Opinion

The Great Debate

“Risk free” rate going way of free lunch

By J Saft
December 10, 2008

James Saft Great Debate – James Saft is a Reuters columnist. The opinions expressed are his own –

One of the many comfortable but unreliable certainties now coming unglued is the idea that U.S. Treasury interest rates are the paramount benchmark, a measure of “risk free” investment, an idea at the heart of finance.

In the old days we quaintly believed that U.S. government debt yields represented a benchmark against which all other types of risk taking could be measured. The 30-year yield, later supplanted by the 10-year, used to be called the most important rate in the world for just that reason. All other risk taking began from this handy jumping off point and all capital allocation decisions used it as an implicit or explicit input.

That role of the benchmark of benchmarks, which greases the wheels of finance making it more “efficient” but more prone to spectacular error, is now under attack from a number of directions.

In retrospect, it seems clear that artificially low interest rates, due in large part to Treasury purchases by China seeking to keep its own currency and exports competitive, helped to turbo charge risk taking during the boom.

Living in a world of “low” interest rates and eternal moderation, investors didn’t realise how much risk they were taking on when they sought extra return above government debt, and after a while the money was so good they didn’t really care. In combination with credit ratings, another failed benchmark, that helped to fuel the boom.

Now we are living with the bust and coming to realize just how useful and dangerous benchmarks are.
“Nowadays it would be too much to ask for benchmarks. We all have to make our decisions on the basis of our own perceptions of the situation,” said Stephen Lewis, economist at Monument Securities in London.

Well and good, but as you can see the result of us all making our own decisions based on our own very limited data about how much risk there is in the world or in a given investment is abject terror
and an inability to act: much less risk taking.

People are only really willing to lend or invest in what they truly know, and as we each individually or as institutions know very little, we will invest very little and at, for the economy, ruinously high rates.

100 TIMES MORE RISK

The U.S.’s benchmark status as a “risk free” borrower is based on the idea that it is the best available credit, a solid gold borrower that will not default. And of course as Treasuries are denominated in dollars and as the state ultimately can print money to fulfil its obligations, that is correct.

But investors clearly are becoming increasingly spooked that the United States’ difficult situation and its absolutely huge borrowing plans are making it a less certain risk.

It now costs 60 basis points a year to buy a five-year credit default swap insurance policy against U.S. sovereign default, up from about 15 basis points in August and 100 times more than in January 2007 when it was 0.6 basis points. Clearly, somebody thinks risk free isn’t so risk free any more.
This compares with a 50 basis point cost for German or Japanese debt.

And remember too that 5-year Treasuries are only yielding about 1.70 percent, so a hedge against default would eat up quite a lot of one’s return.

Ironically, the Federal Reserve’s potential strategy of buying up government debt to reliquify the economy and avoid deflation may just make things worse.

Federal Reserve chairman Ben Bernanke last week said the Fed could directly purchase “substantial quantities” of longer-term securities issued by the U.S. Treasury or government-sponsored agencies to lower yields and stimulate demand.

Fair enough, and it’s not as if I have a better plan for jump-starting the economy, but having the state buy up Treasuries will only put more distance between a genuine “risk free” rate and reality. Investors will be even more in the dark about what and where risk is. They will not know where Treasuries would trade without Fed intervention, nor will they know when and how quickly the Fed will roll back that intervention when growth and inflation inevitably arise again.

That may sound like a technical point, but it is extremely serious. It seems likely to me that investors will alternate between two poles: totally terrified and unwilling to take any risk, and too giddy and scared to miss out. My guess is that this policy will extend the first state and turbo-charge the second.

Lack of confidence in benchmarks will keep people frozen longer, and make them float another bubble when at last they come round.

The failures of the past 10 years are failures of misallocation of capital; first the dot-com bust, then housing.
It is very hard to know what to root for: another bubble or deep, deep recession as investors, stripped of all their illusions, advance capital only to what little they actually know.

