Tuesday, November 30, 2010

The Cost of Capital

Just a quick note for tonight.

The Cost of Capital
There has been a strange dynamic in play for about a year now in regards to the cost of capital. In normal markets rates are set by various inputs that in the end give both the borrower and the creditor a feeling that they are getting "fair value" both in taking the loan and in making it.

That is not how things work anymore. What would a mortgage written by a bank cost right now if they were left alone to set rates? With the double dip in home prices already here and a slew of inventory on the books, I think the 10 year US Treasury number would not even be in the ball park. Of course policy now is to make sure those rates stay ultra low.

CDS spreads have gone crazy for many European countries, but I have been watching CDS spreads for some time and they fail to make me take them too serious. What is serious is even a troubled state like Portugal is looking at rates going up to the 7% level(up from 4% in March) but along comes the ECB and they say "that is not right, we will lend money at 4% or 5%". The US FED has done much the same here. Add to this troubled US states like California have been taking advantage of US backed muni debt sales at rates far below what a open market would demand.

Now I think we all know that distortions cause problems....eventually. Easy money has a nasty habit of finding poor places to live. You can get things like bubbles or woefully miss priced instruments of all kinds that imply a lack of risk that simply does not exist. I think this should be clear. But let's look at another point.

If creditors are forced by the will and actions of government to lend at lower rates than they might want to, they are going to push rates where they can much higher. I would ask you all to review your credit card rates over the past year and see how they are moving. I just got a huge letter from my bank explaining the monster fees and penalties that will result now if I go into overdraft or miss any kind of payment on anything. Of course no one speaks for the little guy here, we will all just pay high rates and fees because that is where the banking system has pricing power now. They will chase return where they can.

Taking a step back, when you read that Ireland or whomever simply cannot pay debt back at such "high rates" as 7%, or even 10% there is an issue there. If a US state is on the verge of going bust over a 2% difference in a loan rate that is really walking a fine line. Yes, I know we are talking big bucks and it adds up, but really? I have argued that artificial low rates are now a structural necessity, not a short term support mechanism. Can the 10 year really be at 6% in 2 years without major issues? I would ask that the readers ponder what steps will be needed to keep rates of all stripes at all time lows for the next 5 years at a minimum and write them down or write them in the comments. Going further, ponder what avenues will be used by creditors to balance out their "fake risk" book with their "real risk" book. I think the answers will be useful in making investment decisions going forward.

Have a good night.

1 comment:

crisis garden said...

>Easy money has a nasty habit of finding poor places to live.

Great line.