impact of low interest rates

[ERICOPOLY]

Observation:

 

A bank with non-interest-bearing deposit base can take on more risk with Fed base rate of 2%.  There is more profit to be made if things go right with a given loan, thus it can help defray the costs of the loans that go bad.

 

Therefore, the bank can afford to make loans to less-creditworthy borrowers.

 

Just an observation.  Wondering how much the slow economy is being hurt by low rates.  It's being helped in some ways, but surely hurt as well.

[jay21]

Observation:

 

A bank with non-interest-bearing deposit base can take on more risk with Fed base rate of 2%.  There is more profit to be made if things go right with a given loan, thus it can help defray the costs of the loans that go bad.

 

Therefore, the bank can afford to make loans to less-creditworthy borrowers.

 

Just an observation.  Wondering how much the slow economy is being hurt by low rates.  It's being helped in some ways, but surely hurt as well.

 

Disagree.

 

If I am making 1% risk free, by taking on 1% of credit risk I double my yield.  If I am making 2% risk free, by taking on 1% of credit risk I 150% my yield.  More reasons to take on credit risk when rates low.

 

 

[gary17]

That's an interesting perspective thx.

I just wonder if interest rate has been this low ever in history.  Low interest means low interest rate for home mortgage,and credit cards, etc,

My concern is are we creating a generation of people in the west that will not be able to cope with higher interest later ... 

[ERICOPOLY]

jay,

I'm thinking about a scenario where (think of Bank of America) you have hundreds of billions on deposit that pay no interest.  These deposits are non-interest bearing deposits, so when there is a parallel shift in the yield curve they will be more profitable.  Right now the net interest margin is razor thin, so you have to be very, very, very, very careful about who you make loans to.  More careful than normal because you need to reduce the amount of loans that go bad in order to preserve the thin profits from the loans that don't go bad.  Even after doing that, you are still at record-low profitability from your deposits.

 

Suppose the base rate goes up to 2%.  The rise in profitability will incentivize putting more of it to work.  Given that each loan has the potential to make much fatter profits, you can afford to lend to less creditworthy individuals.  Why?  Because you don't have enough highest-credit people to lend to -- so otherwise those deposits sit there underutilized.

 

It takes a relatively healthy NIM before you can profitably lend to people lower down the credit quality spectrum.

 

Thus I can understand why loan to deposit ratios are slight right now.  makes sense.  They have to be low, because NIM aren't high enough to support lending to lower quality borrowers.

[Palantir]

That's an interesting perspective thx.

I just wonder if interest rate has been this low ever in history.  Low interest means low interest rate for home mortgage,and credit cards, etc,

My concern is are we creating a generation of people in the west that will not be able to cope with higher interest later ...

 

Some people say low rates are "unprecedented", however, there is plenty of evidence to suggest that periods like right now have happened multiple times throughout history.

 

The point of low rates and QE is not to make the economy grow, but to prevent it from getting worse. It's like being on life support.

[jschembs]

How about the demand side of the equation? The slow deleveraging process certainly has restricted demand for new borrowing among many individuals and corporations.

[ERICOPOLY]

You can't afford to have too much of the portfolio go sour if the economy weakens.  So you keep it very high credit quality because there is no fat NIM to cushion the blow when it comes.  During the onset of the 2008 crisis, I believe the profitability of good loans initially widened as rates were cut (lowering cost of deposits).  That was a big cushion to help fight off the mounting loan losses.  Next time, there won't be any such effect.  So by having a presently tight NIM with no chance of deposit costs dropping in the next crisis, don't banks have to be more prudent?  It seems to me like that's the case.

 

[ERICOPOLY]

 

Disagree.

 

If I am making 1% risk free, by taking on 1% of credit risk I double my yield.  If I am making 2% risk free, by taking on 1% of credit risk I 150% my yield.  More reasons to take on credit risk when rates low.

 

What if credit losses hit 3% in a prolonged recession? 

 

You are giving examples that don't take into the cost of bad times.  Sure, you can make twice as much profit as the risk free rate, but get hosed when things go bad. 

 

Instead, what if risk free rate were 3% and you lend at 4%. That's only 33% more than the risk-free rate during good times, but you are still profitable during bad times when losses are running at 3%.

 

Even if those times never come, you need to pass these severe-adverse scenarios the Fed dreams up where you have spiking unemployment and spiking interest rates.  I don't see how you are rewarded to lend much out at these low rates where you aren't being compensated for the potentially high default rates and potential spike in interest rates.  I should think those scenarios would make you want to sit on your deposits and be very, very, careful loaning them only to people who don't need the loan in the first place.

[Mikenhe]

 

 

Therefore, the bank can afford to make loans to less-creditworthy borrowers.

 

 

define less creditworthy borrower.

 

 

I think we discussed this briefly in the past.

 

 

with neither of us being creditworthy for various reasons...

 

yet both having the highest net worth we've had. although your is smacking mine outta the park...

[Morgan]

My concern is are we creating a generation of people in the west that will not be able to cope with higher interest later ...