– At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. For previous columns by James Saft, click here. –

Comments
28 comments so far | RSS Comments RSS

Enough alarmist journalists who need to justify their job by printing Chicken-little rantings.

Why don’t you offer a constructive solution instead of adding to the same paralysis and chaos.

People make decisions according to what they read. Be constructive and/or offer a new insight. Stop making it worse.

Posted by will they post this | Report as abusive
 

The stupid bail out make the economy much worse. Goverment should never do bail out and just let the capitalism to do its course. Bad executive should be punished. Goverment should buy all the foreclosed homes thru one institution and let them rented to the people in a meantime to cover the cost and sell them slowly. These morron people should not buy what they cannot effort and should bear the consequences.

Posted by waslen naibaho | Report as abusive
 

This aversion for risk has a “shape” which is akin to a pyramid. The base of this pyramid consists of millions of small (retail) investors who have fled the markets and are now sitting on huge piles of cash.

The rallies which are taking place are predicated on thin trade because these frightened investors are not about to return to the market and will …… “advance capital only to what little they actually know”, to use your words. In other words they will only return to the markets once they feel they can trust the same “experts” who caused the collapse in the first place.

This could take years so brace yourselves for a long wait

Posted by anton kleinschmidt | Report as abusive
 

Mr. Saft, an enlightening analysis, as usual. Great stuff for those who choose not to hide their head in the sand.

So, even though global risk aversion is presently benefiting Treasuries and the dollar, beneath the surface global aversion to the dollar is mounting. It’s a tug of war between the pro-dollar and anti-dollar forces. Presently, the pro-dollar forces are winning out, but for how long? The tug of war isn’t over. I can think of a number of factors that could well flip the advantage to the anti-dollar side of the tug of war. If that happens, the dollar resumes its strategic slide, interest rates go up, the cost of servicing all the old and the huge (and growing) mountain of new U.S. debt skyrockets, and such a resumed slide in the dollar has every prospect of turning into a self-reinforcing downward spiral. In short, the present dollar “recovery”, based mostly on rabid investor fear, isn’t sustainable, for the colossal debt that the U.S. is rapidly piling up in order to “jump start” the economy is the force that will emerge at the top of the heap – and it’s predominantly an anti-dollar force.

 

Too much Paper Not for Me.

Gold and Silver….is Real Money

Bonds are rated AAA … for how long..??

Too much Fraud Here.. The markets are Broken.

The Dollar is Dog Food…!!!

Posted by Bill L. in NC | Report as abusive
 

It is possible to take risk off the books of the government and put it on the backs of average investors and taxpayers. Then everybody gets a pat on the back for the splendid work they do. So actually it is possible to have return without risk.

Posted by Don | Report as abusive
 

So maybe we should call it “relative” risk.
Certainly US Treasuries are relatively safer than, let’s say, Ecuadorian bonds. And, therefore, yields will reflect that relative risk. Right now, US Treasuries are the only game in town for the risk averse. And I’ll bet not even Mr. Saft is stashing his dollars under the mattress quite yet.

Posted by J Ingram | Report as abusive
 

Anyone who studies business and economics and who also has any critical thinking skills realizes that our economic system is founded on a number of increasingly smug but false premises(some of which are put forward by Mr. Saft in this article). When an economic system is founded on what is essentially fraud, then after a while the people upon whom the fraud is being perpetrated, start to wake up and play the same game as the perpetrators. We shouldn’t be blaming ordinary people for bubbles when they are being promulgated from the top.

All economic activity is based around trying to get an advantage to rise above the average standard of living. All of the cheap tricks and obfuscations that make the few reach exalted status at the expense of everyone else are more and more rapidly being rooted out and emulated.

Why? Because the shamelessness to which individualist materialism has risen in our society is now actually destroying the food chain that it feeds on.

