Guest Post: Falling Interest Rates Destroy Capital

Submitted by Keith Weiner of 'Gold and Silver and Money and Credit' blog,

I have written other pieces on the topic of fractional reserve banking (http://keithweiner.posterous.com/61391483 and http://keithweiner.posterous.com/fractional-reserve-is-not-the-problem) duration mismatch, which is when someone borrows short-term money to lend long-term and how falling interest rates actually encourages duration mismatch (http://keithweiner.posterous.com/falling-interest-rates-and-duration-mis...).

Falling interest rates are a feature of our current monetary regime, so central that any look at a graph of 10-year Treasury yields shows that it is a ratchet (and a racket, but that is a topic for another day!).  There are corrections, but over 31 years the rate of interest has been falling too steadily and for too long to be the product of random chance.  It is a salient, if not the central fact, of life in the irredeemable US dollar system, as I have written (http://keithweiner.posterous.com/irredeemable-paper-money-feature-451).

Here is a graph of the interest rate on the 10-year US Treasury bond.  The graph begins in the second half of July 1981.  This was the peak of the parabolic rise interest rates, with the rate at around 16%.  Today, the rate is 1.6%.

Pathological Falling Interest Rates

Professor Antal Fekete introduced the proposition that a falling interest rate (as opposed to a low and stable rate) causes capital destruction.  But all other economists, commentators, and observers miss the point.  It is no less a phenomenon for being unseen.  In early 2008, a question was left begging: how could a company like Bear Stearns which had strong and growing net income collapse so suddenly?

Here is Bear’s five-year net income and total shareholder’s equity

Year	2003	2004	2005	2006	2007
Income	$1.156B	$1.345B	$1.462B	$2.054B	$0.233
Equity	$7.47B	$8.99B	$10.8B	$12.1B	$11.8B

Isn’t that odd?  Even in 2007, Bear shows a profit.  And they show robust growth in shareholder equity, with only a minor setback in 2007.

And yet, by early 2008 Bear experienced what I will call Sudden Capital Death Syndrome.  JP Morgan bought them on Mar 16, for just over $1B.  But the deal hinged on the Fed taking on $29B of Bear’s liabilities, so the real enterprise value was closer to $-19B.

Obviously, Bear’s reported “profit” was not real.  And neither was their “shareholder’s equity”.  I think it something much more serious than just a simple case of fraud.  Simple fraud could not explain why almost the entire banking industry ran out of capital at the same time, after years of reporting good earnings and paying dividends and bonuses to management.

Also, other prominent companies were going bankrupt in 2008 and 2009 as well.  These included Nortel Networks, General Growth Partners, AIG, two big automakers.

I place the blame for Sudden Capital Death Syndrome on falling interest rates.  The key to understanding this is to look at a bond as a security.  This security has a market price that can go up and down.  It is not controversial to say that when the rate of interest falls, the price of a bond rises.  This is a simple and rigid mathematical relationship, like a teeter-totter.

A bond issuer is short a bond.  Unlike a homeowner who takes out a mortgage on his house, a bond issuer cannot simply “refinance”.  If it wants to pay off the debt, it must buy the bonds back in the market, at the current market price.

Let’s repeat that.  Anyone who issues a bond is short a security and that security can go up in price as well as go down in price.

Everyone understands that if a bond goes up, the bondholder gets a capital gain.  This is not controversial at all.  Nor is it controversial to say that there are two sides to every trade.  And yet it is highly controversial—to the point of being rejected with scorn—that the other side of the trade from the bondholder incurs the capital loss.  It is the bond issuer’s capital that flows to the bondholder.  To reject this is to say that money grows on trees.

We won’t explore that any further; money does not grow on trees!  Instead, we will look at this phenomenon of the capital loss of the bond issuer from several angles: (1) Hold Until Maturity; (2) Mark to Market; (3) Two Borrowers, Same Amount; (4) Two Borrowers, Different Amounts; (5) Net Present Value; (6) Capitalizing an Income; (7) Amortization of Plant; and (8) Real Meaning of an Interest Rate.

