How to get paid to borrow money
And I thought my mortgage offer of 1.49% for two years was good. But Bloomberg reports on the most absurd development in financial markets yet:
‘…a banker took a few steps away from his desk this week to make sure his eyes weren’t deceiving him.
‘As mortgage-bond refinancing auctions came to a close in Denmark, it was clear that homeowners in the country were about to get negative interest rates on their loans for all maturities through to five years, representing multiple all-time lows for borrowing costs.
‘“During this week’s auctions, there were three times when I had to stand back a little from the screen and raise my eyebrows somewhat,” said Jeppe Borre, who analyzes the mortgage-bond market from a unit of the Nykredit group that dominates Denmark’s $450 billion home-loan industry.
‘For one-year adjustable-rate mortgage bonds, Nykredit’s refinancing auctions resulted in a negative rate of 0.23%. The three-year rate was minus 0.28%, while the five-year rate was minus 0.04%.’
Paid to borrow money? It sounds ridiculous. How did it happen?
Well, in Denmark, mortgage rates are influenced by government bond yields. And government bonds have gone negative too.
In fact, Bloomberg estimates that more than US$10 trillion in bonds now have a negative yield.
People are paying governments for the opportunity to lend them money. Barron’s described this as ‘a post-2000 B.C. first’ for financial markets.
But why would people pay governments to lend them money? Why not just leave it in the bank, where it won’t fall in value?
The answer is simple, but deeply disturbing. Not that you’ll find many people who agree with me…
The mystery of negative interest rates explained
Sovereign bonds are safer than cash in the bank when you’re expecting bank failures. That’s because governments rarely default on their debt. Especially compared to banks, which fail periodically.
Governments can just print the money to repay their bonds, if they need to. So the default happens via inflation. But that’s better than what you get during a bank run.
Given the likelihood of a bank failure during a crisis, the wealthy flock to the only safer asset during such a time: Government debt.
Because they’re worried about bank failures — defaults — the wealthy don’t really care about returns. They don’t want to make money; they want to escape the possibility of a default on the money they have.
The surge in demand for government bonds pushes the price of government debt to absurd levels. This also means the yields turn negative.
Holger Zschaepitz from Die Welt newspaper explained the result like this on Twitter:
‘MAD WORLD! #Italy’s BTPs now the only choice for positive 5yr yields among major Eurozone bonds w/ 5y Bund yields at -0.55%, #Spain’s 5y yields at -0.003%, #Portugal’s 5y yield at -0.047%.’
In other words, Europe’s governments are getting paid to borrow money for up to five years.
The exception in Europe is Italy. Why? Because default risk does actually come into the equation for Italy.
The Italian government can’t issue its own euros like governments outside the eurozone can.
And Italy doesn’t like the lack of support it gets from the European Central Bank.
So the government has threatened to leave the euro and default on its debts. Financial markets price this probability at about 18%.
That’s why Italian debt is trading apart from other European bonds.
It’s worth pointing out that banks themselves are among the investors turning to sovereign bonds.
The banks only trust their government as a borrower. They don’t trust each other, nor their usual borrowers.
I think negative-yielding debt is a sign that the banking system is unstable. It’s only one of many factors influencing bond yields, but it’s one that I don’t see covered elsewhere. And it explains negative rates well.
If I’m right and the banking system is unstable, then the next recession will quickly turn into a financial crisis too.
Risk comes in all shapes, sizes and rewards
Ask a financial historian when a particular past financial crisis really kicked off and they’ll likely point to a bank failure.
Creditanstalt and the Great Depression. Lehman Brothers and the GFC.
So, which bank will ignite the next financial crisis?
There are a lot of contenders around right now.
China just experienced its first modern bank failure. Baoshang Bank was taken over by regulators and emergency funding from the central bank is on the way too.
How will the communist authorities handle the situation?
In Italy, bank shares plunged around 30% this month. Italian banks own a lot of government bonds, so if the Italian government defaults, the banks will go down too.
In Australia, an imploding housing bubble and a class action lawsuit threaten our own banks as well.
One of the biggest and most important banks in the world, Deutsche Bank, is turning into a slow-motion train wreck. Its shares, bonds and default insurance are at dangerous levels.
As part of my UK financial licence exams, I did a course on the UK regulatory system. Our instructor told us he doesn’t expect to ever get his Deutsche Bank pension…
But perhaps trying to find the bank that buckles is the wrong way to go about all this. It may be how historians identify the onset of a crisis in hindsight, but that’s like blaming a snowflake for an avalanche. It’s the snowpack you have to watch.
That’s why ski patrol dynamite the mountainside instead of trying to catch snowflakes in a bucket.
If any given bank’s failure is enough to trigger trouble, it doesn’t matter which one goes first.
Unless, of course, it’s your bank<…
Then, my friend, wonderful explanations about snowflakes and avalanches seem a long way off…
Until next time,