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06/18/12 - We Answer Questions - Operation Twist

Now and then we get questions from our friends and family, and we try to answer them. Here is our answer to two related questions: What are bonds? and What is Operation Twist?

1) Bonds are just loans. If someone, usually a company or government entity, wants to borrow money, they can write down promises to repay in the form of bonds which are legal documents, contracts, that state:

  • a) A certain sum must be paid on a certain future date
  • b) Certain sums of interest must be paid at certain intervals
  • c) The borrower may repay the loan early, but not before a certain date, the call date
  • d) This is a contract since a, b & c are because the borrower received a certain amount when the bond was issued.
A bond is a fungible instrument. It can be bought and sold. Typically, the borrower engages a bank or other financial firm to serve as the underwriter. The underwriter is responsible for rounding up the money to be lent. Underwriters usually have clients who are looking for investments, so they'll typically arrange to sell their clients a lot of the bonds before the issue date, the day the borrower gets the money and the lenders get their bonds. Even they can't sell enough bonds, the undewriter is still obligated to lend the full sum, so they try and sell as much of the loan as they can up front.

A lot of financial instruments use the same structure. If you buy a CD at your bank, you get a certificate of deposit which is basically a bond saying you'll get your money, your principal, back on a certain date, and you'll get interest at various intervals up until then. If you borrow money and sign a promissory note, you promise to repay and to pay interest. A mortgage is just a promissory note wrapped up with land and a house as collateral. A treasury note is just a bond issued by the federal government. Corporate bonds are just bonds issued by corporations.

You'll notice that most of finance is about money now and money later, so it's mainly about how money travels through time.

Also, there are a lot of names for the same thing. The distinctions are usually historical. On the sidewalk it might be an IOU; 20 floors up it's a bond; if there's real estate as collateral, it's a mortgage. (The real in real estate comes from the same root as royal, not realize.)

2) Operation Twist is based on the segmentation of the market for treasury notes and the fact that the US government cannot go broke.

Despite what the deficit scare mongerers say, the US government cannot go broke. It can always print more money. This means that federal debt is the safest game in town. (Look at what happened when one of the rating agencies cut the US credit rating; interest rates went down making it even easier to borrow.) Since interest rates are based on the level of risk of repayment, the treasury pays the lowest rates at every time scale. All other interest rates are based on these. A lender always has the choice to lend to the government or to some riskier party, but they expect higher interest payments as a premium for accepting the risk of losing their money.

The federal government borrows money at many different time scales, so one can buy government bonds with periods ranging from 30 days to 30 years. The short term notes, for a year or shorter, are mainly used for parking big lots of money safely. Large bank accounts are not FDIC insured, so if you have a million dollars you might need at any time, you'd constantly be buying and selling, 30 or 90 day notes. If you are a pension fund and are trying to meet your 2040 obligations, you might buy 20 or 30 year bonds. Most business lending is in the 10 year range so the interest rates on business loans are roughly tied to the 10 year government rate.

The goal of Operation Twist, also called quantitative easing, is to lower the 10 year government rate by manipulating the market for government bonds. The idea is that the Federal Reserve owns trillions of dollars of treasury bonds, more than anybody else, so they are big enough to influence rates across the board. Operation Twist has the Federal Reserve selling their 10 year bonds and buying 30 year bonds. This should lower the rates on 10 year notes and raise them on 30 year notes. Lower rates on 10 year treasury bonds should mean lower rates for loans across the board. Lower rates should stimulate the economy.

This would usually be the case, except that interest rates are already very low, and the economy has lots of other problems. If you account for inflation, federal interest rates are negative, meaning that the lender is paying the government to hold his or her money. It isn't clear they can go a lot lower or that this would have much effect. Also, businesses consider other factors when deciding whether to borrow money or not, for example, many of them are worried about their customers, and their customers are worried about their jobs and the size of their paychecks. It doesn't make sense to expand if no one is buying now.

Keywords: historical, art, science