Hold Until Maturity

There is an argument that the bond issuer can just keep paying until maturity.  While that may be true in some circumstances, it misses the point.  When one enters into a position in a financial market, one must mark one’s losses as they occur, no matter than one may intend to hold the position until maturity.  How would a broker respond in the case of a client who shorted a stock and the stock rose in price subsequently?  Would the broker demand that the client post more margin?  Or would the broker be sympathetic if the client explained how the company had poor prospects and that the client intended to hold the short position until the company’s share price reflected the truth?

Mark to Market

The guiding principle of accounting is that it must paint an accurate and conservative picture of the current state of one’s finances.  It is not the consideration of the accountant that things may improve.  If things improve, then in the future the financial statement will look better!  In the meantime, the standard in accounting (notwithstanding the outrageous FASB decision in 2009 to suspend “mark to market”) is to mark assets at the lower of: (A) the original acquisition price, or (B) the current market price.

There ought to be a corresponding rule for liabilities: mark liabilities at the higher of (A) original sale price, or (B) current market price.  Unfortunately, the field of accounting developed its principles in an era where a fall in the rate of interest from 16% to 1.6% would have been inconceivable.  And so today, liabilities are not marked up as the rate of interest falls down.

Refusing to put ink on paper does not change the reality, however.  Closing one’s eyes does not prevent one from falling into a pit on the path in front of one’s feet.  The capital loss is very real, as we will explore further below.

Two Borrowers, Same Amount

Let’s look at two hypothetical companies in the same industry, pencil manufacturing.  Smithwick Pen sells a 20-year $10M bond at 8% interest.  It uses the proceeds to buy pencil-manufacturing equipment.  To fully amortize the $10M over 20 years, Smithwick must pay $83,644 per month.

The rate of interest now falls to half its previous rate.  Barnaby Crayon sells a 20-year $10M bond at 4%.  Barnaby buys the same equipment as Smithwick and becomes Smithwick’s competitor.  Barnaby pays $60,598 per month to amortize the same $10M debt.  Is it correct to say that both companies have identical balance sheets?  Obviously Barnaby will have a better income statement.  This is because it has a superior capital position, and this should be reflected on the balance sheets.  It certainly is not because of its superior product, management, or marketing.

Let’s look at this from the perspective of the capital position: the present value of a stream of payments.  Obviously, at 4% interest the monthly payment of $60,598 has a present value of $10M (otherwise we made a mistake in the math somewhere).  But what is the value of an $83,644 monthly payment at the new, lower rate of 4%?  It is $13.8M.  Smithwick’s has just experienced the erosion of $3.8M of capital!  This is reflected in reality, by the uncontroversial statement that it has a permanent competitive disadvantage compared to Barnaby.  Barnaby can undercut Smithwick and set prices wherever it wishes.  Smithwick is helpless.  Most likely, Barnaby will eke out a subsistence living, until the rate of interest falls further.  When Cromwell Writing Instruments borrows money at 2%, then Smithwick will be put out of its misery.  And Barnaby will be forced into the untenable position it had previously placed Smithwick.

It should be noted that the longer the bond maturity, the bigger this problem becomes.  For example, if this were a 30-year bond, then Smithwick would take a $5.4M hit to its capital if interest rates were 8% when it issued the bond and then fell to 4%.

Two Borrowers, Different Amounts

This is not the only way that a competitor can exploit the capital loss of a company who made the mistake of borrowing at a too-high interest rate.  Let’s look at the case of Poddy Hoddy Hotel and Casino.  Poddy sells a 20-year $100M bond at 8%, and has a monthly payment of $836K.  It builds a nice hotel and casino with bars, a restaurant, a pool, and a few jewelry stores.

