Every one was expecting - or may be hoping - that Ben Bernanke would do something different to jump-start the US economy, after the failure of two rounds of Quantitative Easing. In typical Bernanke style, he had already taken much of the surprise element off the table by hinting at an Operation Twist. But when the actual announcement was made, global markets reacted negatively.
What exactly is this Operation Twist? Here is KKP's spin on it.
--------------------------------------------------------------------------------------------------------------------------Is the Fed Twisting the Future?
The US Fed announced Operation Twist. What is the Fed ‘twisting’? Most people that I have talked to (average Americans), do not even know this stuff was announced and going on (poll based on discussions with my neighbors at a party on Sat. Sep 24 ‘11)!
Basically, the Fed never does anything that affects the long term bonds or bond rates. Rates are already so low that for those who wanted to refinance, they have already done so. Fed always assumes that when it lowers the short term rates (which is the only thing in its control), the banks will react to the message that goes along with the rate change (at the FOMC meeting), and adjust the mortgage rates which are linked to the Prime Rate (usually).
The Fed also said that when mortgage-backed securities (MBS) that it owns right now is paid off, it will roll the money back into new securities that are linked to mortgages. This means, it is also now trying to affect the mortgage rates, which would also go down with this move so that people can lower their mortgage payment (EMI) and spend the extra cash flow that they have received (and people here in the US sure do so).
The idea being that with lower interest rates on housing (long term rates of 10, 20, 25, and 30 year mortgage terms), people who are thinking about upgrading their homes would start going after a bigger loan and buy new homes. Once the housing boom starts, there are tons of businesses that get the support needed and, hence revive the economy. Homeowners who have a lot of home equity and are current on their mortgages may also be given an opportunity to refinance, freeing up cash flow that could be spent on buying a car, upgrading the home, and/or paying off other high interest loans.
The issue is that lower interest rates, or lower price of homes has not really triggered a buying frenzy. That is because of two reasons. First, banks are scrutinizing loan applications with a super-high-standard. Everything has to be too perfect on the loan application, and any small element that points to risk, means that the loan officer rejects the loan. Second, people who need new houses, and have one (or more than one) family member that may not have a job, or might have a weak job-income, or might not have the feeling of being secure in their current job, do not go out and make a big house commitment.
A case in point is a single woman with a good job who wanted to buy a $325,000 home with $50,000 down payment, and $275,000 in loan was denied. This is according to one of our neighbors who is livid about how the banks have tightened their purses for some unknown reasons. Corporations, Banks and People (who have cash), are all ‘holding back’ due to the unknown future. This is actually creating a ‘bigger’ issue than what it would really be. So many of us are living normal lives in this recessionary environment, but we all have a fear of the future, which is what makes all of us spend less, conserve more, and wait for a brighter day (my personal situation is different, since I am capitalizing by buying real estate, which is exactly what the government is trying to do by keeping short term interest rates near zero).
Fed wants banks to loan money, which is why they had provided the TARP funding. A lot of the TARP funding is being returned by the banks. There are announcements that show this return of funds that is on-going, and even a couple of bank VPs told me this in confidence. They are afraid to tap into it, loan the money, and lose profits (and capital) by loaning it to someone, specially if the economy gets worse. In reality, the central bank requires banks to keep a certain level of reserves on deposit at the Fed. Legislation passed in 2006 permitted the Fed to start paying interest on those reserves starting in 2011. This requirement of reserves and ratios by the Fed makes the loan officers reluctant to give out loans to people with the smallest risk.
Group of 20 finance chiefs are pledging to address rising risks to the global economy and are “committed to a strong and coordinated international response to address the renewed challenges facing the global economy,” confirmed in a statement in Washington. These officials cited “financial system fragility” and “heightened downside risks from sovereign stresses” among the threats to growth. They said they will ensure banks are adequately capitalized and have access to liquidity, while reiterating an aversion to volatility in the currency markets. This support model is what we need to keep our world spinning and continue e-commerce for the world to survive. It is amazing that we are fearing a collapse when there is everything in abundance!
So, all in all, what is the ‘twist’ in the Operation Twist? The twist really is that the Fed is trying to affect long term rates or mortgage rates without really dipping in any huge way into a QE3, which would have affected how investors around the world view the US.
Daniel Gross’s Upshot View: This move by the Fed is better than doing nothing. But there's no reason to think it will make the difference between unsatisfying and satisfying growth.
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KKP (Kiran Patel) is a long time investor in the US, investing in US, Indian and Chinese markets for the last 25 years. Investing is a passion, and most recently he has ventured into real estate in the US and also a bit in India. Running user groups, teaching kids at local high school, moderating a group in the US and running Investment Clubs are his current hobbies. He also works full time for a Fortune 100 corporation.
