The Real Secret to Fractional Banking

Aug. 25 (Bloomberg) -- Treasuries rose the most in almost two weeks on speculation credit-market turmoil may be widening.

The gains pushed yields on U.S. 10-year notes to the lowest since May 13 as financial stocks fell amid speculation American International Group Inc. will post a loss and Korea Development Bank may be reconsidering a possible bid for Lehman Brothers Holdings Inc. Interest-rate derivatives imply banks are becoming more hesitant to lend.

Oh boy…here we go. I’m struggling to even figure out where to start. First of all, anyone who buys a U.S. Treasury Bond should be taken out back and shot. Instead of filling your retirement fund with government debt, you could simply give me your money and I’ll burn it. Net-net, the scenarios are pretty much even.

Dear reader, I apologize. Sometimes financial stupidity aggravates me being that I have very little patience for such things. I understand if someone does their due diligence, and still ends up with a losing investment. It’s part of the game, and it’s impossible to pick 100% winners. Our goal is to simply put ourselves in a position that gives us a statistical advantage over the rest of the players. It’s sort of like poker. If you can get your money in the pot with the best hand prior to the final card or cards being dealt, you will win more than you lose. For any who are interested, it’s called the law of large numbers.

Negative Real Rates: The House Wins

What I don’t get is why anyone would want to give themselves a guaranteed loss. Look at it this way. Currently, a 10-year Treasury Bond gives the holder a 3.75% yield. That means you have a NOMINAL return of 3.75% on your investment. If inflation is 1% you will also receive a net 2.75% REAL return.

The problem is that a majority of investors, active or otherwise, don’t get the concept of nominal versus real returns. As mentioned above, the only difference is that real returns are inflation adjusted.

So what happens if inflation is above 3.75%? Well, it doesn’t take a mathematician to realize that you would be receiving a negative real return. In other words, the money you invested, although it grows nominally, actually loses purchasing power over the duration of your investment.

This also works the other way around. According to Bloomberg, today’s national average for a 15-year mortgage is 5.84%. Just as we have negative real returns on our T-Bonds, we actually have negative real interest rates. Translation:

A bank gives out a loan with an interest rate of 6%. I will look a little more specifically into real inflation numbers in just a second, but for argument sake, let’s say inflation is running at 10% per annum. So the bank gives a lump sum of cash away in return for interest on the money. In actuality, the money plus the interest is worth less than the initial lump sum the bank gave out. The bank actually loses 4% of its purchasing power over the life of the loan. Don’t forget that the bank assumes all of the risk in this transaction as well. Not a very good deal if you ask me.

How about the lendee side? This may sound crazy, but if you take out a loan and do absolutely NOTHING with it, you would be making money.

It’s crazy to think about negative real interest rates, but the best way to do so is denominate the money in something other than dollars.

Let’s look at it from the banks' perspective. I’m going to keep the numbers simple, so let’s say one year ago the bank dishes out a loan of $10k to be paid back today at a 6% yield. So the lendee has to pay back $10.6k.

Now let’s convert everything into the truest form of a currencies value: gold. $10k would have bought you 14.8 oz of gold one year ago ($675 /oz). One year later, $10.6k will buy 12.8 oz of gold. So you can the loan has actually lost 13% of its value.

You could adjust the numbers with crude, wheat, corn, or even the Euro and you will get numbers that are even more extreme.

Real Inflation and the U.S. Banking System

What I’m trying to get at is inflation is higher than many people who use the credit markets even know. THIS IS A LARGE REASON FOR TIGHTNESS IN LENDING MARKETS. Who wants to give out a loan when it’s a guaranteed net loss for the lender? It’s the same question as, who in the world would buy a T-Bill when it’s a guaranteed net loss for the investor. The end game is frozen LIBOR markets.

I mean, even government reported inflation statistics show that inflation is higher than interest rates show, and statistics like the CPI, PPI, and GDP deflator are a complete joke. Here’s the two best ways to judge inflation: money supply growth and the price of gold. 

You think the government and the Fed don’t know that? Just a couple of years ago, the government stopped reporting M3 money supply. M3 is the broadest and most accurate measure of money supply. The U.S. is now the only developed country in the world that doesn’t report M3. I guess they didn’t want the world to know that they have been and are continuing to run the printing presses on overdrive.

So I just want to end this article with a little food for thought. We are starting to see the effects of negative real interest rates in the credit squeeze, but how do negative real interest rates effect inflation itself? Who are the people and institutions that have access to discount lending in order to take advantage of the low interest rates? Last, but definitely not least, who gets pinched by this sort of monetary policy? I will answer these questions both inadvertently and intentionally going forward, so stay tuned.

In the mean time, I encourage you to look back and analyze other financial markets like I did with the $10k loan scenario. Denominate the DOW in gold or Euros to see the real performance of domestic equities. You might be surprised.

Disclosure: none

Comments

[tvb:]

You have to use overall inflation to calculate real rates, not cherry-pick the most appreciated asset classes of the past year (e.g. gold). If you are going to arbitrarily chose an asset class to calculate real rates, try using the deflated housing prices of the past year. Makes just as much sense as using gold (none). You could have made your same arguments a year ago -- and those who invested in 10 year treasuries last year (at around 5% yields) made substantial returns -- particularly compared to those who lost tons in the equity (around 20% from the peaks) and housing markets. I'm not saying that treasuries are attractive now (I don't think that they are), but your analysis is flawed.