A short while later, Xtreme Hotels sells a $138M bond at 4%, and has the same monthly payments.  The extra $38M goes into a second pool with a swim-up bar, another restaurant that is themed based on the Galapagos Islands, bigger and more opulent retail stores, and a spiral glass elevator to take guests up to their rooms while enjoying the breathtaking 270-degree views of the city.

Which hotel will consumers prefer?

The Poddy Hoddy Hotel may have been planned based on accurate market research that showed real demand for such a hotel in that location.  Unfortunately, the falling interest rate has undermined it.  Its investors will likely lose money.

The Xtreme Hotel, on the other hand, is probably a mal-investment.  It is likely a project for which there is no real demand.  But the falling interest rate gives a false signal to the entrepreneur to build it.  Of course, the Xtreme won’t be the one to experience Sudden Capital Death Syndrome first.  That fate will befall Poddy.  Xtreme’s turn will come later, at a lower interest rate.

With Smithwick, one might argue that it can pay off its bond in the 20 years it originally expected, so it has not experienced a loss.  But in fact, there is a loss even from this angle.  Smithwick is paying off its 8% bond at $83,644 per month.  But the rate of interest is now 4%, which should be a payment of $60,598.  The accurate way to look at this is that Smithwick is paying off a market-rate bond plus a penalty of $23,046 for every month remaining before the bond is fully amortized.

With Poddy Hoddy, one might similarly argue that it can pay off its bond as planned, so it has not taken a loss.  But the loss here is even clearer.  By borrowing $100M at a rate that was too high, it has effectively dissipated the extra $38M that its competitor, Xtreme, put to good use.  It will pay for this waste every month for 20 years (or until it goes bankrupt).

By not marking the losses at Smithwick and Poddy, the accountants are not doing these companies or their investors any favors.  In the short run, these companies may declare “profits” and based on that pay dividends to investors and bonuses to management.  But sooner or later, they will meet Barnaby and Xtreme who will deal the coup de grace of Sudden Capital Death Syndrome.

Net Present Value

As alluded above, one can calculate the Net Present Value (NPV) of a stream of payments.  First, let’s look at the formula to calculate the present value of a single payment is:

It should be obvious that the present value of a payment is lower the farther into the future it is to be made.  One does not value a payment due in 2042 the same as a payment to be made next year.  What is not so glaring is that the value is lower for higher rates of interest.  A $1000 payment due next year is worth $909 if the rate of interest is 10%, but $990 at 1%.  This difference is amplified due to compounding.  At 10 years, the payment is worth $385 at 10% versus $905 at 1%.

The NPV of a stream of payments is the sum of the value of each payment.  The value of a $1000 payment made annually for 20 years is $9818 at 8% interest.  That same payment at 4% has an NPV of $13,590, a 38% increase.

It is important to emphasize that while the bond issuer’s monthly payment is fixed based on the amount of capital raised and the interest rate at the time, the NPV of its liability must be calculated at the current rate of interest.  The market (and the universe) does not know nor care what bond issuer’s entry point was.  Objectively, all streams of payments of $1000 per month have the same value at a given maturity and current interest rate, regardless of the original rate.

Capitalizing an Income

Let’s look at this from yet another angle.  An income can be capitalized, and the purpose of capital is to produce an income.  Professor Antal Fekete wrote[3]:

“Suppose you are a worker taking home $50,000 a year in wages. When your income-flow is capitalized at the current rate of interest of, say, 5 percent, you arrive at the figure of $1,000,000. The sum of one million dollars or its equivalent in physical capital must exist somewhere, in some form, the yield of which will continue paying your wages. Capital has been accumulated and turned into plant and equipment to support you at work. Part of your employer’s capital is the wage fund that backs your employment. Assuming, of course, that no one is allowed to tamper with the rate of interest.” [Emphasis in the original]

“Suppose for the sake of argument that the rate of interest is cut in half to 2½ percent. Nothing could be clearer than the fact that the $1,000,000 wage fund is no longer adequate to support your payroll, as its annual yield has been reduced to $25,000. This can be described by saying that every time the rate of interest is cut by half, capital is being destroyed, wiping out half of the wage fund. Unless compensation is made by adding more capital, your employment is no longer supported by a full slate of capital as before. Since productivity is nothing but the result of combining labor and capital, the productivity of your job has been impaired. You are in danger of being laid off ? or forced to take a wage cut of $25,000.”

