The problem with Operation Twist
Or should I say, another problem. Operation Twist is designed to lower long term interest rates, in order to make it cheaper or consumers to borrow the cash they need to buy more stuff. But in her conversation with David Brancaccio on the Marketplace Index today, Karen Shaw Petrou noted consumers aren’t buying anything right now, not because their loans are too expensive, but because they’re terrified about borrowing or buying big ticket items when their futures are so uncertain.
That’s the problem that calls into question the whole rationale for Operation Twist, but in today’s Financial Times, PIMCO’s Bill Gross points at the problem with the actual mechanism.
Gross notes that the banking system survives on the premise that banks can borrow at a low interest rate and lend at a higher interest rate. A bank might use the overnight market to borrow from another bank at a percentage rate of near zero, and then lend a two-year loan to a company at, say, two percent. That’s how it makes money.
But, Gross notes, by freezing policy rates for at least the next two years, the Fed is making it nearly impossible for banks to make money on debt that runs out to that maturity.
Two-year yields are the same as overnight fund rates allowing for no incremental gain – a return that leveraged banks and lending institutions have based their income and expense budgets on. A bank can no longer borrow short and lend two years longer at a profit.
Common-sensically, an observer might simply suggest that the bank lend even longer with similar risk as before the conditional freeze, but regulators frown on these maturity extensions and discourage them either explicitly via regulations or implicitly via moral suasion.
Operation Twist, which is designed to reduce rates for longer-term debt only exacerbates this problem, Gross says. Right now it’s hard to make money on two-year debt, but if rates on longer term debt fall, then it’s going to be hard for banks to make money on those longer-term loans. Which means Operation Twist may have the exact opposite effect that the Fed hopes: banks could end up lending less. This will reduce leverage in the long term (a good thing) but at the cost of stifling the economy in the short term.
Commenter John Mason puts it this way:
What Gross is arguing that the banking system will not begin lending in an aggressive way … Taking on riskier loans just does not pay in such an environment and the mis-matching of maturities produces only a minimal spread. In order to achieve competitive returns on equity, given these spreads, financial institutions would have to take on massive amounts of leverage…something that the banks themselves don’t want to do right now and something that the regulators would not allow them to do.
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