Extreme times sometimes lead to extremely unusual sights. At the moment, nominal interest rates in Denmark are negative. The zero lower bound on interest rates has been smashed: the return to holding cash is higher than the return to depositing it in a bank or investing it in government debt (with anything less than a five year maturity). Wow. Before asking how we can even get negative rates, how did the economy get here?
Fearing some combination of the breakup of the Euro area, a European banking crisis, and a Europe-wide fiscal crisis, European investors are getting out of risky Euro-denominated assets, such as deposits in European banks or short-term European government debt, and into safer claims denominated in safer currencies, like claims on banks and governments that are denominated in Swiss Francs or Danish Krone. Thus, capital is flowing into Switzerland and Denmark and pushing interest rates down in these countries.
Following the increase in demand for these currencies, the Swiss Franc has appreciated significantly against the Euro, but the Danish Krone is pegged to the Euro. For Switzerland, the appreciation hurts exports and increases imports. For Denmark, there is little immediate effect on exports and imports, but the pressure for the currency to appreciate is the same. To stop the appreciation, the Danish central bank – Nationalbank — has to buy Euros and sell Krone. This is what the peg means and how the value of the Krone is maintained against the Euro. As it turns out, the central bank doesn’t actually sell Krone. Instead, the central bank buys Euros from banks and pays for them by crediting their Krone accounts with the central bank, account balances which are called “reserves.” Reserves are a lot like commercial bank’s bank accounts with the central bank. These reserves can be withdrawn from the central bank as Krone, and some are as the bank’s customers make withdraws to buy safe assets like Danish government debt and the bank withdraws from the central bank to meet the withdrawals. One upshot of all this is that the Danish central bank has roughly doubled its foreign reserve account balances and is becoming a long-short currency fund: long Euros and short Krone deposits (and Krone themselves – cash in circulation is a central bank liability). But that is almost an aside, the interesting point is that the demand for Krone-denominated Danish assets has driven interest rates on short term government debt negative. And Nationalbank has now reduced the interest rate it pays on reserves to negative 0.2 percent! Yes, it is more expensive to hold reserves with the central bank than to hold cash in the vault.
And this is how we actually get negative nominal rates: the convenience and safety of deposits or short-term government debt relative to cash. Holding a large amount of cash is inconvenient and risky. As an individual, it is much easier to buy a house with a check than with cash (imagine how you would feel walking with the suitcase of money from the bank to the closing agent). As a business, it is much easier to meet payroll with deposits than cash. And even as a bank, vaults are only so big and so safe. So short term nominal rates in Denmark are solidly in the negative range. The Zero Lower Bound is broken. Expect an increase in vault construction and possibly an increase in bank robberies. And a reconsideration of the Zero Lower Bound as an economic law.
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Posted in CMBS, spreads, TALF on May 22, 2009|
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The Fed announced Tuesday that previously issued (legacy) commercial mortgage-backed securities (CMBS) will become eligible collateral for the Term Asset-Backed Securities Loan Facility (TALF). This comes less than three weeks after announcing that only newly issued CMBS would become TALF-eligible.
The mission of the TALF is to increase credit availability. So how does expanding TALF-eligible collateral to include legacy CMBS help the Fed achieve this goal? High yields on legacy CMBS discourage the extension of new credit towards the purchase of commercial property. From the perspective of a lender, owning senior CMBS arguably provides a safer exposure to commercial real estate than new loan extensions, while at the same time, delivers a yield well in excess of what could reasonably be obtained in the market for new credit extensions.
As of last Friday, the yield on TALF-eligible CMBS securities was 684 basis points above the 10-year Treasury rate. (This implies a yield near 10%.) By making legacy CMBS securities TALF-eligible, the Fed hoped to spur demand for these securities, and as a result, decrease their yield spread. A week later and three days after the Fed’s announcement, the spread on TALF-eligible legacy CMBS has narrowed to 495 basis points. This suggests that the Fed’s announcement has helped narrow spreads.
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In these turbulent times who doesn’t need additional capital to get through these cold winter months? Because of your strong record of providing banking services to me, I would like to offer you a special opportunity to raise capital and gain liquidity in one easy step. This offer is available only to you, and it is only available for a short time.
As you know, you are the proud owner of my mortgage. As a result you receive several thousand dollars a month from me. I am sure this helps your income statement! I am a great credit risk and this mortgage should be providing you with a great return. Sadly, I am guessing that you, like many banks in these hard times, have actually lost a lot of money on my mortgage. (Phooey on those mark-to-market rules.) We both know the troubling fact is that market values of mortgages have declined precipitously, and as you well know, my mortgage is a nonconforming mortgage. Even some AAA mortgage backed securities are trading at steep discounts, something like 50 cents on the dollar. This puts the market value of my mortgage at around half the outstanding balance.
But I am willing to buy my mortgage from you at above its market price! I am offering to buy that asset that is stuck on your books at about 50 cents on the dollar for 60 cents on the dollar. That’s right, you can sell an illiquid asset, gain hundreds of thousands of dollars in liquidity, and lower your risk of bankruptcy with one easy transaction.
In the future, you will of course not get my loan payments, but once you have sufficient capital, you can turn around and make a very similar mortgage loan at any point – rates are even currently very similar to my current rate.
So don’t sit around waiting for a government bailout! Make you and your stockholders happy. Call me now to take advantage of this exciting offer.
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The U.S. Treasury’s proposed bailout plan raises a number of serious questions, many of which have been well articulated by politicians and pundits. Many of the plan’s merits, however, have been shrouded by confusion. Is the taxpayer losing $700bn to Wall Street? Is the Treasury paying fair value for assets? How will the bailout help Main Street? In fact, there are a number of merits to this proposal which all stem from markets currently being extremely illiquid.
An easy way to illustrate the illiquidity in markets is to look at the price differences between liquid assets and less liquid assets. The figure below plots interest rates over the past month for the 3-month London Inter-Bank Offered Rate (LIBOR) and the 3-month U.S. Treasury bill. LIBOR reflects the rate at which a bank borrows funds from another bank. During less turbulent times, prior to last summer, the spreads between the LIBOR and T-bill rates average around 40 basis points (bps). The spreads recently have been more than 100 bps, punctuated by the surge to 318 bps on September 17.
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