Without capital, human productivity is barely enough to produce a subsistence living.  Without tools, one is obliged to work long hours at back-breaking tasks in order to have a meager meal, some sort of clothing, and something to keep the rain off one’s head.  Capital destruction is the process of moving backwards towards a time where one worked harder to obtain less.

As described earlier, when the rate of interest falls, it erodes the capital of every bond issuer.  If one looks at this capital as being the wage fund (or part of it is the wage fund), then the bond issuer can no longer afford to pay its employees the same wage.  If it does continue the same wage anyway, it will eventually suffer the consequences of running out of capital.

Amortization of Plant

Now let’s consider the concept of amortizing equipment and plant at Smithwick Pen.  Smithwick borrows $10M to buy equipment.  Out of its revenues, it must set aside something to amortize this over the useful life of the equipment, which is 20 years in our example.  This set-aside reduces net income; it is not profit but capital maintenance assuming the company intends to remain in business after the current generation of equipment and plant wears out.

How much should it set aside every month?  This is the inverse of the NPV calculation.  We are now interested in the current monthly payment to arrive at a fixed sum at a future point in time (as opposed to the present value of a stream of fixed payments).  The lower the rate of interest, the more Smithwick must set aside every month in order to reach the goal by the deadline.  To understand this, just look at what Smithwick must do.  Each month, it puts some money into an interest-bearing account or bond.  Even if it chooses the longest possible maturity for each payment (i.e. the first payment is put into a 20-year bond, the next into a 19-year 11-month bond, etc.) it is clear that if interest rates are falling then each payment must increase to compensate.  Smithwick’s profits are falling with the rate of interest!

If Smithwick persists in setting aside every month what it initially calculated when it purchased the pencil-making equipment, it will have a shortfall at the end, when it needs to replace the equipment.

Real Meaning of an Interest Rate

Let’s consider what it really means to have a high or a low rate of interest.  I propose to do reductio ad absurdum.  We will look at two cases (which would be pathological if they occurred) to make the point clearer.

The first case is if the rate of interest is 100%.  This means that a $1000 payment one year from today is worth ½ of the nominal value, or $500 today.  A payment due in two years is worth $250 today, etc.  At this rate of interest, for whatever reason, “future money” is worth very little present money.  In other words, the burden experienced by the debtor is a small fraction of the nominal value of the debt.

The second case is if the rate of interest is zero.  This means that a $1000 payment due one year from today or 100 years from today is worth $1000 today.  At this rate of interest, for whatever reason, future money is worth every penny of its nominal value today.  There is no discount at all, not for the loss of use of the money in the meantime, not for the risk, not for currency debasement.  In other words, the burden experienced by the debtor is the full nominal value of the debt.

Again, to emphasize, one must use the current market rate of interest not the rate of interest contracted by the borrower at the time of the bond issuance.

The lower the rate of interest, the more highly one values a future payment.  The higher the rate of interest, the more highly one discounts a future payment.  These statements are true whether one is the payer or the payee.  The payer and payee are just parties on opposite sides of the same trade.

Irving Fisher, writing about falling prices (I shall address the connection between falling prices and falling interest rates in a forthcoming paper) proposed a paradox[4]:

“The more the debtors pay, the more they owe.”

Debtors slowly pay down their debts and reduce the principle owed.  This would reduce the NPV of their debts in a normal environment.  But in a falling-interest-rate environment, the NPV of outstanding debt is rising due to the falling interest rate at a pace much faster than it is falling due to debtors’ payments.  The debtors are on a treadmill and they are going backwards at an accelerating rate.

How apropos is Fisher’s eloquent sentence summarizing the problem!

