How the Fed Kills the Credit Markets With a Steep Yield Curve
As we explained in our previous post How the Fed kills the credit markets with ultra-low rates, 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%.
Of course, banks would argue that a healthy spread is the key to a healthy banking sector. Banks, and many hedge funds 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. Since the yield curve almost always slopes upward, they can and do make money off that spread.
In 2009, 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, buy 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.Continued on the next page