The bubble is on its way back
There is such a thing as a free lunch, at least if you are a bank. Imagine this: I offer to lend you as much money as you like at 0.5 per cent interest and then I will immediately borrow it back at 4.5 per cent. Not a bad deal, eh? Just borrow £10mi from me and you pocket £400,000. Borrow £10bn, and you earn £400m. Now I am neither so flush nor so stupid as to make that offer—but that is precisely what our governments are doing right now, and that is why banks and financiers are returning to profitability while the rest of us are still struggling.
It is called the yield curve, and right now it is unusually steep. If you don’t work in finance you probably don’t know what a yield curve is but if you do it is your bread and butter. It works like this: generally lenders demand a higher interest rate the longer they lock up their money. A ten-year bond will normally yield more than an overnight loan. Historically the spread between the 20-year US treasury and its three-month bill is around 2 per cent. Today it is almost double that, not because long-term rates are high (they are not) but because the central banks have driven the short term rates (the only rates they control) very very low.
Standard economic theory tells central banks to set interest rates low during a recession in order to stimulate lending, and consequently investment and economic activity. If banks can secure funding cheaply, they should be able to lend at lower rates, which creates incentives for firms to invest in capital projects, for households to borrow and spend, allowing the economy to return to its normal growth rate.
But banks are not lending vigorously right now. In part this is because they are hoarding cash. During the boom optimism reigned and banks would lend to anyone. Now fear is king, and even qualified borrowers find it difficult to obtain funds. But also banks have little reason to lend to you and me when they can make a risk free 4 per cent buying government bonds (and using government money to do it).
Now one can argue, that considering the deficits the British and American governments have had to incur due to the financial crisis, buying a bond yielding 4.5 per cent for the next 30 years is a tad optimistic. Even if the risk of default is overstated, all the new money slopping around the world economy might well spark inflation, raising yields and forcing down the value of the bond. But of course no trader buying a 30-year bond expects to hold onto it for the next 30 years. As long as these markets remain liquid, his 4 per cent spread is safer than houses.
So are Ben Bernanke and Mervyn King being bamboozled by wily financiers? Not at all. Our central bankers know precisely what they are doing. They have done it before. The steep yield curve is a time-honoured way of recapitalizing the banks, replenishing the coffers emptied by all those bad loans. In the past 30 years, the big banks have essentially been insolvent three times: in the early 1980s in the wake of the Latin American debt crisis, in the late 1980s and early 1990s after the junk bond/commercial real estate bust, and today. Each and every time, the central banks engineered a steep yield curve, giving financiers the opportunity to capture that fat risk-free spread. After a few years of these taxpayer subsidies (combined with a few accounting tricks) bank balance sheets are healthy enough so they can spark the next bubble. A steep yield curve is yet another hidden subsidy to the banks, bankrolled by the taxpayers, that is to say, you and me.
In his latest book, Whoops!: Why Everyone Owes Everyone and No One Can Pay, John Lanchester tells us that the great division today is between the people who can speak the language of finance and the rest of us. Bankers profit mightily by our lack of interest in their machinations. Ordinary middle class taxpayers rail against benefit cheats, against immigrants living in subsidised housing. If they understood the yield curve, perhaps they would rail even more at financiers who we habitually subsidise at much greater cost.
Mark Hannam
Tom
Sorry to spoil your “shock, horror” exposition of the mysteries of the yield curve, but things are really not this simple.
First, funding long-dated asset holdings with short-dated cash borrowings is not risk-free: it involved duration and liquidity risk. Profits might be unusually high given the current steepness of the yield curve, but this trade remains risky.
Second, the point of quantitative easing (QE) was that the central banks would buy up government debt, thereby encouraging other investors to buy non-government assets, which adds credit risk to the transaction. QE might not have worked as well as the central bank hoped, but it was an attempt to reduce the opportunity for a risk-free credit spread.
Third, borrowing short and lending long (the so-called “maturity transformation”) is what banks are supposed to do. This is how they convert short term current-account deposits into 25-year mortgage loans. Attacking banks for performing what is a rather useful economic function seems perverse: would you prefer that they kept all their lending under one year and the mortgage market shut down?
Speaking the language of finance is one thing; understanding it is quite another.
Regards
Mark
Tom Streithorst
Mark,
Yes, maturity transformation is the job of banks. And indeed there is some risk borrowing short and lending long (just ask Northern Rock). But remember, steep yield curves were used in the 80s and 90s to recapitalize the banks and it is precisely that cheap money today that is returning them to profitability long before the rest of us.
If banks are using short term government funds to finance long term government debt and thus capturing a huge risk free spread, that is certainly a hidden subsidy that we the taxpayers are granting the banks for the third time in thirty years. This subsidy, rather than their deep acumen and trading wisdom is why banks are showing stunning earnings numbers.
Mark Hannam
Tom
Banks, like any other investor, can seek to take advantage of a steep yield curve to try to make some money. The point is, this trade is never risk free.
But central banks are not holding interest rates low just for the banks’ convenience: they are doing so to help businesses and consumers cope with a debt overhang. The “wealth transfer” that this policy promotes is not between taxpayers and bankers but between savers and borrowers. Anyone who holds short-term assets (a saver) is being paid interest at a rate below the rate of inflation and is therefore experiencing an erosion of capital in real terms; anyone who has borrowed money against a short-term interest rate (mortgage holders, indebted businesses) is paying very little to fund their asset position.
As regards public policy to recapitalise the banks, remember that in 1992 the governmment used lots of our fx reserves trying to defend sterling in the ERM; much of this money went to UK banks who were short sterling, providing them with “excess profits” from fx dealing, which helped to repair their balance sheets. By comparison, low interest rates seems a more sensible policy?
