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Twist and shout... and cry

Open the spigots! The European Central Bank

On Wednesday of last week, the Federal Open Market Committee (FOMC) announced that it would attempt to aid the US economy by extending the duration of its portfolio, effectively performing what the market has dubbed “Operation Twist” (OT). Quoting from the Fed's announcement: “The committee intends to purchase, by the end of June 2012, $400 billion of Treasury securities with remaining maturities of six years to 30 years and to sell an equal amount of Treasury securities with remaining maturities of three years or less.”This $400 billion is a substantial sum as it actually represents about a quarter of the volume of Treasuries held by the Federal Reserve Bank.It also intends to impact the long-end of the yield curve by driving longer term rates even lower. The Fed did not announce another round of what is called quantitative easing; they are essentially not expanding their balance sheet at this point. The market didn't like the Fed's reference to there being “significant” downsize risks to the economy due to problems in “the financial markets”, essentially acknowledging the horrendous problems in Europe.So what effect may this have in general and, more importantly, on Bermuda? I think it's important to consider three aspects:1) Housing market. One major intention of lowering the longer end of the yield curve and long term rates is to help support the housing market. This in my opinion is not going to be very effective. Firstly, it is unlikely that 30-year mortgage rates which are already extremely low in the US will fall substantially because at some point risk needs to be priced. The lender needs to make money so they are unlikely to continue to drop rates in lock-step with Treasury yields. This is also true in Bermuda. Bermuda mortgages are not US mortgages.The loan officer here prices rates to reflect the specific risks and environment in Bermuda which arguably could be assessed as higher than in the US due to the countries more closed and less economically diversified locale.Secondly, it is not the stated mortgage rate that ultimately matters; it's the “real yield”. In this case I'll give you a quick example. The real rate for a mortgage with a three percent rate on a property that is depreciating four percent a year is minus one percent. Who would want to borrow at ANY rate on a rapidly depreciating asset? Rates are important but price even more so. Finally, with nearly 30 percent of mortgages underwater in the US lower rates will not help refinancing until principal balances are reduced.2) Banking. The initial take by many is this will simply flatten the yield curve and make it more difficult for banks to earn interest income. Banks essentially make money through the difference between short rates and long rates the larger the spread the more the profits. This is true over time as yields that are held lower for prolonged periods will ultimately lower the gross amount of interest income the banks can earn, including Bermuda's local banks. This further hampers future revenue generation. Some analysts suggest OT is actually a form of a stealth bailout in that the Fed is now buying (mainly from banks) long dated Treasuries which have rallied substantially and enabling banks to book substantial gains while at the same time reducing their duration risk. This too makes sense. So we could see a short-term benefit followed by a potentially reduced operating earnings potential. Another negative of keeping rates pinned near zero on the short-end is obviously the detrimental effect it's having on money market funds. In Japan, there are no money market funds. In fact it makes little sense from a bank's perspective to run one when the cost exceeds your revenue. Since the Fed has guaranteed to keep short term rates pinned near zero until 2013, money market divisions of local Bermuda banks are not likely to generate substantial revenues net of cost and in fact they will likely see further attrition in assets as savers migrate into areas of higher return.3) Property & Casualty Insurance. Bermuda's property and casualty sector earns income on what it is called the “float”. As a very simple example, companies typically borrow “float” in the form of premiums and then pay out expenses and claims. If one assumes expenses represent 30 percent of premiums and claims represent 70 percent, the company can pay expenses immediately and then invest the remaining 70% in investments. For P&C insurers these investments tend to typically be high quality bonds with shorter maturities. Currently, bond books for these insurers are experiencing record low yields.Given these low levels it would not be unreasonable to assume that low investment income may inhibit P&C insurer profitability on a multi-year basis. It also greatly increases the risk of underwriting error as excessively low rates provide virtually no cushion for underwriting that is not consistently profitable.The near term irony is that there should be mark-to-market gains on the bond books due to the general rally in the bond market. However, it is unlikely that P&C firms will realise a large portion of these for tax reasons and it would simply reaccelerate the ultimate decline in yields on their investment book. All new money will, unfortunately, be investing in substantially lower yields. Lower potential investment income only exasperates the problem of insufficient pricing.Three Fed governors didn't want to dance and dissented. They clearly feel that all this Fed tinkering is not necessary and ineffective at this point. We have to agree. Unfortunately no matter how much the Fed shakes it up, twists or shouts it is unlikely to affect the course of the economy. Ultimately, the Fed's policy moves were more to do with being seen as doing “something” rather than getting concrete results. Housing affordability and cheap financing is not the issue. It is a sense of confidence and optimism that is restraining advancement, coupled with the slow and grinding debt-deleveraging cycle that has started in the private sector but yet to begin in the public sector. This takes a great deal of time.There is only one central bank that can, at this stage, affect global confidence and the world economy: the European Central Bank. Those bankers need to open up the spigots and print like mad. What we really need is QEE (“Quantitative Easing Europe”).