Guest Post: Another Call For The Fed To Raise Rates, So Big Banks Can Start Lending And Hiring Again

Tyler Durden's picture

Submitted by Taylor Cottam of Economy Politics

Another Call For The Fed To Raise Rates, So Big Banks Can Start Lending And Hiring Again

As we explained in our previous article Seeking an interest rate solution,
real interest rates are negative and nominal short term interest rates
are near zero. That is not healthy. What is a healthy interest rate? My
view is that short term rates should be above 1% to make them positive
and closer to 2%.  It has caused consumer credit to contract. 

Of course, banks would argue that a healthy spread is the key to a
healthy banking sector.  Raising the rate would likely flatten the yield
curve.  What gives? 

How banks really make money

Banks are not in the business of making loans per se.  They are in the
business of making more off their assets than their liabilities.  In
normal times, underwriting consumer and business loans are the best
avenue for them to pursue that goal. 

Banks, and many hedge funds, really make money off the yield curve. They
have assets with a higher duration than their liabilities. Although
banks fund their assets with a mix of checking, demand deposits and some
longer dated term deposits (CDs), they have the ability to swap out
longer term deposits (CDs) to make their liabilities duration almost
zero. Their assets, which are typically loans to consumers and
businesses, have a longer duration.  Since the yield curve almost always
slopes upward, they make money off the yield curve spread plus the
credit spread. 

In 2008, I did some modeling for a large financial institution that had
duration of liabilities of roughly 3.5 years, based upon mostly term
deposits. They were able to bring the duration on their entire
liabilities portfolio down to a duration of less than 0.25 (3 months) by
transacting a simple fixed for floating amortizing swap based upon
their CD maturity schedule. Every quarter, with the 3 month rate sunk
below 25 bps, we would receive a large cash settlement from our
investment bank counterparty. I didn't stick for the full term of the
swap, but on a 1.5 BB principal, our estimate of earnings from the swap
alone stood at $100MM over three years. Based upon where short term
rates have stayed, they could have made 1.5 times that.

With our cost of capital below 25 bps, we did the thing that any
rational person would do.  We stopped lending to people and
businesses and lent to the US government instead.  We bought Treasuries.
In this case, the 5-year yields were above 2% bringing our expected
risk free spread above 2 points.

In 2008 and 2009, when it became obvious that Bernanke would likely
leave short-term rates low for an extended period of time, yield curve
risk became an afterthought. Those actions have been largely vindicated.
If we held the Treasuries for at least three years, the term of the
swap, we would just sit back and make money off the spread without
having to originate a single loan.

You get to be a bank, without having to do any work to originate loans.
Who needs a large origination group, when you can make a ton of money
and fire half of your employees?

Pushed or Pulled into Treasuries

During the recession there was often talk of a flight to quality.
Investors would flee risky assets and go into something safe. However,
investors are not always being pushed, they are often pulled. During the
recession, we began seeing a very steep yield curve. The spread
investors are as much lured by the allure of easy money with a steep
yield curve as they are by the fear of risky assets.

You can see that just parking your money in Treasuries from the
beginning of 2008 all throughout 2009 and most of 2010 has yielded the
same spread as AAA and almost BAA lending throughout much of the 1990s.
The point is that a 2% yield is respectable. To be able to do that with
almost no credit risk and without an origination team is enviable.

Which way do I punt?

The nominal spread cannot be looked at by itself in a vacuum. On a
nominal spread basis, the difference between the 3 month and the 5-year
was near historically high levels. However, because the short term rates
were so low, it made the spread much more attractive, and brought the
5-year at almost 20 times the interest rate on the three month.

The spikes you see are for months where the reported price is
effectively zero. The closer the short term rates are to zero, the
greater that spike is going to be. It is clear to see that these rates
are not the norm.

That is important because a primarily long only investor, like a bond
fund or a pension fund, might find it attractive (given the outlook on
interest rates) to borrow and invest and capture that spread. Taking
some yield curve risk and capturing a small nominal spread becomes more
attractive as the nominal yield on the long bond falls.  A 2% nominal
spread to juice up returns is more attractive when the long rate is 3%
than when it is 10%. 

In fact, I would argue that the combination of low short term rates and a
steep curve make it more attractive to be a spread investor than long
only.  So forget the peanuts you can make by investing in risky credit
assets.  Make money off the treasury spread instead. 

Why invest in risky assets if we can make money on the risk free?