2008 Aug 27 06:19 AM

[adan:]

really interesting article -

in your future extensions of the subject, i'd also like your thoughts on the idea that inflation eventually usually leads to deflation

and how that might explain why some people feel it's worth having some $ in longer term bonds

it seems that the two forces, inflation and deflation, are both extremely active on different asset classes right now

and monetarily, credit is being reduced/destroyed, a deflationary trend; while food and energy, til recently, were skyrocketing

might one be lagging the other?

i myself am not predicting anything, but obviously concerned enough to be trying to watch what's happening, including interesting articles such as yours

2008 Aug 27 11:06 AM

[JasonC:]

Let's repeat the trend follower's catechism, shall we?

Why would anyone own anything declining in price? Obvious anything declining in price is not paying you but costing you, yet you tie up capital in it. It should be sold instantly because it is declining in price. Anything declining in price is worth zero if not less.

Anything rising in price is sure to continue rising in price at least as fast as it just did. If you can borrow anything at rates below the rate it is rising, then just add enough leverage and your net worth will increase as fast as you desire. Anything rising in price higher than prevailing loan interest rates is therefore worth infinity. It should be bought instantly on the highest possible leverage.

There. Fixed it. That is all the thought there is in this silly screed. And the flaw is?

What the asset did over the last year has essentially nothing to do with what it will do over the next year. And in particular, the more is went up last year the more overvalued it is becoming, and the more it went down the more undervalued it is becoming - perhaps. Even that - the level trader's view - isn't remotely certain because the real future long run average price of anything changes all the time and is not known.

Here is the next thing wrong with it - one can sell, all cannot. Every asset is owned, and at all times, and precisely once. Assets owned with leverage require someone else passing on owning that asset at its current price, in favor of a fixed debt claim against the holder who uses leverage. Assets shorted have an extra long who took the other side of the trade, on top of all the existing longs. The aggregate return realized by all investors will be the return of every asset times its quantity, and all the trading in existence can't move it one iota.

Why are treasuries so bid? Because they have no credit losses and every other bond market item does, at present. Meanwhile every equity claim stands junior to others that are already distressed. Banks are also bidding for treasuries because they have zero Basel II reserve requirements, while riskier assets require regulatory capital against them. Said capital is scarce because they lost lots of their equity on bad real estate loans etc.

If you think rates are insanely low you should go take out a big loan, regardless of terms, against a valuable real asset. Oh, guess what the real estate bubble *was*? Too many people having exactly that brainstorm at once, ignoring the little question of the actual price paid. No Virginia, the house is not certain to always be worth much more than the piece of paper written against it. Something the despised piece of paper with its little nominal 6% yield is worth so much more than the big honking real house, that the holder of said paper will come kick you out of said house. No, leveraged debt to finance supposedly appreciating real assets is not a guaranteed way to get rich quick off the feckless make-believe of the fiat money system. Those who thought so are now called "bankrupts" and "renters"...

2008 Aug 27 03:34 PM

[japan20000:]

I am not an expert in finance nor a graduate in any of connected disciplines, but some comments here baffle me by basic ignorance.
JasonC already addressed most of points I wanted to add, but I still want to summarise:
1) no, you cannot just take a 3% loan and do nothing with it even if inflation is 10%. You will still have to earn at least nominal 3% somewhere to be able to repay. So nomilal yield does matter
2) gold can go down when iflation is high.
These are 2 sure comments, and one more a bit speculative:
3) I suspect much of investment into treasuries is due to funds (such as pension) funds who must have a certain % of their money invested in high quality debt, so they do it even when their managers wouldn't personally buy any for themselves. This pressures the yields artificially as does politics - I think one of the reason the Fed sticks to a low rate is exactly for the state to be able to borrow at low cost.
Do people here agree to this one?

2008 Aug 28 02:37 AM

[JasonC:]

No, the Fed isn't keeping rates low to reduce treasury borrowing costs. It is simply supporting the banks, which have been in trouble since last July.

As for funds and their directives, they are not require to hold treasuries as opposed to other relatively safe forms of debt (e.g. agencies or very highly rated corporates). People willingly hold them because their credit spreads will not widen and they are therefore expected to do well in the short term, whereas other issuers can see their yields increase and prices fall.

But the biggest thing keeping treasuries "on special" right now, is the way they help banks meet their Basel II capital adequacy requirements. Basically, all banks are required by international agreements to keep the size of their balance sheets within certain limits, compared to their equity capital. But those limits are much more elastic for high quality credits. Basically a bank doesn't need to reserve at all against a treasury bond, while it needs to reserve 8% against a corporate bond.

Since they lost a lot of capital recently in bad mortgage loans, they can meet their requirements only by either raising new capital, or shifting, net, from corporates to treasuries. The Fed has made that easier in the short run by selling half a billion in treasuries to banks, while accepting mortgage collateral in its place. Check the portion of treasuries on the Fed's balance sheet last year and this year...

2008 Aug 28 04:02 PM

[JasonC:]

Sorry, I meant half a trillion, not half a billion. (Approximately, of course).

2008 Aug 28 04:03 PM