---

[1] http://www.wikinvest.com/stock/Bear_Stearns_Companies_(BSC)#History

[2] http://www.wikinvest.com/stock/Bear_Stearns_Companies_(BSC)/Data/Balance_Sheet#Balance_Sheet

[3] http://www.professorfekete.com/articles/AEFLaborLeaders.pdf

[4] http://fraser.stlouisfed.org/docs/meltzer/fisdeb33.pdf

Comments

[elwu]

1st the claim "There are corrections, but over 31 years the rate of interest has been falling" is not convincing, since the 'corrections' were quite extended. A smoothed curve would be interesting.

2nd, even more interesting would be to see over the same period the spread between how much big finance had to pay in interest (you know, zero lower bound and so) vs. how much they charge(d) for loans to customers.

[Thoresen]

Professor Fekete's article was published Nov 2008.

His conclusion was that the US mint should be opened to gold and silver.

Read the original (linked above).

[Thoresen]

And by a happy coincidence, Von Greyerz on KWN.

http://kingworldnews.com/kingworldnews/KWN_DailyWeb/Entries/2012/7/20_Gr...$1.5_Quadrillion_Bubble_%26_Gold_Into_The_Stratosphere.html (Copy and paste the whole link!)

“How can anyone in the world invest in any government bond when they know that it can never be repaid?  The world is simply drowning in debt.  This is why it is guaranteed that governments will print money.

So the money printing will come and the hyperinflation will come because without that we have no banking system and no financial system left.  You are talking about hundreds of trillions of dollars that potentially need to be printed.  The effect of this on the global economy will be disastrous.

Prices of hard assets will go into the stratosphere, and this, of course, includes gold and silver.  Last time we talked about my target on gold of $3,500 to $5,000 over the next 12 to 18 months, and then over $10,000 in 3 years.  But with all of the money creation we are talking about, the world will experience massive inflation.  We already know that gold went from 100 marks to 100 trillion marks, from 1919 to 1923, during the Weimar Republic.

With world debt at much greater levels today vs that time period, the gold price will eventually have lots and lots of zeros after it.  But people who are still holding paper money may very well find it is worthless.  At least gold will protect your purchasing power......."

[Sandmann]

The Weimar Republic Inflation ended in 1925. It was caused by France deliberately undermining Germany by a) Invasion and Occupation in 1923    b) Targeting the Reichsmark on ForeX Markets to damage the German Economy.

The Deflation that followed 1929 and withdrawal of US Loans and the Bruening Deflation did far more damage to the German Economy than Weimar Inflation - it killed the Republic and moved the political system to Rule by Emergency Decree by-passing the Reichstag. Bruening was the longest-serving Chancellor under Weimar - 2 years - and then Professor of Political Science at Harvard from 1939 so perhaps some US Students might actually have learned FACTS rather than platitudes about Inflation in the Weimar Republic. Besides which Austria, Poland and Hungary had Hyperinflation too - Austria 1426% in 1922. The highest Inflation recorded was Hungary 1945-46.

Stop thinking the World is the Weimar Republic - History does not repeat itself, it modifies and changes to stop people using the same template as solutions. They repeat the same mistakes but the solutions are different

[Sandmann]

To comment oin the Article itself. Capital is a Stock and like all Stocks in a dynamic system it requires additions to maintain value relative to other Capital Stocks. The Interest Rate is the support mechanism to prevent Capital Erosion - but only if it is set in line with Income Growth in the long-run and Price Growth in the short term. It is surely axiomatic that Capital is simpl;y the Sum of Accumulated Surpluses from previous Time Periods which buys Forward Income to be Invested or Consumed. In the absence of "C" or "I" however it is simply "Y" a block of income awaiting erosion or devaluation by Current Income Streams.

[disabledvet]

Thank God the Fed is in charge "to keep everything perfectly in balance" then!

[Sandmann]

JP Morgan bought them on Mar 16, for just over $1B.  But the deal hinged on the Fed taking on $29B of Bear’s liabilities, so the real enterprise value was closer to $-19B.

