Who’s got the power?

 

When interest rates go up, and they will, the 50% increase across the board will topple markets, namely bond markets.

Today’s interest rates are unprecedented. The lowest possible bound for an interest rate USED to be 0%. In finance terms, we call it the ZLB or the zero lower bound. Today bond yields in Germany and Denmark (among others) are NEGATIVE! What does this mean for me, the common investor?

Examples of Interest Rates  in History, for relativity:

I’ll admit, I’m not finished with the 700+ page novel written by Sidney Homer first published in 1963. The preface is packed with insightful information such as:

1.) In ancient India, the going rate of interest on livestock was 100%. Then: You can borrow my cow for one year, if after the year is over you’ll pay be back with two cows. Today: I’ll let you use my house for a year, but after that, I’m gunna need that house back, plus a whole extra house.

2.) In early 20th century Indo-China, loans on rice were given at a rate of 50% annually commonly.

3.) In British Columbia, a phenomenon called “potlatch” was first documented. The Kwakiutl, an Candaian Indian tribe, used thin white blankets currency, roughly valued at $0.50 per item. The citizens of this tribe would give the blankets as ‘forced loans’ to one another, with the expectation of receiving what they gave plus interest. “Wealthy Indians vied with each other to see who could give away the most blankets, all with the understanding that even more would be given back—usually double.” – (p. 23, Homer) Kind of wonky huh? They gave because they were greedy.

4.) In Northern Siberia, domesticated reindeer, horses, and sheep were used to collateralize loans. They exchanged the animals like currency, usually charged at an annual rate of 100%.

All in all, lending is not new, but this new environment of negative interest rates is new. You have never  had to PAY someone so they can use your money, that just seems backwards. Remember quantitative easing (QE*)? The Europeans are doing the exact same thing. However, the European Central Bank (ECB) are buying up these negative interest charging bonds because the ECB is attempting to inject liquidity into markets. The ECB is allowing banks to use their cash and they’re paying the banks interest… hmm…

The goal of QE* is to inject liquidity into markets to avoid disastrous outcomes. The program is designed to allow debt to be more readily available for the average consumer. Lowering interest rates and loading up commercial banks with cash will help settle investors’ concerns surrounding a global financial meltdown without a doubt. This being said, if times are bad (economically), the average consumer will become risk averse, and will stay as far from debt as possible until things get better. When consumers get a pay raise or a new job, they might think about taking out a loan to build a new deck or get a new car. Demand drives supply and the policy makers who control interest rates and QE can only control supply. No matter how hard they try to get us to take out debt, we just won’t do it unless market conditions are appropriate. The final result of QE in the United States was a massive increase in the amount of cash that banks hold in reserves.

The graph below shows the level of reserves banks have on their balance sheet from 1984 to 2008. In 1999, banks jacked up their reserves because of Y2K scares; if the whole system imploded at the turn of the century, they wanted to have enough cash on hand to prevent a catastrophic collapse of our financial system. Notice how the level was just shy of $70 billion.

Screen Shot 2016-08-02 at 5.44.39 PM

This graph below shows what has happened to reserves since the beginning of quantitative easing. In 1999, (from above) the level of reserves his $70 billion, here $70 billion isn’t even on the scale. This is where all the bailout money went, onto the balance sheets of big banks.

Screen Shot 2016-08-02 at 5.45.07 PM

Holding reserves used to be an implicit tax for banks, because the more cash they held, the more return they were missing out on (opportunity cost, for you econ buffs). The banks could have put the currency to work in stocks or bonds to achieve a higher return. However, the less cash a bank has on hand, the more risky the institution is. The Fed instituted a return on cash of 50 basis points (0.5%) in order to incentivize holding cash reserves (both required* and excess). The banks can hold all of it in cash and make a half a percent annually or they can buy negative yielding bonds. It’s a positive, riskless yield. Why wouldn’t banks take advantage?

*Note: by law, the required reserve ratio in the US is 10% for big banks.

QE works as a mechanism to prevent economic collapse, but demand drives supply; thus, you cannot force people to buy things they don’t want (except maybe in Communist Russia where they don’t actually tell you what you’re taking until you’re disqualified for the Olympics) QE cannot create prosperity because no matter how available you make debt, it is the preferences of the consumers that ultimately drives demand for loanable funds.

The Federal Reserve of the United States holds way, way more power than Donald Trump and Hilary Clinton, yet when they make a statement in the press, it usually doesn’t even make the front page. The Fed has the power to control interest rates. They also have the power to create money, as in printing currency (yup, money growing on trees). They control what you pay on your mortgage and they control how much interest your money makes (in markets and in savings accounts). This affects how soon you will be able to retire, how much your house is worth, how much your pension has in cash (i.e. how much risk your pension can take), how much your kid’s college fund will make… you name it, the Fed controls it. The best part is, you didn’t get to elect these officials. The US government deemed it too risky to put big financial decisions in the hands of under-informed citizens (*cough* Brexit *cough*).

