Historians say that if we are unable to learn from the past, we are condemned to repeat it. Economists, who study the dismal science, may simply believe that we are condemned. While I hold those who study these two influential and important social science disciplines in great respect, I like to embrace a more sanguine view.
Consequently, when I heard bond guru Bill Gross of PIMCO briefly mention a so-called “Operation Twist”, conceived and executed by the US Treasury in 1961, I was intrigued. The original Operation Twist was developed in response to the need to lower long term borrowing rates, in order to encourage investment and grow the economy, while at the same time raising short-term rates to reduce downward pressure on the dollar. Essentially, it was an effort to purposely invert the yield curve. Thus the ”twist” in Operation Twist.
A similar form of intervention is now being discussed in response to the astounding and rapidly evolving meltdown in the residential and commercial mortgage markets. Thornburg Mortgage, a non-agency mortgage lender to prime, credit-worthy borrowers is now struggling for its very existence. Even agency mortgage securities, those guaranteed by Freddie Mac and Fannie Mae, once thought to be one step removed from the federal government itself, are trading at distressed levels – if they trade at all.
As a consequence, the average weekly mortgage rate for a 30 year fixed-rate mortgage increased by over 50 basis points between February 4th and February 28th. This came in spite of the Fed’s back to back short term rate cuts 0f 1.25% in January, the most aggressive rate cuts in years, and the market’s widespread belief that the key rate will be cut yet again at the Fed’s next meeting on March 18th.
This lack of confidencein non-agency and even agency mortgage securities is causing interest rates to increase rapidly on home mortgages at a time when the economy and the housing market can scarcely afford it. In turn, this is putting further downward pressure on home prices. Put quite simply, as mortgage costs increase, the amount of home that people can afford to buy decreases. So they offer less, and the negative value feedback loop continues.
By all indications, this asset dislocation appears to be of historic proportions. Doubt in the markets about the viability of formerly sacrosanct “government agency” entities to fulfill their financial obligations is causing huge dislocations in the capital markets. Entire tracts of our financial system are at risk, and the continued health of our economy is hanging in the balance. The correction of the housing bubble has clearly reached levels that policy makers did not previously imagine, and tremendous asset deflation is happening now.
In a 2002 speech to the National Economists Club, Ben Bernanke, then a Governor on the Federal Reserve Board, pointed out that the consequences of asset deflation were dire, not unknown, and involved “years of painfully slow growth, rising joblessness, and apparently intractable financial problems in the banking and corporate sectors.”
In an effort to avoid this, he said then that he believed one of the primary options available to the Fed was the option “to use its existing authority to operate in the markets for agency debt (for example, mortgage-backed securities issued by Ginnie Mae, the Government National Mortgage Association)” in order to prevent the widespread detrimental effects of asset deflation.
in 1961, Operation Twist involved the Fed operating directly in the long term securities markets with the express purpose of lowering long term borrowing costs, including mortgage costs, in order to prevent asset deflation. Hence, there is historical precedent for this, and I believe the Fed needs to step in again and offer financing for residential and commercial mortgage securities either directly or through its newly expanded Term Auction Facility, and soon.
Those who hold the levers of power have contemplated and studied just such a scenario, and now it is time to act. If not, we tax payers ought to seriously question the wisdom of the policy makers in whom we have entrusted our national well being.
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