Don’t get me wrong. A reasonable amount of individualist materialism is a natural part of life. But when it becomes the paramount reason for living of the educated and empowered classes, that filters down and the glue that holds our communities together come apart.

When people sell credit default swaps for which they have insufficient capital to pay off in the event of a melt-down should be seen as involved in fraud just like any common con-man. But that is not what appears to be going on. Instead, the government is bailing out the con artists (who have become fabulously wealthy) becoming accomplices to the fraud. Is that really where we want to go?

Life is a balance of forces. On one side we have to concern ourselves with individual needs and rights. On the other side we have to maintain healthy, vibrant communities. The nation has lost its way in over-emphasizing individualist concerns. Now comes the rebalancing or else the crumbling of civilization. But it is our choice.

Posted by Jonathan Cole | Report as abusive
 

I am fed up with “cassandras” seeing only and everywhere doom and gloom. It simply not true however difficult the situation is.

Posted by Marco | Report as abusive
 

When reading the article it came to mind the old line “There is a simple solution to every human problem. Neat,plausible and wrong.” The very premise of the Saft article was fantasy so the end product was garbage.
It is no secret that the US is a country driven by debt. It now takes approximately $3.25 of total debt in the US to generate $1 of GDP, a significant increase from 1952, when it took just $1.30 in debt to generate $1 of GDP. However, in 1952, government debt—federal, state and local— was $244 billion and accounted for 55.1% of the $443.6 billion in total debt outstanding in the US. Today, government debt stands at $7.2 trillion but accounts for just 15.7% of the $45 trillion in total debt. Household debt today has a much larger impact on economic growth than government debt— at $13.6 trillion, it is almost twice as much as government debt, while in 1952 it was just one-third of government debt.
So what is now happening is that the federal govt. is assuming private debt. We may well go back to the GDP to debt ratios of the 1950′s. What is clear is that the Federal govt., in assuming new debt, WILL NOT BE MOVING INTO UNCHARTED TERRITORY. The sky is not falling as Mr. Saft would have one believe.

Posted by Pablo | Report as abusive
 

All the falsehood, corruption, manipulations, excesses, stupidity that the US has inserted into an otherwise sound econo-political system the past decade or so are bearing consequences.

And yes, all the ‘above repeated’ done this year trying to ‘fix’ a rotted apple will ensure stronger consequences down the road.

USA has not fixed anything yet. The same people largely responsible for policy continues to execute policies to hide their previous policies.

All I see thus far is a grander delusion to cover layers of delusion. This is precisely how empires fall.

Posted by TomK | Report as abusive
 

One of the many comfortable but unreliable certainties now coming unglued is the idea that U.S. Treasury interest rates are the paramount benchmark, a measure of “risk free” investment, an idea at the heart of finance. By James Saft.

I like to think in the future that US Treasury rates will still be a measure of “risk free” investment but the way our economy is coming undone and the quick pace of decline, that day when its worthless might be sooner than we expect. Hopefully something can be done to avert it. Enjoyed the article, very informative.

I have to agree with one other commentary of earlier today: Government should not be bailing out capitalism especially if you make a bad product as is the case with American cars. I can just see the long lines of executives waiting in front of the White House with a empty tin can. It goes against the very grain of Capitalism and what America stands for a company to get a bailout.

Posted by Mr. Shah | Report as abusive
 

Having the Fed “reliquify” the economy is akin to have firefighters put out a fire by lighting themselves on fire. We do not need to have the globe delever by having the majors overlever themselves. More of Paulson/Bernanke’s it’s-so-crazy-it-just-might-work nonsense. Back to basics please.

Posted by Chris | Report as abusive
 

…The great risk for owners of real-estate and
shares is that DowJones Index might fall as much
as 6000 point’s = We might be around the year of
1974. To the good news is that all the poor and
homeless people will find pay a lot less in rent
and there should be no problem to find a home to
live in.

Posted by Lars | Report as abusive
 

It truly is unfortunate that we seem to live in a period where there is no accountability.