Regards
Mark
Tom Streithorst
Mark,
Borrowing short and lending long is what banks do. As you put it, they have “borrowed money against a short-term interest rate” and so are “paying very little to fund their asset position.” Thus they are profiting mightily from the steep yield curve.
The government right now is lending short and borrowing long. They are providing liquidity to the banks at infinitesimal interest rate hoping to spark lending to households and firms. Bank lending however remains tight. Instead banks are buying long bonds financed by government paper. By being on the other side of that trade, the government is losing a 4% spread.
I think we all agree that in this economic environment, rates need to remain low. I think we also would all agree that it is in the nature of banks to try and capture a risk free spread when it is presented to them.
What I do think is worth noting is that this is not the first time that major parts of the banking system have been close to insolvency and that each time, under Volker, under Greenspan and today, the steep yield curve played a major role in recapitalizing the banks.
How is that not a repeated taxpayer subsidy to banks that have managed to lose all their money?
Mark Hannam
Tom
First, to reiterate, this trade is not risk-free. If banks (and others) are profiting from the shape of the yield curve, they are taking duration, liquidity, credit and operational risk. Presumably they judge the likely returns to be more than adequate compensation for these risks, but that is not the same thing as a “risk free trade”. To make this point clear: if long-dated yields rise by 1% over the next month, anyone who has borrowed short and invested long will be sitting on a significant mark-to-market capital loss.
Second, Western governments are not issuing long-dated public debt as a favour to the banks. They are doing so because, in many cases, they have mis-managed public finances and are now desperate to raise cash to pay for public services at a time when their tax receipts are low. Banks (and others) might benefit from this policy but it is not being undertaken for their benefit.
SO, I think your main claim – that the current shape of the yield curve represents a public subsidy to banks – is wrong.
Regards
Mark
Tom Streithorst
Then how did the banks recapitalize in the mid 80’s (after losing all their money in the Latin American Debt Crisis) and early 90’s (after losing much of their money in commercial real estate and junk bonds) and why are they so profitable today?
Actually, Mark, rereading some of your comments, I do think our disagreements may be more apparent than real. I agree that there is some duration risk to buying long dated govt bonds. I suspect you would agree that considering the liquidity of govt debt markets, for an attentive trader it is quite small. I agree that the central banks main purpose in driving down short-term interest rates was other than to funnel funds to the banks. I hope you would agree that nonetheless, the steep yield curve is doing just that.
Mark Hannam
Tom
I think we agree on two things. First, that, just as on past occasions, the monetary authorities have responded to the fragility of the financial system and the accompanying risks to global economic growth by bringing short-term interest rates down to very low levels. This has the effect of creating a steep yield curve.
Second, that a steep yield curve allows banks (and others) the opportunity to make capital gains by borrowing short and investing long, although this trade has some risks attached to it.
Where I suspect we still disagree is whether it is appropriate to call this a “public subsidy” to the banks.
Now let me ask you a question: if in a few years time, when economic recovery is assured and inflation starts to become a problem, the monetary authorities raise short-term rates and cause the yield curve to invert; and banks take advantage of the inverted yield curve to make profits by borrowing long and investing short, would you describe that as a “public subsidy”?
Regards
Mark
Tom Streithorst
Mark,
I guess our basic disagreement is that you think it is happenstance that low short term rates and a steep yield curve help recapitalize the banks. I think that although driving down rates is sensible policy during a recession, our central bankers are savvy enough to know this will rebuild shattered bank balance sheets and that is part of their motivation for engineering a steep yield curve.
Again, this is the third time in thirty years that the banks have been essentially insolvent. Each time, they have been recapitalized by taking advantage of borrowing at low rates from the central banks and immediately lending that money back to the goverment by buying long term bonds.
If the central banks fear inflation and raise short-term rates, the bond market, also fearing inflation will cause long term rates to rise as well. This will not create an inverted yield curve. An inverted yield curve is a harbinger of recession, not inflation.
Mark Hannam
Tom
Yes of course, monetary authorities can only control the short-end of the curve. But, for the example to work, let’s imagine that short-term rates are very high because the central banks fear inflation (or whatever) and long-term rates are low, because bond market participants don’t share these fears. Let’s just agree that the yield curve is inverted because short-term rates are unusually high.
Now, the banks (and anyone else) can make money by borrowing long and investing short. So the question is, does this count as a public subsidy?
The point of the example is to test your claim that, in situations when banks are able to profit from public policy, although the policy was not implemented with this as its objective, we should describe this as a subsidy. I am not convinced we should, even if the policy makers are cognizant of the likelihood this outome.
Mark
Tom Streithorst
Mark,
We have to stop meeting like this. Maybe a pint at the pub would be more appropriate and then we can hash it all out.
I find your example of central banks fearing inflation while the bond market does not a bit hard to imagine. But even if it were the case, banks cannot issue 30 year treasuries. The best they could do is buy short term govt paper and issue their own long bonds. Thus they would not be both borrowing and lending from the govt, as they are today. That adds another element of risk and more to your point makes it not a govt subsidy since both sides of the trade are not with the same party.
I certainly don’t think there is anything illegal or even particularly immoral about banks taking advantage of the spread. But I do think that central bankers are conscious of what they are doing, that they expect the banks to use the spread to recapitalize their tattered balance sheets. We both know they have done it before.
To be honest, if I were a central banker, I would take advantage of bank desire for long dated bonds. I would want the average maturity of govt debt to be as far away as possible. In thirty years 4.5% interest may look pretty cheap.
BUT right now, the risk for the banks is miniscule. If they see long rates going up, and they fear for their capital, they can sell. Obviously, they capture the spread only for the duration of the trade but that has been quite a while now.
It is why banks are doing well right now and I do believe that is one of the reasons (probably not the main reason) that the central banks have driven short rates so low.