Aside from the point that I thought JPM paid $236 million and not $1 billion.........how does your calculation work to have $29 billion of Liabilities and Purchase Price of $1 billion to yield Enterprise Value of -$19 billion rather than -$28 billion ?

[disabledvet]

Because the Fed...meaning "you and i the taxpayer" paid the other is it 19 or 28 billion? It's hard to figure when the numbers are that big. "Don't worry...it really doesn't matter. Move along!"

[dogbreath]

I am glad this guy gave credit to Dr. Fekete up front.   If I remember right Fekete said that the negative rates drive the money on the sidelines into the market searching for yeild.  The author is right to point out the 5 trillion eroding away in deposit accounts the owner of which have to sweat the thought of losing a few percent annually to inflation or risk real estate or equities.  Gold at 4400 tons anual demand is healthy to say the least has not yet become the fear trade.

[Debugas]

falling interest rates is not accidental process - they had to be falling in order to attract more borrowers (to let previous borrowers to be repaying their debts) into the ponzi scheme of ever growing debt. Now when there are no more creditworthy borrowers even at zero interest rates we have come to the end point of the ponzi which has shrinking base now and will inevitably collapse like any ponzi

[jimmyjames]

falling interest rates is not accidental process - they had to be falling in order to attract more borrowers

**************

I don't think that falling interest rates were an accident either and i don't think the Fed had much or any control over them-

http://bit.ly/s86T8y

Look at the inversion in 2001-you can see the FFR actually followed the long end lower and when Greenspan tried to push them higher-starting in 2004 the long end refused to move and actually inverted-

The bond market could see the risk that the credit inflation driven 80's/90's had brought-then the credit hyper-inflation that started in 01 drove them lower-it also woke gold up as it too could see the credit risk-

As the old saying goes-

You can't bullshit the long bond and you can't bullshit gold-

[Nachdenken]

Interest as the "price" of capital. 

Low interest rates might mean low demand for capital, overabundant availability of capital, or simply directionless flows of funds that have no place to park.

Baisc Interest rates for all  currencies are set by committees, and not established by market forces (leave the free out).  Interest rates for currencies follow US Dollar rates sooner or later, since that is - still - the reference currency. 

In my view these artificially established low interest rates for fiat currencies destroy or distort return of capital / invested capital so there is no market determined allocation of resources.

[tok1]

The whole principal of the article is incorrect .
The issuer of the bond is not in the same position
as a short bond position ( or a short stock position).
When some one shorts a bond ( or stock) they need to borrow
the bond or stock and pay a repo cost for the period borrowed.
So the broker will be fine with a short position as long as the shor
position can afford the borrowing cost and margin required
if market rallies .
In the case of the issuer of a bond the cost of funding ( ie interest)
is fixed when the bond is auctioned ( presuming its fixed cpn auction).

So the issuer ( ie Govt ) has no additional / risk or obligation as long as
they make the interest payment and principal on expiry. Its the same as
a fixed house mortgage . As long as you make the payments the fact
rates go lower is just a missed opportunity to get lower rates .. It's not a loss that needs to be mark to market .

Lower rates are good for the issuer because it means on expiry the govt
can reissue at lower rates and thus reduce the interest cost ( US and Japan are doing that now).
Agreed this is at the expense of the investors .

One question on QE might be we know how much the fed buys
in 7-10ys each month for operation twist .
The question should be what price do they buy at from primary dealers.
ie presume its above market level so PD's simply lift in the regular
market and sell to Fed ( ie make a price for them above market ).

This is price manipulation as the Fed can buy at higher prices if they want
bonds to rally on any particular day ( to manipulate price
and increase profitability to PD 's).
All trades in bonds and futures should show on time of sales
who bought them (ie broker) and who the end client is ). Also Fed should release who they trade with what price they traded and what time. This would create transparency in market so everyone knows who is buying or selling ;( like the old floor days in terms of brokers at least )
The hiding of who/ what's been traded creates distorted
market . Make it all transparent then there's nothing to hide..