Lie about weapons of mass distruction….no problem. Rape your company in your efforts to secure a golden CEO parachute…no problem.

Where does the buck stop nowdays? No where evidently. It’s all a game of musical chairs.
The sucker holding the —whatever– when the music stops has to eat shi….

In the context of this article we see the Fed chairman “helicopter ben” attempting to save bush cronies.

Wake up America (and world). People will screw you many times over if you’re not vigilant and willing to standup and demand ACCOUNTABILITY!

Posted by Charles D | Report as abusive
 

Mr Saft’s points seem to me well taken. As for those who are inclined to refer to such observations as those of a ‘Cassandra’ I would offer the simple observation that Cassandra was, invariably, right (I’m certain Mr Saft would not claim such infallibility, but, then again, I doubt he shares Cassandra’s particularities).
I see no alternative to governments assuming massive debt in an attempt to mitigate the destruction which will inevitably be wrought by an unprecedented deleveraging. At some point, I would agree with many other observers, it is inevitable that this debt, taken on, will in turn be written down by very powerful inflationary forces. Yes, of course, it would have been infinitely better had we not wrought the folly of horrific over-leveraging. Nonetheless, it was done, and all that is possible is to attempt to deal with it as well as possible. To minimize the damage at ground level. To preserve what degreee of instituional functionality is possible during the years of deleveraging and transition, and to plan for dealing with the ensuing inflationary destruction of the debt burden as rationally as possible. These are not simple tasks. They are not pleasant. Mr Saft’s thoughts seem of value to me, and worthy of consideration.

Posted by Big Al | Report as abusive
 

James the US Treasury Bills of 3 months duration falling to zero yield is ridiculous.Low Interest rates is never going to be the answer.In India where I live,for most of my Life Interest rates were in double digits and it never ever affected growth in any way.It incentivised Savers and made sure Borrowers were financially prudent.Low Interest rates stabbed the elderly and retired who needed safe and secure returns for their limited savings.
Cheap Credit and easy Money Policies currently being adopted is a recipe for disaster.We want to continue creating bubbles,watch them burst and cause even greater destruction.To bring fiscal responsibility the only option is that all Currencies should be pegged to Gold Reserves held.You cannot and should not print money out of thin Air.This will also tame Inflation.Economics is not Rocket Science,just common sense.There has been an amazing lack of this common sense recently.
If anything is too big to Fail,why is it allowed to become too Big?

Posted by goldchest | Report as abusive
 

The questions of when and how quickly the Fed will roll back its ‘quantitative easing’ are enormously important. One suspects that ‘quantitative squeezing’ will begin at the first sign of rising inflation. But that will risk reducing the rate of economic recovery or even stalling it. I suspect we may be in for a period of ‘stagflation’ with economy stagnating while prices rise. Hardly the hoped for outcome.

 

To those who say we should stop having government intervention and let capitalism take its course – I agree – or I would agree except for one thing – the reason we are having to bail out the auto companies and the reason that we have lost millions of manufacturing jobs over the last 30 years is partially because of government intervention FROM OTHER COUNTRIES. If Japan had not artificially boosted the US dollar and depressed the Yen throughout the 70′s 80′s and 90′s and China had not followed suit in the 90′s and the 00′s the dollar would have slowly slid to about 50-60 yen and some lower amount in Yuan and a balance would have been created whereby Japanese and Chinese consumers would have gained purchasing power and American exports would have rose while imports would have decreased. America would not have run a monster trade deficit for three decades and Americans would not have had access to all this free easy money – they would have been forced to save and buy in moderation instead of being so wasteful (me included). So, if you chose to abstain from America bailing out its own vital industries – you are in effect choosing to conceed to the outcome created by foreign countries helping out thier industries – at our expense. It is the equivilent of getting attacked and not fighting back.