Thanks for reading.

– tommander-in-chief.

Note: For more on pensions taking on too much risk check out this economist article, http://tinyurl.com/hg4rbjl

Sources:

  1. http://www.forbes.com/sites/marcprosser/2013/04/07/beyond-the-10-year-treasury-yield-how-to-follow-the-bond-market-with-etfs/#7c753437523d
  2. http://www.wiley.com/WileyCDA/WileyTitle/productCd-0471732834.html
  3. https://fred.stlouisfed.org/series/WRESBAL/

 

Side note on bond prices –

Bond prices are inversely related to bond yields. That is, when the rate on a bond rises, it’s price will drop. Because today’s rates are so low, the effect that a rise in interest rates will have will be massive. For a little relativity, interest rates (the fed funds rate) in 1999 was around 5%. A 50% increase in this rate would raise the rate to 7.5%, which is a massive jump. Now, we are debating a 25 basis point* increase in rates, which brings them from 25-50 bps to 50-75 bps. This may seem trivial, but that represents the same 50% increase in the fed funds rate!

*Note: a basis point is a ten thousandth of a percent; 1 basis point = 0.01%

 

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Who’s got the power?

Vices

I recently quit chewing tobacco, and, as many former nicotine addicts know, your brain does this crazy thing where we try to rationalize our use of the substance. I would say to myself, “Well, everyone has a vice, right? Whether it’s caffeine, food, booze, wasting time on Instagram, etc…. You name it and I guarantee it can be abused, and is abused by at least one of the seven billion people on earth. So what if mine happens to be chewing?”

Laying in bed at night, I pondered the question above. Assuming my thinking was correct, I took the connection further into financial markets. If everyone’s got a vice, who’s to say financial firms (which are made up of people) aren’t subject to the vices of their employees or executives?

I googled, “top excuses made by drug users”. I got a top ten list from spiritualriver.com, but for brevity sake I’ll only mention the top four.

4.) Everyone else is doing it? So why shouldn’t I?

3.) I’m not hurting anyone else.

2.) I need it to be ‘social’.

1.) I need it to be successful.

The goal of every financial institution in the world is to maximize profit. Just look at the 2008 financial crisis. All the media attention that J.P. Morgan has been getting recently is over their reckless behavior selling worthless assets to unknowing investors. I would probably do a crap job of explaining a mortgage backed security, so for an understandable, interesting explanation go watch The Big Short (Margot Robbie, naked, in a bathtub lays it all out for you surprisingly simply). I put a short explanation at the bottom of this post for those of you interested.

At the beginning of the crisis of 2008, financial institutions flooded the markets with these worthless securities and made real dollars. My point being, financial firms will do (and have done) ANYTHING to prop up their valuations.

Onto my real point, vices. Ever heard the term ‘window dressing’ (keyed “Repo 105″ by Lehmann Brothers before its undoing)? (Cohan, nytimes.com) No, not getting new curtains or window painting your friend’s car windows before the homecoming game. Window dressing is a common practice amongst investment banks and mutual funds to make it appear as though their financials are better than they are. For example, one measure of the security of a company is liquidity. Liquidity measures the company’s ability to survive if every one of their customers suddenly runs to the bank and pulls out all their money. One measure of liquidity is the leverage ratio. The more debt it has relative to its assets, the higher the leverage ratio, simply speaking. The lower your ratio, the less likely you are to go bankrupt when the whole market takes a turn for the worse.

In order to appear more financially sound, just before earnings are announced, investment banks will sell short-term bonds (some can be as short as one day) in exchange for cash. They count the bonds as assets, and pay off some of their longer-term debt with the cash. In one move, they increase assets and decrease debt; effectively lowering their leverage ratios. After the earnings are announced and in the books, they load back up on long-term debt in exchange for cash and repurchase the short-term bonds. Debt goes back up, assets go back down, and we’re back at the same place we started in terms of leverage; investors none the wiser.

Everyone is led to believe that financial companies are much safer than they actually are because of this immoral practice. Banking is founded on trust. If I give my money to a bank, I trust them to keep it safe and have it readily available if I ever need it. If my bank is practicing window dressing, how am I to know my bank won’t suddenly go bankrupt if the housing market starts to crash? Deception can absolutely crush a formerly trusting relationship.

In 1833 New York City, Benjamin Day founded The Sun; the newspaper was published and sold at a price that allowed the average, literate New Yorker to purchase a newspaper. The Sun was reputable, but recognized the importance of a compelling headline. They published a story about a man (Sir John Herschel) who had invented a new telescope that could see details of the moon. The story etched details of “a delightful valley ‘abounding with lovely islands and water-birds of numerous kinds… [and] a beaver that walked on two feet.” (White, 92) Though this false spread of information was harmless, it compares to what we’re seeing today across reputable financial firms. Frankly, it’s the spread of misinformation. Misinformation used to make huge financial decisions by the average American, such as, where to put money for your kid’s college fund? Where to keep my life savings? Who should I trust with my retirement money?

