A lot of people are tempted to ride the yield curve, but many get bucked off, and some get trampled underfoot.
The ‘yield curve’ is just a graph showing the interest rates earned by bonds that mature at different times in the future. The bonds must all have the same degree of risk and liquidity so that the only difference is the length of time until the principal and any outstanding interest must be repaid.
Short-term interest rates usually are lower than longer-term ones for bonds or loans of equal risk. The reason is simple: The longer the wait before the principal is returned, the more things that might go wrong.
These could include unexpected defaults by the borrowers for reasons not yet perceptible or unanticipated inflation that would reduce the buying power of money repaid. Since loaning for a longer term inherently involves more risk and uncertainty, investors will only do so if they get a higher return on their investment than for shorter-term alternatives. Hence the yield curve.
Borrowers who need money for an extended period look at lower short-term rates and wonder how they might take advantage of that cheaper money. If only they could enjoy these low short-term rates to fund some longer-term project. This temptation is dangerous.
Adjustable-rate mortgages arose so borrowers could take advantage of the fact that short-term money is cheaper at most given times. But both short- and long-term rates fluctuate a lot. A short-term adjustable rate might be lower than prevailing fixed rates when the mortgage was taken out but could be much higher a few years later.
Many people took adjustable-rate loans when all rates were low, figuring they could quickly switch to a fixed-rate loan later if interest rates started to rise. That thinking resembles the logic of my third-grade classmate who argued he would never die in a plane crash because he would be smart enough to jump out when the plane was one foot above the ground.
But big investment banks were subject to similar self-delusions in their abilities to exploit short-term rates to fund longer-term investments. Bear Stearns and Lehman Brothers were not alone in funding large holdings of what eventually proved highly illiquid securities with very short-term money. They were just two that suffered particularly from their folly.
Both had borrowed using commercial paper. This is unsecured borrowing for periods of up to 270 days, but usually much less. Historically, it was used by manufacturers to cover the time between when they had to pay for raw materials and when they got paid for the finished product, or for retailers who had to pay for new inventory before a major sales season. But by the late 20th century, so-called “financial commercial paper” — issued by financial firms to borrow cheaply from insurance companies, pension plans and others — took on major proportions.
More important, both companies borrowed very short-term using repurchase agreements. These basically are short-term loans secured with collateral, such as a bond or other financial security. The term of the loan can be as little as a week or even overnight.
As the Greenspan-chaired Fed kept short-term interest rates low, borrowing short-term money was the cheapest way for big trading institutions, whether hedge funds or investment banks, to multiply the clout of their own assets. All assumed that whenever their short-term paper or repos came due, they could simply be rolled over with new ones.
For a long time, it worked.
Bear Stearns and Lehman both rolled over tens or hundreds of millions in short-term borrowings each day, as long as the music kept playing and everyone was still dancing.
But the music ended in August 2007, when European commercial paper markets seized up. Usual customers refused to buy new issues to replace old ones that had matured. And once rumors about Stearns and Lehman started to circulate, counterparties that had rolled over short-term repos again and again pulled back. If a substantial portion of your borrowings has to be refinanced every few days or weeks, you go bust quickly.
The same short-term-money-is-cheap impulse drove the local governments and nonprofits that funded long-term projects with “auction-rate securities,” bonds whose interest rates adjusted weekly in many cases. The financial officers who took advantage of this money were deemed wizards as long as rates were low and buyers were plentiful but were proved to be chumps once the music stopped.
But home mortgage seekers, investment bankers and hospital administrators do have one defense. Even the biggest borrower of all succumbs to the same temptation.
As recently as 2000, the average time to maturity for U.S. Treasury bonds held by the public was six years and two months. It fell rapidly over the next eight years as Uncle Sam tried to take advantage of Greenspan’s easy money along with everyone else. By late 2008 it was three years and 10 months.
Since then, it has edged back up by six months, but this means we still have to roll over nearly a fourth of this debt every year. That makes us particularly vulnerable to an interest rate spike if foreign investors get the same sort of qualms as those lending to Bear Stearns or Lehman did two years ago.
© 2010 Edward Lotterman
Chanarambie Consulting, Inc.