Gorton with a Twist

In yesterday’s post, I talked a little about Gorton’s idea of “information insensitive” debt. Well, this framework might be a good one to interpret some of Bernanke’s “unconventional” monetary policies, especially those concerning the purchase of agency mortgage backed securities and long-term U.S. treasury bonds. Of course, QE1’s objective was to restore some liquidity to wholesale short-term credit markets, such as repo and commercial paper, by taking off weak banks’ balance sheets a large amount of mortgage backed securities. A couple of years later, the Fed began “Operation Twist,” which was about buying long-term treasury bonds by selling the Fed’s holdings of short-term bonds, with the purpose of reducing the average maturity rate of treasury bonds held by private agents.

Why? Well, I have no definitive answer, but one possibility relates to these short-term credit markets. Specifically, traditionally, banks operate by borrowing short and lending long. Similarly, banks accumulated large numbers of treasuries as a means of collecting collateral to back debts borrowing on the wholesale credit market (a role that MBS’ and other related assets played prior to late 2007). But, long-term treasuries mature over the long term, and so Operation Twist can be interpreted as a means of forcing the private market to accumulate short-term assets, which means that banks would be borrowing short and lending short. In other words, it’s a method of reducing the chance of maturity mismatching, and the consequent drying up of wholesale credit markets, by making private assets better suited for what banks intend them for.

What is interesting about Operation Twist is that, usually, the opposite is considered preferable. That is, governments prefer to lengthen the maturity of their debt, to avoid having to roll over debt on terms that may become increasingly unfavorable. For the United States, of course, this may not currently be a problem.

Also, this explanation should take away from a common narrative that the Fed is purposefully pushing down interest rates on U.S. treasuries. I’ve taken some flak for not supporting this anti-Fed position, but I simply don’t think it’s very credible. The fact is that after the 2007–09 crash there was a spike in private demand for treasuries, because there was a dearth of safe assets after the collapse of the mortgage market. Even currently, there are really no private assets that are as safe as treasuries. The only caveat is that investment banks haven’t really recovered, in the sense that they haven’t recovered their status, so I’m not sure what wholesale credit markets look like currently. Without a doubt, though, a major concern of the Fed has been to revive these markets (as opposed to supporting fiscal policy by monetizing debt).

P.S. Just to get an idea of what wholesale credit markets currently look like, check out the status of asset backed commercial paper (ABCP) outstanding,


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