That's why it is almost impossible to cure the credit market when there
is the combination of a steep yield curve with rates near zero. Why
originate loans at all if you can get almost the same spread as you used
to get just by buying Treasuries? You get the added bonus of no credit
risk and little overhead?  Nancy, the loan officer, gets a pink slip. 
You, the management, get a bonus check and no annoying meetings where
they tell you to lower your rates. 

That's where the Fed's decision to keep rates ultra-low on the short end
affect a bank's lending decisions on the long end. The question of why
banks are not lending cannot be answered until the ultra-steep yield
curve comes down.

The Fed's current QE2 approach (i.e. bringing long term rates lower) to
flatten the yield curve is misguided. Short term rates are still
negative and still causes distortions and too little savings. Raising
short term rates would be a better way to flatten the curve.

If we did have higher short term interest rates, there would likely be
an increase in capital at savings and checking accounts, because people,
of course, respond to incentives. With banks having to invest
additional capital, the marginal money would be more likely placed into
riskier assets considering the yield curve spread would likely shrink.
That would increase lending, which solves why banks aren't lending much
in the first place. 

Oh, and you can call back Nancy.  I'm sure she's available.  She could
quote Jim Collins, but she still hasn't probably found another loan
officer job yet.

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blunderdog's picture

Honesty is refreshing.

Interest rates are only correct as long as the dollars I borrow to pay for next month's bread are acceptable even when I break my arm.


There's a real-world constraint, isn't there?  Even the "sheep" won't starve their kids in order to do what's right according to some balance-sheet somewhere.

bigelkhorn's picture

Honest! When has the government been honest!

Remember this : "911 was a terrorst event!" BS.... "They have weapons of mass destruction" BS..... "I did not have sexual relations with that women! " BS.

Its all lies these days....normally when the government says something, they mean the opposite. Don't laugh, it is true!!!

These days It is better to turn off your tv, and listen to real people who have a good track record with this stuff. I listen to the guy from FFT, he has been insanley accurate with all this financial crisis stuff. Go check him out.

Stop listening to the government and wake the hell up. What have they ever done for you!!! I mean, comon seriously.



MarkS's picture

Had you not started with:

Remember this : "911 was a terrorst event!" BS....  I might have actually considered what you had to say in the rest of your comment.  Unfortunately, you immediately put yourself in the nutjob file.

Misean's picture

"Banks are not in the business of making loans per se.  They are in the business of making more off their assets than their liabilities."


They make money by gambling the houses chips, that magically get replenished everytime they loose. Making money off their assets in excess of liabilities...cough..chuckle...that almost sounds like work.

bob_dabolina's picture

"They are in the business of making more off their assets than their liabilities"

Strange that they have been making more from their liablilities  than from their assets  as of late.

It's also strange that as the banks shred docs, food prices rise. hmmmm.

You want your loan doc? Fuck you! Here's your $6 dollar cheeseburger (wait, no cheese take that shit off)....EAT IT BITCH!....(Take that bread off too) you don't need those carbs anyway.

Wolf in the Wilds's picture

It cannot possibly happen because of the debt overhang at the governmental level.  Expect more money printing instead of higher rates.

Burnbright's picture

Banks are not in the business of making loans per se.  They are in the business of making more off their assets than their liabilities.

This statement is false. The bank has no liability in loaning money because their deposits do not change from making a loan. The whole housing bubble caused a credit market collapse, why do you think the banks became insolvent? It is because their #1 business is in fact making loans. They suffer no loss from an unpaid loan. The credit collapsed occurred not because of a contraction in the money supply, it occurred because of a contraction in the value of the banks assets in which they can loan against and it destroyed the credit leverage that an average home buyer could create. 

If you do not believe me simply read Modern Money Mechanics page 6 under how new money is created. 

bob_dabolina's picture

That's true:

Banks have NO assets.

....they do have the buildings.

Burnbright's picture

I would say they get assets for free. 

bob_dabolina's picture

I think Bear Stearns would disincline to acknowledge that statement.

bonddude's picture

I'm gonna have a seance to call the spirit of Andrew Jackson forward.

OBAMA?BUSH discuss vampire bankers in Sonoma

blunderdog's picture

At the simplest level, banking is the first order derivative of a real economy.

Banks can't run out of money.  In theory they go insolvent as soon as they can't make their payments.

In practice, they can always sell some dumb sucker another product that makes up for the fact that they're broke.

The bank's liability in loaning money is that they need the payments from a good loan to send to those other assholes who are expecting interest.

They made bad loans to generate bigger bonus payments?  Oopsie.

Any company that permits its employees to cannibalize it for their own gain is not going to survive.  Let's hear it for American banking--fuckers are so stupid they FORGOT this principle.

