Let me start from the beginning and give you a basic and complete walk through explanation of what the Federal Reserve is doing with operation twist.

What is Operation Twist? “Operation Twist” is a form of flattening the yield curve. The reason why the Fed would want to flatten the yield curve is because they want to lower long term interest rates because longer term interest rates are what is tied closely to business expansion (capital investment), mortgage rates (home buying, refinancing, etc), which in turn can lead to more consumer disposable income, job creation, etc.

Why do Operation Twist? Traditionally the fed simply lowers the target fed funds rate, lowers the discount window rate, etc. The issue is….well we are pretty much rock bottom. In addition, the fed manipulates the markets by injecting more money into the system, or as some “anti-feds” may say; print money. With such actions come an increase risk of inflation. Operation Twist, in theory, allows the fed to manipulate long term rates without increasing the money supply.

How does Operation Twist Work? What the Fed will do is sell short term bonds. The Fed announced they will sell 3yr bonds and shorter and use these funds to purchase longer term bonds; between 6 and 30years. The total amount of “money” being shifted is $400 Billion. The act of selling short term bonds will increase the supply of short term bonds, therefore lowering their price (law of supply & demand). This will increase the yield (rate of return) on short term bonds. The action of buying longer term bonds will decrease the supply on the market (law of supply & demand) and therefore drive prices of long term bonds up which in turn means yields will decrease.

Specific $ Details:

$400 Billion Dollars

3 Year & shorter term to be sold to finance longer term

6 to 30 Year considered longer term; financed by short term sale

Market manipulation to be completed by June of 2012

Other Fed Actions: The Fed also plans to use principal payments received from their held mortgage backed securities to purchase more agency mortgage backed securities. The hope here is to directly impact the mortgage market to increase liquidity and lower mortgage rates. In very basic terms here is what they’re going to do. Essentially, every month the Fed receives mortgage payments for the mortgages that they current hold (held as Mortgage Backed Securities, MBS). Part of these payments are interest, while the other part is to pay down principal. When principal is paid down it means there is now that much more money to lend out. Instead of the Fed holding onto that money, or injecting it into the system through treasuries, they will utilize these funds to purchase more mortgage backed securities.

Why Should the Fed Reinvest in Mortgage Backed Securities: Mortgage Backed Securities market provides new funding for roughly 90% of refinances and new home loans. Traditional buyers of such products were hedge funds, pension funds…the list goes on. During the financial crisis this was one of the first markets to dry up. Demand dropped quickly. No one wanted to own a mortgage backed security, it was toxic! This market still has not recovered and demand for mortgage backed securities remains low especially among low returns. The Fed’s action of rolling over principal back into the market means it will start to soak up supply of agency MBS which is a huge relief! While many analysts and traders do not believe this will lead to dramatically lower rates (if any lower at all) it will still help stabilize the market.

Will Operation Twist & the Feds actions help the housing market? In my opinion No. Rates are very low right now, very low. I have two buyers closing next week and both are locked in at 4.35% on a 30yr fixed. That is pretty darn cheap. If we assume that Operation Twist and the Fed’s Actions of buying agency MBS lower rates from 4.35% to 3.9 or 4% what will happen? Unfortunately not much. What it will most likely do is push some people off the fence who were already very interested in buying but just need a little nudge to the buying side. This might do that. However, this demand was essentially already there.

Imagine you’re selling cheeseburgers to a crowd of people. If you’re asking $2 for a burger some people will buy and some won’t. If you lower the price to $1.50 you will probably get some more buyers who were already hungry, but would someone who just ate dinner buy your burger? Probably not. All you would accomplish by lowering your burger prices is get people to buy a little quicker. These people probably would have paid $2 in a hour or so once they got hungry enough.

The same is true with the mortgage market. Rates are so cheap as it is that rates are not the problem! The problem in the housing market are many other factors. Potential buyers are concerned about their jobs, housing prices falling more, their inability to qualify for a mortgage, etc. These are the impediments holding people back, not interest rates. If we do get lower rates, we will see a small quick bump up in demand but it will be short lived.

Refinance: We will see an increase in refinance numbers as well. However, those who really NEED to refinance cannot because their homes are under water. You can lower rates to next to nothing, but if the people who need to refinance the most can’t, then it doesn’t matter.

Markets are Not Down because of Fed Decision: To the idiots who keep saying the markets are down because of the feds decision this is completely false. The markets had already priced in Operation Twist. In recent weeks it was pretty much expected and baked into the numbers. QE3? No, no self respecting investor or trader was truly expecting the Fed to come out with QE3. Why was the market down? Well, Europe isn’t helping any, we had wonderful downgrades by Moodys (don’t even get me started on that) and the Fed did some extra talking too! In the Fed’s statement released along with Operation Twist & their MBS decision were comments that held a very negative bias as to the outlook for the economy. This is what pulled the market down, not the announcement of Operation Twist and the purchase of MBS.