“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. –

28 comments

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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