And these are guys we trust with our money?  Um...duh.

Burnbright's picture

The bank's liability in loaning money is that they need the payments from a good loan to send to those other assholes who are expecting interest.

No they do not owe anyone anything for money they loan, they have no liabilities when they make a loan. It is actually quite deceptive but you can tell when you understand the meaning of the words in a contract and when you understand the basis of contracts.

First off all loans from a bank are promissory notes. In the loan is states something to the effect "I promise to pay the sum of $ to the bearer of the note". You will notice that it is a unilateral contract because it only requires your signature. A promissory note is exactly like a reserve note only the reserve note is "reserves", like bank reserves" and the promissory note is simply money created by you. After all the reserve note is a promise to pay as well, only it doesn't promise to give you anything. The reason it is important to understand why it is a unilateral contract is that in a bilateral contract both parties are obliging themselves to do something, i.e. it is being acknowledged that a party is giving something of theirs in return for the other parties consideration (something they own like a house or money). A unilateral contract however you promise to yourself to give the bank money, only you are tricked into believing it is for something of theirs only because we know they don't also sign we also know they are not obliging themselves to give any kind of consideration. 

Like I said, if you doubt me read Modern Money Mechanics. "Loans (assets) and deposits (liabilities) both rise...Reserves are unchanged by the loan transactions."

If a banks deposits do not change, and both deposits and liabilities both rise when a bank makes a loan, it means that they do not suffer any loss when a loan goes unpaid. The bank makes money on both interest and principle. 

Ham Wallet's picture

@Burnbright- Is "Modern Money Mechanics" just a 42 pg book?  Im interested in it from your posts, just wanna make sure Amazon brought up the right book in my search.  TIA.

Burnbright's picture

It is printed by the Chicago Federal Reserve. It is currently out of print so you have to find old copies. I checked on Amazon and apparently the people complained about the print size of the current one for sale so here is a link to a online pdf of it.

Ham Wallet's picture

Exactly. FDIC isn't there so John Doe doesn't lose his 500$ deposit in the event of a banking collapse.

keepusfree's picture

Sure interest rates are low. If you're a bank borrowing money. Of course if you're a consumer and pay a credit card late, it's 30 percent.

Akrunner907's picture

The author of this article needs to go pull a UBPR to understand how a bank makes money.  It’s unreal how some of this passes for legitimate discussion.

tom's picture

Actually banks prefer agencies to Treasuries, although they have been taking on more of the latter since interest rates were slashed. They had about $1 trillion of agencies and $100 billion of Treasuries in early 2008. Now they have about $1.3 trillion of agencies and a bit more than $300 billion of Treasuries.

No More Bubbles's picture

The FED will NEVER raise rates.......

Johnny Dangereaux's picture

"What is a healthy interest rate?" Me and Grandma say 8%. Savers are paid to save, and productive economic activity can pay it. 2% MFA!

bronzie's picture

"What is a healthy interest rate?"

to be 'healthy' means that real interest rates are at least positive - meaning that the interest rate paid on money saved is greater than the rate of inflation

John Williams at calculates economic numbers using the methodologies that were in place prior to all the massaging that govts are currently doing (hedonic adjustments, substitutions, weighting, etc) - he places the current inflation rate at a little over 4%

that means interest rates have to be 5% before we can even begin to talk about 'healthy'


and, as a second thought, inflation appears to be much higher than 4% - just this year my internet connection fee has gone from $35/mo to $40 - my insurance premium has gone from $265/mo to $301 - and Netflix has gone from $15/mo to $20 - all of those increases are pushing 15%

Hephasteus's picture

Interest rate raise won't mean anything. They'll raise rates and pay interest on deposits in an attempt to pull people out of gold and back into the good money for bad scam. Send a signal that we've stolen enough and now money mcbags ready to hire and push our sheep onto the next big thing. Unfortunately none of this is remotely true. The next big thing (green revolution) died in a fire of stupid. They are going to keep people fired and starve them through inflation. And make it work for them as long as possible while they try to get all us ducks in a row.

sbenard's picture

I love the insights I gain here at ZH, both from the articles and the comments. Thanks ZH! Thanks all!

Snidley Whipsnae's picture

No More Bubbles has it right... 'The Fed will never raise rates'... But, very few people understand why this is true. The Fed is playing near the edge of the cliff...

"Because the size of the monetary base has become so extreme relative to historical norms, the likely price pressures in response to even modestly higher short-term interest rates are equally extreme. For example, given the present level of the monetary base, an exogenous increase in short-term Treasury yields to even 1% would imply a GDP deflator of about 1.59, which is about 42.9% higher than present levels. In order to counter such pressure, the Fed would have to contract the monetary base by about $600 billion, from the present level of about $2 trillion to a still bloated but less extreme $1.4 trillion.