Posted by Graham Brown | Report as abusive
 

The reasons for collapse of the financial market place are simple
We fine the rich for their crimes(civil penalties).To deflect from this outrage we creates jobs for the poor by jailing people for selling pot and harder drugs and build new prisons and hire thousands of guards
Mexico is almost under the control of the drug cartel
Which is more immoral? Drug crime or white collar crime
!
Why not make milking investors of billions a offense equal to(economic )treason a criminal offense Until and unless we penalize the greed SOB\’s can a revolution by the working classes be far off

 

The bailouts slow down real economic activity. Instead of managing the business, everyone is running to Washington to see what they can get.

Posted by Derek | Report as abusive
 

Good comment by Anton K. — However, I think he has his pyramid upside-down. As a former broker, I can say that it’s the institutional investor who has all the money at the top, and that top is small because he’s lost a lot of his wealth. The little guy is definitely on the bottom and that’s why the pyramid is falling down. The base is ‘broken’……

Posted by Jim | Report as abusive
 

Judging by recent slow actions of the SEC in Enforcement matters and efforts to keep contraversy quiet one might guess that China is begining to pull the strings of more than just the US Treasury Secretary. We are only a store of value so long as we preserve our Values: Truth, Justice and Liberty are what make our debt a store of value, when we foresake these principals we will lose that leverage in borrowing from the international community. Cox’s resignation is overdue.

 

Some good comments here but what’s puzzling is the emotional aspects of the comments and the doomsday scenarios offered by some. Sure, the US consumers are at the heart of this mess and they have been led that way (you know the American Dream etc) but they are also the key to the recovery. Don’t be fooled the chinese or anyone else have little to offer in a way of future turnaround. And by the way US debt has one nice aspect to it – most of it is owed to itself ie. it’s not going to hurt once a decision is made to wipe it off – and it will come. I am more worried about Japan, it’s debt size is much bigger than that of US.

Posted by John Stor | Report as abusive
 

I see two big problems with allowing current Fed and Executive Branch bailout/stimulus policy to continue.
First, we are ratifying the feel good/no pain ever actions that have prevailed in both state and federal government for decades and making it ever more difficult to back away from this policy and ensuring that we get more and more government, where decisions have little to do with productivity.
Second, we are very negatively effecting the creative/destructive function of capitalism by propping up failed businesses and institutions and crowding out startups, which traditionally would have a positive affect on employment.
It appearss that crisis management experimenting will prevail regardless of the unintended consequences.

Posted by Gary Leeper | Report as abusive
 

Nobody sees that USA is changing into the socialism country, where a government makes the economy “working”. It is one way road only – bankruptcy.

 

We are where we are due to ethics and greed. The entire system from borrowers to Securities Companies, Banks and Insurers rose to an uncontrollable critical mass where they fed off each other. The financial model finally failed not due to inadequacy but because good common sense, rules and boundary lines became blurred and both Government (Congress) and Institutions (Business) either changed, ignore and/or forgot why they were there.

Now is time for bold action, the US should turn on the presses, purchase back our IOU’s from around the world ASAP, immediately impose a substantial gasoline tax and use these proceeds to bridge to energy self-sufficiency as quickly as possible. The window is small

The markets, business integrity and following the rules will sort the rest of this out over the coming years. I can’t get real enthused about trowing the baby out with the bath water re CAPM….just everyone follow the rules and prosecute severely those that don’t

Posted by Michael | Report as abusive
 

To the above commentor. While you rail against Mr Saf for his “rantings”, you make a rant of your own!

Nowhere in your post do you try to justify why Mr Saf’s article is bad; it is because you say so? In other words *your* post is the rant; at least Mr Saf puts forward some interesting points which he tries to elucidate with facts.

All he is actually saying is that the benchmark “risk free” status of the 10 year paper is somewhat more opaque than we thought it was, this is hardly saying that the sky is falling, or in your words “adding to the same paralysis and chaos”….

Posted by Gareth Evans | Report as abusive
 

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