Category: CD rates

Out Of the Tent and Into the Forest

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May 12, 2013
We can take some steps to reduce our susceptibility to adverse events but if our primary aim is to reduce uncertainty as much as possible, our lives suffer in quality and our wallets suffer in quantity.  In our financial lives, we must try to find a balance between risk and reward.  There is a high demand for low risk, high reward investments.  Unfortunately, there is little supply of such investments and the few that are offered are usually scams.

There is a good supply of low risk, low return products. In the past ten years, conservative savers have taken a beating.  There have been only two periods where the interest on one year CDs has exceeded the percentage increase in inflation.

Challenged by low interest rates on CDs, savers have fled the market.

Older people who rely on their savings to generate income continue to search for yield, or the income generated by an investment.  The iShares High Yield Corporate Bond ETF, HYG, and the iShares Dividend Select Index ETF, DVY, have posted strong gains.  As more investors chase yield and drive up prices, the yields correspondingly become lower.   In December 2007, DVY paid out an annualized 4.7% yield on a price of about $53.  In March 2013, the yield was 3.4% on a price of $65 (Source)

Despite the fact that the Federal Reserve has held interest rates at historic lows, the amount of household savings continues to climb.  Some of this is due to an aging population which has more in savings and tends to be more conservative.

The Federal Reserve is essentially kicking people out of the tent and into the forest where the wild animals live.  It’s risky out there in the forest.  How come the banks don’t want our money?  Some people do not realize that a CD or savings account is essentially a loan to the bank.  Through the FDIC, the U.S. government insures most of these loans.  Loan your brother in law money for a  year and you might not get it back.  Loan your bank the money and you are assured that you will get it back.

In the simplified models of banking we learned in grade school, the bank pays us interest for the money we loan it (deposits) and loans that money out to other people at a higher rate of interest.  The difference in the two interest rates is how banks pay their employees and other business costs and make a profit. The reality is much more complex.  A bank does not take a $10 deposit from Mary and loan it to Joe.  The bank takes the $10 deposit from Mary and loans $100 to Joe.  Where did the other $90 come from, you ask?  It is created out of thin air in a process called fractional reserve banking, which allows a bank to leverage the $10 deposit by ten times, in this example.  Because banks are leveraging money, there is a labyrinth of financial metrics of stability to insure that the banks are not taking too much risk.  Some of these metrics include the risk weighting of assets (deposits, loans and securities, for example) and capital asset ratios.

In a 1985 paper by Federal Reserve economists, they note that “There is remarkably little evidence, however, that links the level of capital or the ratio of capital to assets with bank failure rates.”  This paper was written before the S&L crisis of the 1980s.

The financial crisis in 2008 led to a surge of bank failures, peaking at more than 150 in 2010.  In this past year, failures have dropped to a level that can be counted with two hands.

 During the recession, the amount of commercial and industrial loans declined but have risen to nearly the same level as 2008.

From a thirty year perspective, we can see just how severe the decline was.

While loans and interest bearing accounts, or assets, at the largest banks are nearing 2007 levels, assets at small banks have declined.

The banking industry has been consolidating, larger banks eating up the smaller ones.

This past Friday, the Chairman of the Federal Reserve, Ben Bernanke, expressed concern that some of the larger banks are still prone to failure.  The ever increasing size of the big banks has enabled them to have an even greater voice in the halls of Washington.  Bernanke’s remarks hint that he is a proponent of further regulations which would reduce the amount of leverage that banks can use to increase their profits.  Banking industry lobbyists are making the case that if they are required to reduce their leverage, it will hurt the economy by reducing the amount of loans they can make.

The banks are feeling squeezed and they are sure to let lawmakers know.  Their net interest margin, or the spread between what they pay to depositors and what they charge to borrowers, has fallen to pre-recession levels, putting pressure on banks to take more risk to increase their bottom line.

I am reminded of a comment made by Raymond Baer, chairman of Swiss private bank Julius Baer, in 2009 who warned: “The world is creating the final big bubble. In five years’ time, we will pay the true price of this crisis.”  Let’s see: 2009 + 5 = 2014.  Hmmmm….

But we can’t live our lives waiting for the next catastrophe.  We must take some risk, be diversified and be vigilant.  As the stock market reaches new highs with each passing day, more investors will reassess their risk profile.  Some will curse their caution of the past few years and move money from safe but low yielding assets to the market, helping to fuel rising market prices.  The demand for yield creates a feedback loop that actually makes it harder to achieve yield.  If only we could live in a world where they didn’t have these darn feedback loops.

