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
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.