Note to Readers: This updates the previous related post Fixing The Mortgage Mess: an Old Twist?, which was written just before the Fed actually Twisted.
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” last week, I was intrigued. The original Operation Twist was developed by the U.S. Treasury in 1961 in order to lower long term borrowing rates, in an effort to encourage investment and grow the economy, while simultaneously raising short-term rates to reduce pressure on the dollar. Essentially, it was an effort to purposely invert the yield curve. Thus the ”twist” in Operation Twist. Part of the operation involved direct intervention in the market for residential mortgages.
Today, the Fed announced a similar, albeit incremental form of intervention in response to the astounding and rapidly evolving meltdown in the housing market. In response, the dollar soared and there is now some hope that the costs of longer-term borrowing will be reduced.
Why it took so long is hard to fathom. Thornburg Mortgage, a non-agency mortgage lender to prime, credit-worthy borrowers is 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.
Doubt in the markets about the viability of formerly sacrosanct “government agency” entities to fulfill their financial obligations has caused huge dislocations in the capital markets. The correction of the housing bubble has clearly reached levels that policy makers did not previously imagine, and tremendous asset deflation is shaking markets worldwide.
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, highly destructive, 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, to ignite economic growth. Hence, there is historical precedent for this recent Fed move, and hopefully it’s not too late to avert the dire consequences Ben Bernanke described in 2002.
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