Fed’s response to the financial crisis created winners and
losers. Ultimately it produced a massive transfer of wealth from savers and conservative
investors to financial intermediaries, corporations, and risk takers. Retirees and
others who traditionally relied on modest and reliable interest received to
generate cash income or grow their wealth have suffered an extended period of
zero returns while the value of cash is eroded by inflation. Moreover, losses
experienced during the crisis removed the risk-taking ability of many investors
forced to move to safety.
The “yield famine” represents years of lost returns for
savers and investors unwilling or unable to take risk. With the economy still
operating below potential, and unemployment being reduced only slowly,
short-term interest rates are likely to remain exceedingly low well into the
future. Add massive government debt comparable to levels after World War II and
“financial repression” is
virtually guaranteed for decades. Low rates will continue to keep savers hungry
while subsidizing the government, the financial system and the corporations. Meanwhile,
profits at the largest US banks are now the highest they have been in history.
Institutions and individuals holding assets in banks and low-yielding
funds would be wise to invest directly in the same way that banks do. Cutting
out the middleman would provide them with a similar level of safety that banks
enjoy, yet generate substantially higher returns. However, doing so requires,
first and foremost, the knowledge to find the right opportunities coupled with the
courage to move out of the comfort zone and take a modest level of risk. Investors with
diversified portfolios across the risk spectrum might also find it rewarding to
reallocate both ultra low−risk and very high−risk assets into moderate-risk assets with superior
The Conference, hosted by NYSSA Private Wealth Management
Committee on October 1st, 2013, presents a menu of choices available
for generating income from various sources. Topics of presentations include:
expanding outside the US into the global bond market, using equities for income
and growth, a look at the advantages of preferred stocks, visiting synthetic
bonds, evaluating the risks and returns of muni bonds, and sampling Master
Limited Partnerships and Business Development Companies.
Federal Reserve and its Chairman are often praised for the
swift and forceful response to the financial crisis, which helped avoid a
repeat of the Great Depression. Both conventional and unconventional monetary
policy actions were used to increase liquidity, shore up the financial system,
stimulate the economy, and reduce the high level of unemployment. Reducing the overnight
borrowing rates is a standard conventional policy response and the Fed, unlike
other central banks, took the bold step of reducing this rate to near zero.
The zero interest rate policy (ZIRP), along with infusions
of cash, saved the financial system from imminent collapse in 2008. Since then,
“too big to fail” institutions along with their thousands of smaller brethren
were able to borrow at infinitesimal rates. Such ample liquidity and low rates
propagate through the system, and determine
the rates of all other ultra-safe, short-term lending and borrowing such as
Treasury bills and commercial paper. In turn, these rates determine the
interest paid on so-called Money Market funds and bank accounts as well as
interest on short-term Certificates of Deposit or Bank Savings Accounts.
Short-term interest rates are unlikely to rise by any
substantial amount in the near future for a few reasons: continued quantitative easing,
massive government debt, and demographics. Quantitative easing (QE) is an
extension of the conventional monetary policy using interest rates. Most
likely, an increase of the Fed Funds Rate would have to be preceded by the
complete stop of Fed’s asset purchases. There should also be a reasonable
belief that no further QE would be needed. Since the Fed is just beginning to
consider a “taper” from the $85 billion per month in purchases, a lasting and
complete QE stop may be a long way off. It is also possible that the Fed may
wish to unwind at least a portion of its balance sheet before raising rates.
This would push the time to raise rates further into the future.
Government debt has more than doubled since the crisis and
now stands at 16.7 trillion or about 100% of GDP. Such high levels of
debt-to-GDP have not been seen since the end of the Second World War.
Government’s massive borrowing gives it a strong incentive to keep the interest
rate it pays as low as possible to avoid piling on even more debt. With most of
the government borrowing concentrated in short-term securities, it is in its
best interest to have short-term rates close to zero. Fed’s independence would not
be a barrier if it acted in the interest of the country and kept rates low. In
the 1940’s and 50’s, interest rates well below the rate of inflation amounted
to what is now known as Financial Repression. History appears to be repeating.
Lastly, demographic changes in the US, as a result of
retiring baby boomers, present serious economic challenges. Lower consumption
levels reduce the rate of growth while future promises in entitlements are
estimated at a gigantic $200 trillion, according to some .
The economy is unlikely to have such hypergrowth to support those levels of spending.
Thus, the government debt is likely to start increasing massively by the end of
the decade. Larger debt is likely to extend financial repression much further
into the future while inflation is likely to rise.
The objective of yield-oriented investors is to generate a
steady cash flow from a moderate return with a high degree of safety of the
principal capital invested. This applies primarily to retirees who need a
relatively fixed income for living expenses. It is well known that a loss of
principal account value, especially in the early years of retirement, can have
very negative or even devastating consequences in one’s ability to fund future
needs. This is because assets get depleted quickly at low valuations and can no
longer recover from a low base.