 

I wonder about about that sometimes too. When getting loans to buy apartment buildings at 4%-5% thinking about the future where the rates may be 10% or 15% or higher... I mean, it seems crazy to buy more property. The purchase price of the building would need to be significantly lower to keep the financing costs in line. Maybe I'd get edged out of a high rate market, but who knows about others. People can be crazy.

 

To counter that though, I know a guy who way back in the day got a loan for ~20% to develop some property then refinanced when construction was completed. He has been very successful, but he said he hardly slept during construction. Crazy, but doable I guess.

[ERICOPOLY]

Some people say low rates are "unprecedented", however, there is plenty of evidence to suggest that periods like right now have happened multiple times throughout history.

 

Should we not require higher rates to compensate us for not being able to exchange our dollars for gold?  Risk adjusted, can we honestly compare the interest rate today to that of 1870?

 

How much of that interest paid can we keep?  Before 1913 there was no income tax.

[Palantir]

You are free to exchange your dollars for gold anytime.

 

May I ask why you are referencing 1870?

[ERICOPOLY]

You are free to exchange your dollars for gold anytime.

 

Are you being facetious?

 

May I ask why you are referencing 1870?

 

It was the terminal point in the plot of long term interest rates that Fairfax was presenting a few years ago, and this saves me time looking for other data.

[frommi]

I don`t know if it helps, but here is a 130-year chart of 10y treasury yields. http://www.multpl.com/interest-rate/

[collegeinvestor]

When interest rates rise, loan demand goes down so even though NIM goes up the total volume goes down. This is what I have read--I am not an expert.

[Palantir]

I think you need to look longer than 1870 to determine whether the current scenario is unusual. You may have read Reinhart and Rogoff's paper that looks back 500 years. I don't believe the "low interest rates" is as unprecedented as some say.

[ERICOPOLY]

I think you need to look longer than 1870 to determine whether the current scenario is unusual. You may have read Reinhart and Rogoff's paper that looks back 500 years. I don't believe the "low interest rates" is as unprecedented as some say.

 

The base rate is unusual.  Once it goes back to the usual level, the banks make more money on the non-interest-bearing deposits.

 

[ERICOPOLY]

I don`t know if it helps, but here is a 130-year chart of 10y treasury yields. http://www.multpl.com/interest-rate/

 

Thanks.

 

In 1900, when the rate was 3%, you actually got to keep the entire 3% (no income tax).  And it was backed by gold, so you were actually making a real return on the money you lent risk-free.

 

Today when the rate is 3%, and I'm in the 40% tax bracket, I get to keep 1.8%.  The very same people paying the interest on the bond are taking 40% back in taxes.

 

That 1.8% is not backed by gold.  It could very well be a negative real return.

 

Today's interest rates are not comparable to those in 1900.  One gives you a real return, one probably won't.

 

Yet the interest rates are the same.

 

[gary17]

I think you need to look longer than 1870 to determine whether the current scenario is unusual. You may have read Reinhart and Rogoff's paper that looks back 500 years. I don't believe the "low interest rates" is as unprecedented as some say.

 

The base rate is unusual.  Once it goes back to the usual level, the banks make more money on the non-interest-bearing deposits.

 

So higher interest -> more people want to save -> banks make more money on deposits (the spread on the saving side)      so banks need to pay 3% interest to saver and it needs to somehow make money somewhere in a higher interest rate environment....    could they make 5% almost risk free?  so make 2%?

 

Higher interest also leads to less loans - so that side of the business goes down. 

 

It's interesting to see which of the two forces will make banks more or less profitable than in the current low interest enviroment

 

[Palantir]

I think you need to look longer than 1870 to determine whether the current scenario is unusual. You may have read Reinhart and Rogoff's paper that looks back 500 years. I don't believe the "low interest rates" is as unprecedented as some say.

 

The base rate is unusual.  Once it goes back to the usual level, the banks make more money on the non-interest-bearing deposits.

 

What is a "usual rate" and what is an "unusual rate"?

[ERICOPOLY]

so banks need to pay 3% interest to saver

 

non-interest-bearing deposits.  Their value will be seen when the base rate goes back up.

[ERICOPOLY]

I think you need to look longer than 1870 to determine whether the current scenario is unusual. You may have read Reinhart and Rogoff's paper that looks back 500 years. I don't believe the "low interest rates" is as unprecedented as some say.

 

The base rate is unusual.  Once it goes back to the usual level, the banks make more money on the non-interest-bearing deposits.

 

What is a "usual rate" and what is an "unusual rate"?

 

2% would be more usual/policy-neutral.

 

today's rate is unusual/policy-accommodative

[Palantir]

Even if you take 2% as your "base case" scenario, it doesn't mean that suppressed rates relative to that "base" are unusual in the strictest sense. There is a clear case that suppressed rates are very much the expected case in a deleveraging/post deleveraging environment.

[ERICOPOLY]

There is a clear case that suppressed rates are very much the expected case in a deleveraging/post deleveraging environment.

 

And that's "usual" environment?

 

[ERICOPOLY]

So an example.  Take BofA:

 

$363.962 billion in non-interest-bearing deposits

 

That's 1/3 of their deposit base.

 

The low rates are killing their ability to earn.

 

Were the risk free rate on short-term money to rise by 2%, they'd get $7.2 billion more profit from those non-interest-bearing deposits.