The Law of Averages

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February 17th, 2013

The spending sequester, or sequestration, set to take effect March 1st is a series of automatic and indiscriminate spending cuts that was part of the “Grand Bargain” compromise between President Obama, together with a Democratically led Senate, and the House Republicans in the Budget Control Act of August 2011.  The agreeement was rather like a Sword of Damocles, a chopping of spending programs cherished by one party or the other.  The term “sequester” means that there will be some actual spending cuts, not the usual budget and appropriations gimmicks that Congress is fond of. The unpalatable cuts to both defense spending and social programs were supposed to be an incentive for both parties in Congress to come to an agreement on deficit reduction as a condition of raising the debt limit.  It was hoped that the 2012 election would decide which party’s priorities would take precedence and the dominant party could then pass legislation to avoid or modify the sequester.  Instead, the election left the balance of power unchanged.  Republicans had dismissed the probability of the Democrats winning a majority in the House.  There were just too many seats that the Democrats need to gain to accomplish that.  Hoping to take the Presidency and having a good chance of taking control of the Senate in the 2012 elections, Republican lawmakers agreed to the sequester. The 2010 post-census election had put Republicans in charge of crafting voting districts, which enabled them to retain a majority in the House despite losing the total popular vote for House seats in the 2012 election. Several key Senatorial races imploded when Republican candidates made ill-advised (to be charitable) remarks.  Instead of gaining control of the Senate, Republicans lost two Senate seats.  Despite the high unemployment rate and the poor to middling economy, President Obama won re-election.

After navigating a mind numbing maze of previous law and baseline budget projections to arrive at actual spending reduction goals, the sequester will reduce defense spending by $55 billion and non-defense spending by $38 billion in 2013.  While this sounds like a lot of money, this is just 2.4% of the estimated $3.8 trillion in total federal spending in 2013 or a mere .6% of the estimated $16 trillion of this country’s GDP.  This past week the Democratically controlled Senate revealed a plan that would avoid the sequester for 2013.  The plan achieves deficit reduction goals with spending cuts and revenue increases but the revenue increases will probably be unwelcome to the Republican majority in the House.  Despite the rhetoric of calamity coming from either side of the aisle, both parties are anticipating that the sequester will probably take effect in two weeks.

Since mid November the SP500 has risen 12%; except for a sharp decline in the last week of the year in response to fears of the fiscal cliff, the market has climbed steadily.  The market has been largely ignoring the upcoming sequestration. 

More concerning to some is the slowdown in Europe, where the Eurozone economy has contracted for 4 quarters in a row.  Even Germany, the manufacturing and export stalwart of the Eurozone, saw a .6% contraction in the final quarter of 2012.

For many decades, the two prominent parties have been fighting an ideological battle over the role of the Federal government.  The Democratic Party regards the Federal government as largely beneficial and wants a greater role for the Federal government.  They have ushered in many social programs including Social Security, Medicare and Medicaid, programs that are largely on autopilot, beyond the reach of the Appropriations Committee in the House, where a select few can make the law by deciding which programs and federal agencies receive funding.  The philosophy of the Republican Party is that the Federal government is intrinsically a burden and therefore deserves a smaller role.  The Republican Party was out of power in the House for forty years until 1994; as a result, their role consisted largely of blocking or modifying Democratic Party ambitions.  Except for four years from 2007 – 2011, they have controlled the House since 1994 yet often conduct themselves as the opposition party that they were for much of the latter part of the 20th century.

In the tug of war between these two ideologies, the budget has suffered.  A recent report by the non-partisan Congressional Budget Office (CBO) contains a graph of Federal revenue and outlays and their long term averages which clearly pictures the “scrimmage” of ideologies between two yardlines, marked 18% and the 21%.  Republican politicians, together with conservative talk show hosts and commentators, speak of the “traditional” role of the Federal government at 18% of GDP.  This is simply the average of Federal revenues, not its role, for the past fifty years. Revenues have been, on average, 3% below that of Federal spending, which has averaged 21% of GDP.  The “traditional” role of the federal government, then, is to have an average annual deficit of about 3% of GDP.  In a $16 trillion economy, that average deficit is $500 billion.