Years of missed returns cause serious setbacks and greatly
increase the risk of running out of money during lifetime. Many institutional
investors such as endowments, foundations, and pension plans have substantial
assets in safe investments. An extended period of near zero returns impairs the
ability to meet their objectives and in some cases can even threaten their
Ultra-safe investments caused investors to experience a
yield famine. The Great Irish Famine in the mid-nineteenth century caused a
massive death toll, disease, and misery because the majority of the population
became almost entirely dependent on a single source of food: the Irish Lumper
potato. Ironically, even during the famine, the country overall produced enough
food to feed its people. Starvation occurred because the food produced within
the country did not get to the people, for
various political and economic reasons,. Likewise, there appears to be a
sufficient amount of yield in the investment universe today. However, for different
reasons, it is not getting to a large category of investors.
While depositors are starved for yield, the financial
industry continues to feast. Profits at big banks and financial institutions
have recovered quickly after the crisis and are making new highs again. This is
in spite of the fact that banks are quite inefficient and have high costs. Running
a large bank is an expensive operation that includes rents for headquarters and
branches, expensive internal systems, regulatory overhead, and large salaries
and bonuses paid to senior staff and executives.
Ironically, after having been one of the principal causes of
the crisis, the financial sector is now reaping 30% of all domestic corporate
profits while contributing only 8% to GDP. As the chart below shows, on a
percent of GDP basis, the Financial Profits are at all-time highs. Clearly,
financial institutions are having a profit bonanza and getting more than their
fair share from the income pie. Largely because of the Fed policy, their
profits are subsidized by depositors who lend money at zero interest.
Based on these facts one would deduce that investing in
banks should produce outstanding results. Nonetheless, experience shows that stocks
of the financial companies have not been on par with the expectations. Why the
difference? One explanation is that a large part of the profits since 2007 has
gone to fight alleged misbehavior. According to Bloomberg, the six largest
banks in the US paid $103 billion in legal costs and settlements with the
regulators for selling shoddy mortgages, misleading investors, or manipulating
the LIBOR rate. By comparison, their total payout in dividends to shareholders
of common and preferred stock amounts to $98.6 billion during the same time.
OPTIMIZING BALANCE SHEETS
Given the dire state of affairs for savers, one would assume
that a large part of them would revolt and vote with their feet. However,
paradoxically perhaps, the amount of money on deposit with the banks has increased
by 70% from $4 trillion to $6.8 trillion between 2008 and 2012. It appears that
businesses, institutions, and individuals are making this voluntary decision
because they either too scared, don’t fully understand the consequences, are
unaware of other choices, or are simply complacent.
Most people automatically associate investing with the stock
market. This is an incorrect view since every held asset type and liability
(such as mortgage or credit card debt) should be considered. For example cash
in a bank account is an investment losing value because of inflation. Business
or personal debt is an investment choice that can earn the interest rate
currently being paid to the lender. For example, a business paying 7% interest
on a loan can “invest” in its own debt by paying it off. Importantly, this is a
risk-free rate of return for that business.
Mental accounting biases are likely responsible for viewing investment
accounts separately from cash and from debt. Instead of thinking in terms of managing investments, both advisors and
investors should be thinking of managing
Typical balance sheets tend to be suboptimal. Investors
holding cash and low-yield assets while simultaneously having debt are
subsidizing the financial system. Some
low-yield assets may be hidden in the portfolio inside money-market funds or
diversified bond funds. Investors may have much higher allocations than they
are aware of in such assets. Well-diversified portfolios also tend to have a
portion of assets in high-risk investments or strategies. The high-risk part of
the portfolio tends to underperform more conservative investments on a
risk-adjusted basis. (Reasons for such underperformance can be the object of
Both low-yield allocations and high-risk allocations can generate
a serious drag on the balance sheet performance. As a general rule, investors
should avoid extremes and reallocate these types of holdings to value
investments with moderate risk and positive expected real rates of return.
Investors may be surprised to find that the overall risk of their balance sheet
may remain nearly the same, while long-term returns could be substantially
Because of the highly profitable nature of the banking
business, investors can learn a great deal from the way these financial
institutions are managing their own investment portfolios. Moreover, by
understanding that the principal role of the Fed is to deal with financial
crises and protect the banking system investors can have a higher degree of confidence
in their investment strategy of following the model of financial institutions.
Astute investors are able to find opportunities for attractive
yield and returns from different sources:
- Bypassing banks and investing in similar ways by
lending to consumers, governments, municipalities, and businesses.
- Implementing strategies used by financial
institutions, including capturing the spread between short term and long term
interest rates, insuring risk, purchasing securities at a discount, and
capturing premiums for illiquid investments.
- Lending to banks by investing in the bonds or
preferred stock issued by banks and other financial institutions.
- Identifying investments with solid collateral
and attractive cash flows such as commercial properties and master limited
The “great rotation” that many speak about does not have to
be from fixed income to equities but rather from a yield famine to real return.
–Robert Andriano, CFA is the Chief Investment Officer of Pure
Investment Advisers, Inc., a boutique investment management firm specializing
in portfolio management and comprehensive balance-sheet optimization. For more
information please visit the company website at www.pureinv.com
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