Another call for the Fed to raise rates, so big banks can start lending and hiring again

Article first published as How The Fed Kills The Credit Markets With Ultra-Low Rates. on Technorati.

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. 


  1. Real interest rates are what the masses pay for the use of money - credit debt rates range from 12 to as high as 32 percent and home loan rates as high as eight percent (inclusive of amortized fees)for average buyers who can get a loan or refinance. The 'real' rates you discuss are a subsidy that only the Fed tapping banks get and, thus, are 'unreal.'

  2. What you say has some merit.. that the rates you see are nowhere near the interest rate that we talk about.

    The real interest rate are the treasury rates less the inflation rate. In this case they are real. These are very tenuously related to the rate that you get from the bank.

  3. It's interesting to see how the policy of keeping interest rates low is actually having the reverse effect on stimulating the economy by making it less attractive for banks to actually loan money. One question though - if short term interest rates go up, is inflation going to follow? I'm starting to wonder how we can avoid it.

  4. the nominal rate is the real rate plus inflation. If the nominal short term rates increased as I suggested, then the real rate would increase. It would have no affect on inflation.

    On the other hand, if inflation did increase, then we do see causality with the short term rate.

    The real problem is that rates are control by a bunch of balding phds who were overacheivers in school and now tend to be control freaks who try to "steer" the economy by the money supply and interest rates.


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