Lessons not learned: how low interest rates and federal insurance may bankrupt America

From the file of Not-Learning-From-One’s-Mistakes, comes this report from Bloomberg:

In the best year for Treasuries since 2002, fund managers who only buy government bonds are seeking permission to invest in corporate debt they considered toxic just a month ago.

Treasuries “are yielding next to nothing,” said Robert Millikan, who manages $5 billion at BB&T Asset Management…“Trying to do something for your shareholders, it’s hard to sit there and buy a bond that yields less than any fees you charge.”

…Merrill Lynch & Co. index data show [that government debt] yields [have] dropped so low that fund managers have little chance of offering anything but subpar returns in 2009. Two-year Treasury note yields fell to a record low 0.95 percent on Nov. 20.

That helps explain why BB&T, BlackRock Inc., T. Rowe Price Group Inc. and Sage Advisory Services Ltd. are looking elsewhere for returns, including bonds of the banks that were almost ruined by $967 billion in losses and writedowns since the start of 2007. Treasury funds are receiving permission to buy debt of Morgan Stanley, JPMorgan Chase & Co. and Goldman Sachs Group Inc. after the Federal Deposit Insurance Corp. finalized plans on Nov. 21 to guarantee their debt.

The FDIC program announced on Oct. 14 is part of the more than $1.5 trillion in unprecedented financing from the Treasury and the Federal Reserve to end the worst financial crisis since the Great Depression. The U.S. now guarantees more than $13 trillion of debt.

There are two lessons not being learned here: first, artificially low interest rates encourage investors to take imprudent risks.  Second, federal insurance guaranteeing their investments does too.  Combine the two and you have a witches’ brew that totally disrupts market incentives and puts taxpayers at great risk.

Lesson #1:  A key factor precipitating the current financial crisis was the low interest rate policy pursued by Alan Greenspan earlier this decade.  That caused investment managers to seek higher returns in riskier investments like CDOs and other toxic debt securities. Complain all you want about Wall Street banks and ratings agencies that manufactured those investment opportunities, but underneath it all were investors demanding more yield.  And investment managers sold them higher yield by taking greater risk.

Personally, I think investment managers violated their fiduciary responsibility to investors, selling “cash plus” money market accounts, auction-rate securities and other investment filth as ultra-safe alternatives for investor money.  They were anything but, of course, as the auction-rate debacle demonstrates.

And yet this report from Bloomberg shows some investment managers have learned nothing.  They are once again putting investor money at risk in order to squeeze out just enough yield to offer a competitive return after their own fees.

Not so, these managers would argue. This debt is backed by the FDIC, so it is just as safe as Treasuries.  I wonder how many of them have actually stopped to look at the FDIC’s balance sheet, which now has somewhere south of $40 billion in reserve to protect the nation’s entire deposit base.  That was only 1% of all insured deposits BEFORE deposit insurance limits were raised to $250k from $100k.  To this they might respond that the FDIC wouldn’t be left hanging by Treasury if it needs additional funds.

Fine.  And where does Treasury get the funds it will need to back the entire financial system when it implodes under the weight of old financial bets gone bad?  That is, effectively, what Treasury and the Fed have done over the past year: written an implicit guarantee protecting the vast majority of private debt securities.

And this brings us to the second lesson that hasn’t been learned…

Lesson #2: Government insurance perverts economic incentives, encouraging risky behavior that blows up in taxpayers’ faces. The S&L scandal is the prime example.  Reagan deregulated the interest rates S&L’s were allowed to pay on deposits without putting strict controls on the use of those deposits.  This led to all manner of shady characters applying for S&L charters, the deposits from which they used to finance their risky investment schemes.

Depositors may have seen this, but why should they have cared?  Their savings were insured by FDIC!  As such, they went shopping for the highest deposit rates without a moment’s thought as to the riskiness of the financial institutions into which they entrusted their savings.

And this brings us back to lesson #1 above.  When risk is under-priced because interest rates are held artificially low, dumb investors underwrite bad bets. These investors should, of course, lose when their investments go sour.

But the sheer scale of the bad bets made recently are so large that if they were allowed to go bad, the global financial system would implode.  The government’s choice, then, is to repeat the same mistakes, only this time on a much grander scale.

Bernanke is lowering interest rates to avoid deflation, which encourages savers to seek higher yield by investing in riskier paper.  Compounding the problem, the Feds insure all of it, removing any incentive for investors and investment managers to carefully consider risks.

The endgame is easy to forecast.  As with the S&L scandal, investors will continue to pour money down a hole, losing huge sums of money in the process.  Because their investments are federally-insured, taxpayers will be left holding the bag.

Posted in Fed, Wall Street, bailout, banking, bubble, credit crunch, inflation, taxpayer issues |