Republicans simply can not say “no” to the Defense Dept; at times, they have forced spending programs on the Defense Dept that it doesn’t want.  The Democratic Party has become the champion of a hodge podge of Federal social welfare programs.  Neither party proposes taxes that will actually pay for the spending.  For all the Democratic rhetoric about taxing the rich, there simply aren’t enough rich people to pay for that average $500 billion deficit.  Large corporations continue to dominate both parties.  Campaign laws in most states as well as the federal government permit no fundraising in government buildings.  Almost every day, the members of the House and Senate must leave the government building where they work in order to do the daily drudgery of promising favorable legislation to corporations and associations in return for campaign contributions. 

We are still way above the 3% deficit average of the past fifty years.  The CBO projects that this year’s deficit will be 5.2% of GDP, almost half of the 10% deficit in 2009.

Over the next two decades, that 3% budget deficit average is about to grow larger.  For the past fifty years, the demographic bulge known as the Boomers have been paying into Social Security.  Those taxes have exceeded payments in most years, reducing overall Federal government deficits by .6% of GDP each year (Table 1.2 OMB historical tables, 2013 Budget).  Those surpluses have masked the reality that average annual Federal deficits, excluding Social Security, have been about 3.6% of GDP.  In a $16 trillion economy, that is close to $600 billion.  As the Boomers retire over the next twenty years and are collecting Social Security payments, add in another $100 billion a year as the Boomers draw down the $2.7 trillion dollar Social Security surplus they have built up.

We’re now up to a $700 billion annual deficit based on revenue and spending patterns over the past fifty years.  As the total Federal debt grows, so will the interest costs on that debt.  Over the past seventy years, interest costs have averaged 1.8% of GDP, almost 30% higher than the 1.4% of the past few years (Table 3.1 OMB 2013 Budget)  Ballooning debt levels and rising interest rates could easily add another $100 billion to annual deficits.  We’re now up to $800 billion and growing, based on historical averages.

Republicans will continue to call for spending cuts – it’s their brand.  Democrats will call for more programs and more taxes – but not on the poor and middle class – that’s their brand.  The political and economic tug of war will continue, meaning that uncertainty will be the new normal.  Uncertainty usually leads to lower economic growth which exacerbates social and political tensions which leads to more uncertainty until eventually there will be another crisis. 

In preparation for a cycle of uncertainty and crisis, the prudent investor might ask “What’s my backup plan?”  If you are lucky enough to have a defined benefit pension plan with the company you work for, what is your backup plan if that “defined” benefit is “redefined.”  Well, you might be thinking, my company is so large and dominant in its market that such a possibility is unlikely.  Tell that to the employees of United Airlines, a dominant player in its industry, who lost part, or in some cases, more than half of their benefits when United Airlines shed part of its pension obligations in bankruptcy court.

In the mid nineties, IBM converted its defined benefit plan to a “cash balance” plan, effectively lowering the pension amounts due older workers.  After seven years, a contested lower court decision and a victorious appeal, IBM won their right to do this.  IBM and other large companies have lots of lawyers and accountants trying to figure out legal ways to reduce their liabilities.  How many lawyers and accountants do you have? 

A March 6, 2012 article in the Wall St. Journal reported that “Business groups are urging Congress to let employers put less money into their pension funds, saying that exceptionally low interest rates are forcing them to set aside too much cash.”  I’ll bet your company has more lobbyists in Washington than you do.

These past few years have been a wake up call for those who worked, diligently saved and invested, planning on a certain retirement income based on historical returns of various investments in the stock, bond and CD markets.  Too many people discovered that their backup plan was either to keep working or go back to work, a fact supported by the monthly household survey from the Bureau of Labor Statistics. 

Many retirees built CD “ladders” in federally insured certificates of deposit that paid 4 – 5% interest or more, offering them the safety of their principal and a steady income.  With interest rates for CDs at 1% or less, many retirees have either had to find more risky investments or simply spend less or – there’s that backup plan again – go back to work to make up the difference.

Then there are the folks who planned on selling their home, downsizing and using the difference as an income stream in their retirement years.  Now they wait, hoping that housing values will return to the lofty levels of the mid-2000s or – backup plan again – keep working.

Some people think that the past few years have been an aberration and are waiting for things to get back to normal, or average.  What I’ve tried to show is what those averages have been for the past fifty years and that those averages are better than what we can plan on for the next twenty years.  We certainly can not plan on a vague hope that the folks in Washington will find either a solution or a compromise to a problem that has remained unresolved for the past half century and will continue to worsen in the next two decades.