[Withdrawn Sanction]

There ought to be a corresponding rule for liabilities: mark liabilities at the higher of (A) original sale price, or (B) current market price.

There is.  The banksters have it both ways.  First, they are not required to mark declining asset values (Loans and securities) to market, as the article's author correctly points out (suspension of FASB 157).  However, they are allowed to mark (down) their liabilities such as subordinated debt (referred to many times during earnings season as a DVA via FASB 159).

Consider for a moment what this heads-I-win-tails-you-lose setup generates.  First, bank income is overstated, b/c the DVA flows to the bottom line (see for example MS or BAC).  Second capital is overstated as assets remain at inflated and unrealistic book values, while liabilities are marked down.

So, next time you hear some shill touting banks as trading at "less than book" ask yourself, how does he know that? Anyone who invests (or has deposits) w/these TBTF frauds, deserves what they're going to get.  

[disabledvet]

so what could possibly go wrong then! we should be able to lever up 1000 fold under this scam! Hell i'm even shitting gold bars in here! (what do you mean i'm only allowed to play with one dollar under this scenario? WTF?)

[Racer]

Got a banksters statement today (have nearly finished closing the account, kept it open while resolved dispute over wrongful charges... and won!) that says

no interest paid on money in account, but if you go over any agreed overdraft the interest rate is 17.50%!

And that is cheap compared to some loan shark other banksters!

ZIRP only applies to peoples money in bankster account, yet if they lend it to you they charge massive interest rate

[michigan independant]

So why confuse a 50k wage earner flat earnings since inflation is theft as the so called wise management went from 650K to 6500k on the same bonded argument timeline. Pointless circular argument as they designed it to collapse. This is the same fucking argument since workers can save or starve in the capital structure so assholes who are deemed smart shred another viable technology and move to another subsidized fiat fatted cow work zone. The issue is they could care the fuck less and never did since firms that had to have a community to thrive are gamed. Look for decades you run the 19 years cycle so you can move it 300 miles down the road across state lines, now just global zones. Imagine a spread sheet without lies and actual capital structures. Nope never going to happen since the point of the matter is to dig ditches for those who question there reality. Never confuse why financial repression is utilized since any rational person can see the consequences. Really sucks for the assholes since other are doing the same thing called currency's with the same tech.

[ArkansasAngie]

The moral to the story?  Don't mess around with markets as their reversion to mean via moral hazard preserves capital ... in the long run.

[Yen Cross]

 Falling interest rates create lots of part time jobs for people over 60. /sarc

[Heroic Couplet]

This is what collapse looks like. Enjoy.

[disabledvet]

Actually it's called "the New Normal." Get with the program, Mister. YOU are the program now! RESPOND TO COMMMAND! RESPOND TO COMMAND! DATA ENTRY ERROR! DATA ENTRY ERROR!http://www.youtube.com/watch?v=RG0ochx16Dg

[tony bonn]

this article is a tour de force.....i read fekete's articles on the subject a few years ago but found them lacking in vivid illustrations which you abundantly supply.....

on the other hand, there was much more going on with bear stearns and lehman than npv problems, not the least of which was the planned ambush by jpm and its allies on both firms.....yet, all of the banks are zombies, including jpm, due do the collapse of bubblenomics...

[GoingLoonie]

Fekete is the first person ever in my knowledge to present this rule.  He is a little technical to read, but accurate and directly on point.  He should be our secretary of the treasury.

[Bagbalm]

If you have a capitol asset it is not 'destroyed' by a change in interest rates. However when you lock it's value to an arbitrary number of dollars and then those dollar units are of less value you have reduced it's monetary value. It still has the same utility. But since you are locked in by law and tax structure you are screwed. If you have a garden plot of land it can sustain you by it's productivity no matter what it is worth in dollars. That dosn't do you much good if the county takes it away because it wasn't productive enough IN DOLLARS, not cabbages.

