Yesterday we looked at how debt is used to generate high returns, particularly for a small subset of the population and especially during times when central policy makers commit to extended periods of low, stable interest rates. Today we’re going to add a couple more pieces of financial background before we move on and apply this to our current situation.

We all understand how savings is supposed to work. We put our money in a bank and the bank pays us a rate of interest for our capital. The bank then turns around and loans that money out at a higher interest rate, a mechanism by which they (a) make money and (b) pay depositors interest. If you had a lot of money, you could make your own loans, but for most of us (and even for the wealthy) it makes more sense to diversify over many projects and have the bank, made up of financial experts, evaluate projects on your behalf. 

So, in normal times, we must save to invest. The bank is not going to have any money to loan out unless people deposit money into it. (If you want a 200-level explanation, note that banks are part of the process in which money is created, a process described eloquently by Chris Martenson in this Crash Course video.)

Here’s the next critical insight: In a normal market system, interest rates represent the supply and demand for capital. If there is a lot of demand for money from businesses and individuals that want to borrow, then a bank will raise interest rates to encourage people to save more. If the bank has too much money and not enough people asking for loans, then interest rates will drop. Now banks borrow money back and forth among each other which tends to even things out across institutions, but every now and then you’ll see one pop up with a rate quite a bit on one side of the curve. Something’s going on — they either have a big deal and they need some capital or they have too much money and are having a tough time putting it to productive use. 

Now enter the Federal Reserve system and national, centralized monetary policy. I’m not going to go Ron Paul on you here and get into talk of the Fed being a construct of Wall Street, etc… I simply want to point out that, when the Federal Reserve intervenes to manipulate interest rates, it is distorting the relationship between supply and demand of capital. That is by definition. If the Fed raises rates, it will encourage people to save and if the Fed lowers rates, it will encourage people to do something else with their money. This is irrespective of what would naturally be happening in the market.

I’m not suggesting anything sinister there. This is, after all, an accepted practice among nearly all economists. According to their theories, when the economy needs a kick in boot, the Federal Reserve should lower interest rates to make capital easier for people to borrow. When the economy is overheated, manipulating interest rates higher is a way to dampen that.

It is important to understand the mechanism the Federal Reserve uses to raise and lower interest rates. Remember yesterday we talked about the 90-day and 30-year treasuries? To lower rates, the Fed simply buys treasury notes. When they buy the notes from Wall Street banks, those banks then have a lot of cash and so they need more borrowers, fewer savers. Thus interest rates go down. To raise rates, the Fed does the opposite and sells notes. When it does that, it is putting these US treasury certificates — instruments of savings — out there and taking the cash back in return (which they put under their mattress). This reduces the amount of cash the banks have and, to have money to lend, banks then need to raise interest rates.

So let’s put these two things together; When the Federal Reserve determines that the market is not working correctly — generally that growth, unemployment and inflation are not being optimized — they will intervene to manipulate the market interest rate.

I feel like that’s a lot, but there is one more concept we need to get through so we can spend the rest of the week talking about implications, and that is the Mortgage Backed Security (MBS). As an analogy, if you created a company, had that company buy a thousand mortgages, then you sold a thousand shares in that company, each of those shares would be a MBS. With that MBS, instead of owning the debt of one mortgage, you would own 1/1000 of each. You are essentially spreading out your risk over a wider pool, just like a bank does when they do multiple loans. 

Mortgage Backed Securities become important to this story for one reason: yield. Yield is the interest rate at which the MBS pays. Due to the fact that there is more risk in an MBS than in a Federal Treasury note — even when that MBS is rated AAA — the MBS is going to pay a higher interest rate.

Now go back to yesterday where I described the carry trade. An MBS with a higher yield and a generally shorter maturing period (few mortgages make it the full 30 years w/o a refi) is a much more attractive buy when compared to a 30-year Treasury note. The MBS now has a higher return with less long term risk, a nice combo when trying to spur home purchasing.

See where this is going?

Actually, I’ll throw in one last thing here. You may remember the Federal Reserve’s Operation Twist. This was a shift by the Federal Reserve from buying short term Treasury notes to long term notes, driving down the interest rates on those longer notes even further. The effect of this is to make those MBS investments even more attractive by comparison.

So let’s summarize:

  • In a normal economy, we must save to invest.
  • In a normal economy, interest rates represent the supply and demand of capital.
  • When the Federal Reserve determines that the market is not working correctly — generally that growth, unemployment and inflation are not being optimized — they will intervene to manipulate the market interest rate.
  • Mortgage Backed Securities provide a higher yielding, shorter term investment than long term Treasury notes.

Tomorrow we start talking about the implications of these interest rate manipulations, as pointed out by the Fed’s own advisors. Then on Thursday I’m going to bring it all together and show how the current growth in stock prices and housing is a debt-fueled illusion, one begging for dumb money to rescue the smart money. Finally, on Friday I plan to lay out two scenarios — one optimistic and the other pessimistic — for how this could all play out.