Risk
Costs
John Riley, Chief Strategist
01/19/08
To stimulate
growth, much lower interest rates is the last part of the stimulus
plan that the collective wisdom of the team running the economy
into the ground is proposing.
This will be
known in the future as "Bernanke’s Folly". Too bad,
because its Greenspan’s doctrine, but he was smart enough
to get out before the waste product collided with a wind machine.
Understanding
Debt
Any time you buy a bond, invest in a CD or deposit money in a bank,
you are making a loan. You are loaning to your money with a promise
to get that money back at a certain time in the future. The borrower
pays you an interest rate for the privilege of using your money.
The rate of interest you as the lender collects is commensurate
with the risks of the borrower being able to pay you back.
Putting money
in a bank is low risk, so you get very little interest. Putting
money into Junk bonds is riskier, so the interest rate you are paid
is higher, compensating the lender (you) for the extra risk.
Any time you
borrow money, you borrow from an investor that has loaned his money.
You as the borrower are determined to have a certain amount of risk
and the lender demands a certain amount of interest to offset that
risk.
Homeowners with
great credit get the lowest interest rate mortgages, homeowners
with lousy credit have to pay higher rates on their mortgage.
But for a while,
the rates that lower quality borrowers had to pay kept getting lower
and lower, closing in on the rate top quality borrowers paid. The
chart below shows the spread between AAA rated debt and BAA rated.
As risks rise, and lenders re-price risk, the spread between the
two ratings rises. Since early 2005, the rate has climbed over 1/2%.
Source: Fed Reserve, Format: CIS
Spreads bottomed in early 2005. Since then a re-pricing of risk
has accelerated
until the 4th quarter of 2007 when the spread jumped about 40 basis
points.
The past couple of years has seen a re-pricing of risk in the bond
markets, especially the mortgage markets. During the heyday of the
real estate peak, anybody with a pulse got a mortgage. We all saw
the TV commercials for that one mortgage company that used to say
they had banks competing for your business. You as the borrower
could sit back and choose the lowest rate.
Lenders were
falling all over each other to get their money lent into the hot
real estate market. And to compete, they ignored some of the basic
rules. The most basic is to get paid for the risks they took. This
is where sub-prime mortgages come from.
People that
should never have qualified for a library card were getting $500,000
mortgages. (We are not going to go into the “predatory practices”
some lenders are accused of. People are responsible for their own
actions. I do not believe that homeowners bought houses 2 and 3
times what they could afford didn’t know it. This does not
include fraudulent lenders that lied to the borrowers. They should
have their corporate officers in jail.)
Why
It Won’t Work
So now we fast forward to the lower interest rates planned to stimulate
the economy. According to the Monatarist’s World Economic
view, (See Money
Money…) lower interest rates stimulate lending and this
new money in the economy propels the economy forward.
Almost right.
Lower interest rates do not stimulate lending. Higher interest rates
stimulate lending. Lower interest rates stimulate borrowing, sometimes.
It is simple,
if you have $100 to lend to your friends, who are you going to give
it to, Friend A offering you 5% interest or Friend B offering 10%
interest? You will give it to the guy offering the most interest,
all other things being equal. (These aren’t really good friends
for all of you thinking I wouldn’t charge a friend interest!)
But what if
they are not equal? What if Friend B still owes you a bunch of money
he can’t pay off? What if Friend B had a hard time paying
you off the last time you loaned him money? What if Friend B just
lost his job? Friend A is a much better risk, even though you will
get less interest.
So at what price
would you lend to Friend B? Is there an interest rate that would
get you to look past the risks? Is it higher or lower? Of course
it is higher.
Lenders in the
US economy have to ask themselves the same questions. Is it worth
the risk? At what interest rate am I being properly compensated
for the risks I am taking when lending money to this homeowner or
that small business? The idea that that lower interest rates will
stimulate lending in this part of the cycle ignores the lender’s
position.
Real
Life Example
We don’t have to look far to see the failure of the Monatary
World View. Japan has been in a deflationary funk for almost 20
years. Since its market peaked in 1989, Japan has slipped into a
deflationary economy that is held back by a mountain of debt.
Interest rates
in Japan have hit 0.00%, (zero) and yet their economy still can’t
get up off the mat. Why? Because while rates were low, lenders increased
their requirements to qualify for a loan.
The same thing
is going on in this country right now. Lenders are increasing their
qualifications for borrowers and people that qualified for a loan
a year ago, may not today.
Conclusion
Regardless of the direction of interest rates, if lenders don’t
want to lend, the economy goes no where. Since we should be concentrating
on reducing our debt burden anyway, this isn’t a bad thing.
The economic
decline that comes along with that will be painful to many lenders,
homeowners, the stock market and unprepared investors. They will
be finding out the true cost of the risks they took.
Investment
Implications
Having hedge positions on the US Equity markets, bond markets and
the Dollar are important. Hedges should benefit from declines in
these areas. As risk is re-priced, the values of these markets should
decline significantly.
At Cornerstone,
market hedges are the first thing added to a new client’s
portfolio. We don’t just anticipate the declines, we are prepared
to profit from them.
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