The Implications, Intentions, and Likely Outcomes of “Operation Twist”

by Benjamin Fendler on Oct 14, 2011

On September 21 the Federal Reserve Board (FRB) announced that it would undertake further monetary stimulus in an attempt to revive the staggering economy. The FRB made the announcement after their Federal Open Market Committee (FOMC) meeting, one of eight such meetings held each year to set monetary policies in accordance with the FRB’s “dual mandate” of fostering maximum employment and price stability. To achieve these goals, the Board has a number of policy tools at their disposal, aimed at lowering long- and short-term real interest rates, rates on U.S. Treasury securities of varying maturities, and conventional mortgage rates. Since December 2008, the central bank has purchased $2.3 trillion in longer-term Treasury securities, agency debt, and mortgage-backed securities in an effort to lower longer-term interest rates, including mortgage rates.

Their most recent action is called “Operation Twist,” named after the dance “The Twist”, a dance popular when an operation of comparable mechanics was first (and last) utilized by the central bank. Under Operation Twist, the FRB will purchase $400 billion of Treasury securities with remaining maturities of 6 years to 30 years and sell an equal amount of Treasury securities with remaining maturities of 3 years or less by the end of June 2012. In their notes, the FRB says Operation Twist is an effort to push long-term interest rates down and encourage lending, especially when it comes to home loans. By reducing the supply of longer-term Treasury securities in the market, this action should put downward pressure on longer-term interest rates.

A “FAQ” document posted on the FRB’s website, said the program should help lower costs for home loans, corporate bonds and other consumer and business lending. Specifically, the FRB projects a reduction in long-term interest rates of between 10-20 basis points as a result of the operation. The FRB, under Operation Twist, will also reinvest principal payments from its holdings of agency debt and mortgage-backed securities into additional mortgage-backed securities in order to further reduce mortgage rates.

The goal behind the low mortgage rates policy is based on the hope that low enough mortgage rates will spur consumers to either invest in new properties, or refinance their current mortgages to lower interest rates. Encouraging consumers to buy new homes could reduce the supply of homes on the market and increase housing prices. Stimulating refinancing activity can lead to further economic stimulus, as consumers would have more money in their pockets each month to spend on goods and services, as well as reducing the high rates of foreclosure across the country by easing the payment strain on borrowers – by modifying loans that are past due or by refinancing performing loans at lower rates.

Operation Twist could offer a range of additional positive and negative benefits. The policy could spur taxable investors to flee to the municipal market seeking the higher absolute yields offered by municipal bonds. For municipal issuers of single-family and multifamily housing bonds, such as state and local housing finance agencies, increased demand in the municipal market could reduce their cost of borrowing. However, a flattened yield curve would mean lower bank profitability as banks’ net interest margins narrow. Additionally, those holding long-term bonds are likely to see their interest income dip.

In order to determine how effective Operation Twist will be at reducing mortgage rates, and eventually at reviving the stagnant housing market, we must review the bank’s past performance. To do so, we can begin by looking at a graph showing the number of mortgage-backed securities held by the FRB and compare those purchases to the 30-year fixed mortgage rate over the same period. The graph shows that since QE1 (when the Federal Reserve first began purchasing mortgage-backed securities), mortgage rates have declined in a relatively consistent manner. We can also see that the reason for the reduction in mortgage rates is not as important as the fact that the rates continue to decline. Therefore, we can be relatively confident that mortgage rates could continue to fall in the months during which the FRB carries-out Operation Twist (even if Operation Twist is not the reason for the decline).

To determine how effective low mortgage rates will be in reviving the stagnant housing market, we have to look no further than a study the FRB released last week. The study shows that the low mortgage rates in 2009 and 2010 did not lead to as much home refinancing as anticipated. Many borrowers have not been able to take advantage of the near record low interest rates because they have little or no equity in their homes, according to the study. In addition to this, credit conditions remain tight for many consumers and investors interested in buying or refinancing residential real estate; people holding high-rate mortgages fail to qualify for refinancings because their loan-to-value ratio is too high, their credit scores are too low or they don’t have sufficient income. Finally, the lack of sufficient numbers of buyers and sellers can hinder price discovery, increasing the uncertainty already plaguing consumers about the “right” price for real estate. This could mean that refinancing activities are not likely to increase substantially under the new program, regardless of their level.

It seems as if reducing mortgage rates to increase consumer demand for homeownership can do little to combat the factors affecting the supply side of the equation. Factors like overbuilding during the housing bubble, in addition to high levels of foreclosures have both resulted in a national housing inventory that is bloated. Without a reduction in the supply of homes on the market, FRB policies to stimulate demand are nearly useless. And while plans to turn real-estate owned (REO) or agency owned properties into rental units has been floated by the Administration and congress, the hope of any real action any time soon is unlikely.

We know that in past recessions housing has helped to lead the country out of economic duress; oftentimes, it has even helped to catalyze strong economic recoveries. However, low mortgage rates have failed to increase new or existing home sales, both of which remain at near record low levels. The reality of the situation might unfortunately be that the FRB faces more difficulty in revitalizing the housing market than it does in its other primary task; that of creating more jobs in the stagnant employment market.

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