Tuesday, April 6, 2010

Treasuries, Investment, Interest Rates, and Risk

Treasuries, Investment, Interest Rates, and Risk
by Alex Merced

In todays world investment revolves around US Treasury debt cause it's AAA rating. Since the return yielded from treasuries is considered the "risk free" rate of return it establishes the minimum return someone should make from their investments. So since this interest plays sucha pivotal role in the investment decision and risk taking learning a little bit about how it works would be pretty important to understanding excessive risk taking by the banking system.

What is Treasury Debt?

We believe that it's taxes that pay for military, medicare, and all the other government services and programs we may approve or dissaprove of. In Reality, tax revenues are not enough to pay for the growing role of government and the public sector so money must be borrowed via bonds known as treasuries. As any debtor would, the government wants to pay the lowest rate possible so they have an auction for the debt similar to lendingtree in which the largest banks in the world known as primary dealers (for Primary Dealers include Lehman, Bear Sterns, Merrill, etc.) bid on the debt in order for debtor to get the lowest interest rate possible.

What is with all the demand for treasuries?

Now why would banks bid treasuries to near below inflation/CPI levels when they could use that capital for other higher yielding investments? In order for this to be the case there must be some mechanism to stimulate the demand of these banks very similar to what happened in the housing crisis...

Why did lenders make so many bad mortgages, cause they didn't have to hold the loans they could just turn around and sell it to Fannie or Freddie so this created artificial demand for mortgage debt pushing lending rates low. A similar mechanism is used with treasuries since these treasuries can be used in a variety of ways in dealing with the central bank, the federal reserve.

The central banks primary role in this is to keep fueling the demand for treasuries by entering in repurchasing agreements with these primary dealers. In these agreement the central bank promises to buy back these treasuries and to do so the central bank must expand the money supply (inflation). Also, these primary dealers can use these treasuries as collateral for loans from the discount window in order to get emergency funds when these banks overlend or practice bad banking. Essentially, in exchange for facilitating the financing of government operations the banking system are given their own life support system in the form of the federal reserve bank.

So as government increases it's deficits need the demand of treasuries to increase meaning more pressure on the federal reserve to buy these treasuries from the bank with new money (aka monetizing the debt). So as the federal reserve inflates the money supply to facilitate government spending the increase reserves of these bank effectivly lowers lending rates sending a flase signal to the economy of non-existant savings causing the mal-investment charachterized in the austrian theory of the business cycle.

The effects of all this on investment and risk taking

At the same time, this inflation of the money supply will put upward pressure on price levels which increases the neccessary return from investment needed to maintain purchasing power. Also the increasing government debt puts upward pressure on taxes which means even more must be yielded from investment to make up for the tax burden. So effectively, when you combine the burden of inflation and taxes the return needed to make any profit is so high that modest medium risk investing just doesn't yield enough putting pressure on investors and investment institutions to have to take on risker investments to just walk away with anything at all.

Moral of the story:

- Inflation and Taxation only stimulates risk taking and distorts economic calculation of investors

- Inflation and Taxation are a product of growing government spending

- In order to maintain this Government Spending a strong relationship between Government and Banking must be established

- To be truly against bank bailouts and for main street you must be against the central bank and runaway spending which creates the moral hazard that strips the nation of their savings and retirement

- To believe in government entitlement programs you must be for the bank bailouts, cause without the bailout government cannot continue it's funding of programs like medicare and social security

- Money lent to the growing public sector is money not lent to the private sector, so as one grows the other must shrink along with the countries productive capacity increasing the burden over time as more and more people find themselves pushed out of an economy that can support less and less people everyday.

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