Something extraordinary happened this month. Interest rates turned negative in Germany, Switzerland, and Japan. In fact, the headline of a recent article in The Telegraph, a British newspaper, read, “Europe's Bond Yields Fall to Their Lowest Level Since the Black Death.”
Suppose you’re the trustee of the endowment fund for a large German university or the trustee of the pension plan for a large German corporation. Your trust documents require you to keep 15% of your corpus invested in German federal treasury bonds – known as bunds. Since the German national government is almost running a budget surplus, there are a limited number of these bunds. Other trustees want them for their own funds and plans, so you are forced into a bidding war for them. When the bidding settles, you realize that you have actually paid a huge premium for these bunds. Your yield over the next five years is a negative 0.007% annually. Basically you’re paying the German government to store your money for 5 years.
Italian, Spanish and Portuguese yields have also seen spectacular drops over the past several weeks. The French state can borrow for five years at an annual rate of 0.13% (much less than 1%), and Ireland can do so at 0.32%.
One reason for these spectacularly low rates is that the European Central Bank (ECB) has just embarked upon its own quantitative easing campaign, in order the head off deflation and to jumpstart the slowing European economy. The ECB will soon be buying massive amounts of European government bonds.
The issue is caused by far more than just a shortage of European government bonds. There is a currency exchange rate issue as well. The Swiss Central Bank recently removed its peg to the Euro, resulting in a stunning, one-day, 25%+ leap in value for the Swiss franc. As a result, large Swiss banks, like UBS and Credit Suisse, can now pay a negative 0.75% on deposits, loan it out to hedge funds at 0.50% annually, and still earn a handsome 1.25% spread on their money.
Why would any investor pay a private bank 0.75% annually to store his money? It’s the exchange rate! Sure, you might lose almost 1% on the interest rate, but if the Euro falls another 3% versus the Swiss franc, you are still miles ahead when you convert your Swiss franc deposits back into Euros.
A banker buddy of mine recently shared this true story on Facebook: My wife needs a little cheering up, so I would like to share one of our first and funniest memories. After a few months of dating, Amy was kind enough to accompany me to one of my annual poison ivy ER visits. Yep, I needed a shot. Without hesitation, I dropped my pants AND underwear. With my naked butt in the air, I heard the nurse surprisingly say, "Sir, the needle actually goes in your arm."
Is the ECB making the right decision at this point to embark on another round of quantitative easing? While I absolutely saluted Ben Benanke’s Quantitative Easing to save the U.S. economy, I wonder if the ECB is not now confusing bad deflation and good deflation.
There are actually two kinds of deflation – bad deflation and good deflation. Bad deflation is typically accompanied by fear and panic. It is time of money destruction, as debtors go bankrupt and banks stop lending. Often the underlying basis of that fear and panic is the excessive debt accumulation and the poor investments made with the proceeds of that debt in prior years. Economists from the Austrian School of Economics call investments that fail to pay off malinvestments. A good example of excessive debt and malinvestments were the home purchases made by unqualified subprime borrowers in the decade leading up to 2008.
But deflation is not always bad. Did you know that during the period between the end of the Civil War and the start of World War I the U.S. economy enjoyed slow deflation and steadily falling prices? This and other periods of slow deflation were the result of scientific discoveries, improvements in production methods, and increased competition. For example, oil prices today are declining because of advances in oil extraction technology, such as horizontal drilling and fracking. U.S. producers are now competing with Russia and Saudi Arabia, resulting in falling prices.
One could therefore argue that the ECB may be overreacting to a modest amount of good deflation; but there is no question but that the ECB is indeed acting. With European investors now desperate for yield, our mortgage bonds and commercial real estate look very, very attractive. You can therefore expect mortgage rates to stay low for a number of years, and you can expect cap rates on commercial properties to continue to fall.
“Keynes did not teach us how to perform the ‘miracle of turning a stone into bread’ but the not-at-all miraculous procedure of eating the seed corn.” – Ludwig von Mises, Austrian economist
I had a very interesting conversation with a CMBS lender this morning. He said the conduit loan business was fabulous.
Conduits are now regularly making 75% loan-to-value loans on multifamily, office, and retail centers. This translates to debt yield ratios of 8.0% to 8.5%. Conduits are also making 70% loans on hospitality properties, which translates to debt yields of 10%.
These leverage levels are much higher than I had expected to hear. No wonder he is just killing it in conduit loan originations.
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