A larger increase in Treasury bill yields to 4% would imply a GDP deflator of about 2.35, which is more than double the current price level. The implication is that any normalization of interest rates would need to be accompanied by a massive contraction of the Fed's balance sheet in order to avoid inflation, otherwise the collapse in liquidity preference (resulting from the higher interest rates compared to zero interest on base money) would trigger a collapse in the purchasing power of cash."

Outstanding comments provided courtesy of Mr John P Hussman.

The remainder of Mr. Hussman's short but stunning essay available here...

1-24-11 "Sixteen Cents: Pushing the Unstable Limits of Monetary Policy" 

Waterfallsparkles's picture

I think that raising rates will create inflation.  Although, the FED says they want inflation they seem to want to control were that inflation is targeted.

I wonder what will happen when they finally increase interest rates.  The interest on the National Debt would explode with all the Money they have printed just in the last 2 years.  Like with consumers when the Banks raised the rates on Credit Cards to 29.9%.  The Consumers were forced to default.  If rates got as high as when Volker was Treasury Secretary to 18% I think the United States would have no choice but to default on the Debt.  I do not think the FED wants that, as that would surely be their end.

Dollar Bill Hiccup's picture

If the FED is setting effective negative real rates and the rational response from banks is to buy treasuries and take on no risk for a handsome return, and if the FED is itself buying treasuries and is now the single largest holder, does the FED really want the banks to lend? And the answer, if the FED is itself rational, is NO. Hmmm.

Bearster's picture

The first problem is that interest rates are set by central planners.  Central planning has never worked, and it doesn't work for interest rates.  What is the "right" interest rate for today?  No one knows because there is no market, only Bernanke.

The second problem is:

"Banks, and many hedge funds, really make money off the yield curve. They have assets with a higher duration than their liabilities."

This is a formula for instability and sudden, catastrophic losses.  A bank takes money from, say a depositor.  The depositor puts the funds in a checking account, i.e. a demand deposit.  The bank lends the money to someone to buy a house.  Or the bank takes money by selling a 30-day note and lends the money to a business to expand.

Either way, the bank is relying on always being able to "roll over" the short-term liability.  If and when it cannot, for any reason, there is absolute chaos and markets crash.


topcallingtroll's picture

Yields may all go up slowly as the economy kicks into gear. This is the optimist scenario. We most definitely need to.see rising rates. However the only two or three datapoints that matter now are gdp unemployment and inflation. The rest is just noise as long as positive events continue in those data sets.

VaJim's picture

Raising rates will crush Bernanke's banks.  QE isn't about the economy, employment....  It's all about saving insolvent banks.  That's all.  Give a QE net interest margin gift to them, inflate their assets (which hasn't occurred), pass the trash to the Fed (MBS) and then get the Fed bailed out by the taxpayer.  Bernanke will have to be removed forcibly to end it.  It's been that way from the very beginning IMO.

red2893's picture

If the banks have no incentive to lend...they won't...It's all risk/reward

bronzie's picture

"short term rates should be above 1% to make them positive and closer to 2%"

'positive rates' means that the interest rate is above the inflation rate is showing real inflation at 4%+ so interest rates would have to be 5% before they were positive

imagine what would happen to the real estate markets if interest rates went to 5% from the current 0% - 30 year mortgage rates would be pushing 10% - and remember that the entire Western world's economy rests atop real estate valuations - that's how we know the central banks will never willingly move back to positive interest rates

and as long as we have negative real interest rates the bull market in precious metals will continue

rock, meet hard place ...

overmedicatedundersexed's picture

ben can raise interest rates, but we all know what happens to the gov debt..he can keep printing destroying the value of the $.

the suppliers to our economy, commodities like oil, or china goods are stuck. they need our markets so they will take the $.

they do not need to take our gov debt.

ben has to buy it. he does.

the new gop congress wants to move to control the fed..ben will point out what happens to gov debt if the fed is undermined by congress.

ben is very comfortable with the above..he is king of the world.


Plainview's picture

Ben will not do a new QE3 (GOP congress, unpopularity of QE2 and ineffectiveness of QE2); the lack of a QE3 it will initially bring rates down because it will change attitudes to Ben's printing and inflation expectations. To hold rates down they will initiate a program to get/force a part of US household assets into Treasurys: currently a mere 1.6% of these assets are in T's, that will change drastically.