[disabledvet]

how about Brussel Sprouts then? Imagine if we could back our currency with that...and then we could corner the market in them and RULE THE WORLD!

[grid-b-gone]

My first house mortgage was:

1983 12%, refinanced a few years later at 9%, refinanced again and eventually paid off in 2007 at 7.6%.

2012, my son just locked in 3.75% (about 4.1 APR) for 30 years. If we ever get hyperinflation, he'll own a million dollar house.

If we get meaningful deflation, it is limited to the base cost of producing lumber and other commodities, although for a short time panic selling could dip value even below commodity cost. 

To me, it seems the relative logic of debt over time is pretty constant. My 12% mortgage and my son's 3.75% mortgage both made sense for their respective times. 

So, the point that the counter party to a bond is short a security is a good one. My son's house has limited downside. I would not want to give a $200K 3.75% loan, even with CDs paying much less these days.

Sane people and corporations issue bonds when they expect to use the money for an even greater return. The U.S. government (Fed and Treasury) are making bad loans just to help member banks and in hopes that low rates will produce more economic activity.

Even with artificially low rates, the Fed and Treasury have to buy each other's instruments to complete an issue or sale. This lack of a true market is strong evidence of malinvestment.

The big risk of people taking on debt today is the stability of their job.       

The big risk of government-issued debt is no longer even debt or deficits, it's confidence in the currency. 

[GoingLoonie]

Good points grid, but I would like to simplify it a little.

Each time you refinanced it cost you.  Points, time, maybe even more interest as you had a new 30 year front loaded with interest.  Those costs are what it cost you to readjust to the falling interest.  Did the falling interest rates destroy some of your saved capital?   Yes indeed, thousands of dollars each time you refinanced.

[GoingLoonie]

This is the most important economic concept for any economist or investor to grasp.  Thankyou for posting it.  It is true and should be taught in every economics course in every school.  

Let's simplify it a little more.  You invest in a business where you borrowed at 6%.  I move next to you with the same business, but I know the Banker.  I get my start up loan (same size, same use) at 1%.  You are screwed because I will put you out of business.   Same goes for mortgage holders trying to compete for food, or other of life essentials.  This should be the first tenant of all economics that deals with loans and leverage.

Excellent Article.

[Grand Supercycle]

As mentioned before, market intervention has only postponed the inevitable.

Despite short and medium term market vacillation - the following remains a constant :

>> USDX monthly indicators [ie big picture] continue to warn of significant long term USD upside. (thus EURUSD & AUDUSD etc bearish)

>> SPX monthly indicators [ie big picture] continue to warn of significant long term downside for equities which will be worse than 2008.

http://www.zerohedge.com/news/2012-12-24/market-analysis

[dolph9]

Whatever you do in today's environment, don't buy bonds.

Remember...the elites will need people to dump their bonds onto as they exit into real assets...don't be the patsy.

Acquire real assets...think "portable and/or productive."

If you think the system is going to implode, you can risk going into debt to acquire assets, with no intention of paying the debt.  But that's risky.  I personally would not want to take the chance of becoming an indentured servant.

[NaN]

Reading this article motivated me to look for a time series model for gold.  I happened upon this attempt:

http://www.crossingwallstreet.com/archives/2010/10/a-model-to-explain-the-price-of-gold.html

While looking for data to update/extend/validate the model, I noticed that FRED announced on July 6 that it is now tracking gold:

http://news.research.stlouisfed.org/2012/07/6-daily-gold-prices-added-to-fred/

maybe something is afoot.

[Martin T]

While the author's point of view is indeed very accurate when it comes to describe the "unintended consequences" for companies balance sheets, destroying in the process corporate balance sheets, using the curve at the highest point of inflation when Volker took the helm of the Fed can only be called disingenuous at best, or the legend could be "how to lie using statistics"...If the author had used 10 or 20 years before, the results would have been of course materially different to his demonstration.