Bart McDade, head of equities at Lehman Brothers before its collapse, “said the accounting practice was just ‘another drug’ the executives were on”. (Cohan, nytimes.com) Let’s go back to the top four excuses an addict makes when confronted:

4.) ”Everyone else is doing it, why shouldn’t I?” Because it’s false information, you cretins.

3.) ”It’s not hurting anyone else.” You mean besides the millions of Americans choosing to invest in your bank?

2.) “I need it to be social.” If everyone else is doing it, it’s social to partake. You don’t want to be seen as the one who ruins the window dressing party. “Next to doing the right thing, the most important thing is letting people know you’re doing the right thing.” – John D. Rockefeller. Expose the industry and you may be rewarded.

1.) “I need it to be successful.” If you need to spread false information to be successful, you’re just con artists dressed up in $5,000 suits.

The rationalization I spoke of at the beginning of this article is attributed to an individual’s limbic system. This bastard is responsible for the late night Twinky you’re shoving in your mouth while watching Jeopardy under the assumption that ‘you’ll run it off tomorrow’. The limbic system is in charge of your emotional and instinctual needs. The reason we are able to abstain from our vices is our frontal lobes. These are your control boxes in charge of rational thinking. They are able to override the excuses your limbic system is giving you through rational, calm reasoning. When I am able to override my craving for a midnight snack or my dire need to check Instagram one more time, my frontal lobe section of my brain overpowers the limbic system. While the people who make up the banks are more than likely capable of fighting off that late night Twinky, the investment banks themselves seem to have evolved absent a frontal lobe. Conclusion: Yes, everyone has a vice, even investment banks.

I would argue that the act of window dressing should be illegal, not only for the sake of investors, but for the sake of the average American.

Fun Fact: Wall Street ‘dogs’ are commonly associated with cocaine and money, both of which directly stimulate the limbic system. Source: http://tinyurl.com/hnwxrvj

Whew, I’m going out for a Twinky.

Here’s a few links about window dressing in today’s markets.

Mortgage-backed Securities:

Before the 2008 financial crisis, there was the invention of the mortgage-backed security (MBS). The idea behind these securities was to minimize risk across the board, so banks sold pieces of mortgages to other banks, pension funds, mutual funds, hedge funds, and others. It was as easy as buying a stock or bond on the market. In exchange, the banks would reward the investors for taking on the risk with a relatively high return. “Where’s the problem?” some of you might be thinking. “Banks get less risk, I get more return; who’s getting hurt?”

Let’s say John and Jane Doe are hard working, responsible citizens, who pay back their mortgages and still have enough to take the kids to Chuckie Cheeze on the weekends. If they pay back their mortgage in a timely fashion, the banks get paid, the buyers of the MBS (who took on the risk) get their cut, and we had nothing to worry about. Everyone gets paid. Way to go John and Jane, you’re perfect examples of how the system was SUPPOSED to work.

The problem wasn’t with John and Jane, it was with Joe Smith. Thanks to slack standards of lending prior to the financial crisis in 2008, Joe was able to get a loan on a house he couldn’t afford. Joe was a hard worker, ate Ramen noodles for dinner, and didn’t take the kids to Chuckie Cheeze on weekends. Thanks to Joe’s financial illiteracy (and his degenerate mortgage broker), the rates on his mortgage were too high for him to repay. Bills started piling up at Joe’s door. If Joe doesn’t pay, the banks don’t get paid, and the investors who bought the MBS’s don’t get paid. We call this “defaulting” on your loan.

Banks accounted and prepared for the occasional default, because, to quote one of my favorite movies, Forest Gump, “shit happens.” (http://tinyurl.com/loavwqm) However, this ‘shit’ was happening far too often (again, thanks to financial illiteracy and slack lending standards) and investors failed to realize it. Everyone failed to realize it, until it was far too late to amend.

Banks started realizing that some of the MBS’s were crap, utterly worthless, because the people who were supposed to be paying the mortgages were defaulting like crazy. They started unloading these assets. They dumped them onto the market, selling at whatever price they could get, to keep their bottom lines looking tasty.

Sources:

  1. Cohan, William D. “Lehman’s Demise, Dissected.” Opinionator Lehmans Demise Dissected Comments. 18 Mar. 2010. Web. 28 Jan. 2016.
  2. Clark, Andrew. “Lehman Brothers: Repo 105 and Other Accounting Tricks.” The Guardian. N.p., 12 Mar. 2010. Web. 28 Jan. 2016.
  3. White, Shane. Prince of Darkness. New York: St. Martin’s, 2015.

 

 

Vices