The WSJ has an article spelling out potential policy actions that are being debated in the Fed.  They are:

1. Operation Twist

2. Eliminate the .25% being payed on excess reserves

3. Use language to direct to convey likely policy moves, in essence state a target for for unemployment as well as inflation

4. Cap intermediaqte interest rates

Operation twist seems to be the most discussed option, potentially because of the probability of implementation but possibly just because the media finds it a slightly obscure term which the readership finds compelling.

At issue is the current slow economic recovery.  The Fed creates liquidity and the bank funnels this to the real economy.  The consensus is that banks aren’t lending.  The arguments are:

1.  There are no opportunities for lending

2.  There is too much incentive for the banks to keep money in reserves earning .25% instead of taking on some credit risk and lending to the economy for a spread of potentially more than .25%

The reality is that banks are still trying to repair their balance sheets.  They have to rebuild capital to replace losses on the MBS loans and subsequent defaults of the likes of Greece, Lehman etc.

What decision does the bank face?

The bank can lend to the Fed at .25% for 1 day, leveraged against borrowing for .09% from the Fed.  At 16:1 leverage this gives banks a return of about 2.5% essentially risk free.  This by the way is a bail out, our government is slowly just printing money and putting it into bank black holes.

The bank can lend to the gov’t for 2 years at .2% and borrow from the Fed at .09%.  Choice 1 is a better return, with less risk.  There is something called duration risk.  Banks borrow daily and lend for 2 years.  Borrowing for 1 day and instantaneously refinancing while lending that money for a 2 year term is a duration mismatch.  The possibility of borrowing rates exceeding the return on the money they lent the government is duration risk.

The bank can lend to a current home buyers for 30 years at 4.25% leveraged against borrowing from the Fed for 1 day at .09%.  At 16:1 this would yield a return on capital of 66%.  But this scenario has both duration risk and credit risk to the bank.  Short term funding could rise or home owners could default on their mortgage.  The spreads obviously aren’t justifying the risk to the banks.

Operation twist would see the Fed buying longer term debt and selling shorter term debt.  I guess the belief is that it would squeeze margins on short term lending and make longer term borrowing more readily available to the banks.  This would at least help mitigate the duration risk.  The question becomes, will anyone lend to banks, some of whom are not so credit worthy.

The idea of letting the banks fail 3 years ago was to prevent this reality of a broken conduit to money.  If these weak banks failed, their loses and assets would have been absorbed by the smarter and stronger.  These entities would have the strength to fulfill the primary service they provide to the economy, allocation of capital to growth opportunities.  Instead we are stuck with these wounded, gun-shy entities nipping at our ankles for additional fees and churning 2.5% ROE a year from Uncle Sam’s printing press.

Whatever the Fed decides, hopefully nothing dramatic, the unfortunate reality is they brought these banks back from the dead and put them on life support.  How many more months or years of card board signs from begging banks on corners across this country are we going to need to endure.



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