiding it is deflationary. A prime example of the Fed doing this is ARMs. Remember when Greenspan pointed out to home-owners how much money they were giving away in interest by holding fixed mortgages instead of flipping into adjustable rate mortgages? Why was this done?
When a home-owner holds a fixed mortgage, they hold an option, a very valuable one. At any time they can refinance when rates go lower (for a fee). This option makes them long volatility, a position home-owners have held for decades. Lenders are short this option. We have explained this in detail when talking about Fannie Mae (FNM): when prepayments occur because of refinancing, FNM must rebalance their duration and buy bonds as they are rising in price (yield falling). The more rates move around the more FNM (or any lender holding a mortgage as an asset), the more FNM must adjust; each time they do it is a cost.
When home-owners en mass flipped into ARMs, they became sellers of volatility (they gave up this option) and lenders became long volatility (exchanged convexity risk for default risk). The absolutely massive amounts of ARMs significantly reduced volatility in the bond market, which transferred into all markets.
The Fed used the home-owner to reduce volatility. VAR went down and investors took more risk.
