by Bill Bonner
Anything is possible in a NIRP (negative-interest-rate policy) world.
When central banks are resorting to negative interest rates, as the ECB did recently, everything goes topsy-turvy. A trillion dollars here… a trillion there. Pretty soon we’re talking about the end of the world as we have known it.
In the US, in the first seven decades of the 20th century, the relationship between debt and GDP was fairly stable. Debt was at about 150% of output. Then Nixon severed the link with gold in 1971… and debt grew even faster than GDP. Right now, the ratio of debt to GDP is 370%.
By my calculations, the excess over what is needed to generate growth in the post-war years is about $33 trillion. Annual US GDP is about $17 trillion. At 150% of output, we’d have debt of about $26 trillion. Instead, it’s $59 trillion. We’d have $33 trillion less debt, in other words, if we’d stuck to the 150% ratio.
An Explosion in Debt
The central question we asked at the recent Global Partners’ Reunion in France was: Why didn’t we stick to the old ratio? And where does all the explosion in new debt lead?
In my opening address to the group, I named the place we find ourselves “Neverland,” like Michael Jackson’s ranch in California. It’s a place where anything can happen… and something bad always does.
For example, Elizabeth and I were recently wondering if we should upgrade some apartments we own in Baltimore. What if we spend $50,000 on each of them? How much more in rent would we have to get to make the investment worthwhile?
The answer is it depends on the cost of capital. If it costs you 4% a year to borrow money, you’d need a return somewhere in excess of $2,000 a year—or about $170 a month—to make the improvements pay off.
These are dumpy apartments—renting for about $800 a month each. But it’s a good area. Up and coming, apparently. Putting $50,000 into each one would mean a total investment in the building of about $400,000. And there would be a loss of income while the work was going on.
Still… the investment seemed worthwhile, largely because we wouldn’t have such a dumpy place next door to our house. But the key question is always: What is the real cost of capital? It makes financial sense only if your return on investment is greater than your cost of money. That’s why this is probably the single most important question in a capitalist economy.
The interest rate is often called “the hurdle rate.” Because, if the return on your investment can’t jump the hurdle, it means it’s not a good idea. Instead of adding to the wealth of the human race, it subtracts from it. Net result: a loss of capital. If you don’t know what the hurdle rate really is, you are likely to do a lot of dumb things… and likely to get poorer as a result.
What is the real cost of capital now? What’s the hurdle rate? Does anyone know?
Things Aren’t What They Seem
In Neverland, things are never what they seem. And we never know what they should be. Real prices are not set. They are discovered. Every minute. Every day. We know that today’s interest rates are not exactly on the level. But we don’t know how far off they are. Because the process of discovery has been perverted.
The interest rate you will pay depends on who you are. If you are a well-connected financial insider—say, a member of the Federal Reserve’s banking cartel—you can borrow from the Fed at 0.25% a year.
For much of the financial establishment—non-money center banks, investment firms, private equity houses, large investors—the rate is only slightly higher. This corporate carry trade functions at a borrowing rate of 0.5% or 1%. The proceeds are then used to buy back shares with a 2% to 3% dividend yield. Obviously profitable. And the interest is tax-deductible!
Value investor and editor of Capital & Crisis Chris Mayer spoke about this in France. Chris told us about a finance company that borrows at 0.28%. Because the real rate of consumer price inflation is considerably higher than the borrowing cost, this is effectively free money. No—it’s better. You get paid for borrowing. That’s what you get in a NIRP world.
As we discussed in France, this bizarre situation is a threat to the economy. And to you and your family legacy. Because, as it evolves, trillions of dollars of wealth will disappear or change hands.
It Pays to Be Rich
The lifestyle implications of free money are obvious. Suppose you wanted to live in a mansion. The top 1% of housing transactions in the San Francisco area are above $5 million. At 0.25%, your interest cost to own such a house would be just under $1,050 a month—little more than it costs to rent a pad in a trailer park. So, in theory, a zero-bound interest rate makes having money of no importance.
Most likely, the best trade of our era will turn out to be finding ways to “lock in” the extraordinary gains offered by free money… and avoiding the extraordinary losses that will come when the free-money era ends. So far, investing in real estate, using borrowed money, is the best fit. But we are on the lookout for other ways to profit.
Free capital is capital of no value. In theory, whether you are rich or poor, you can live about the same lifestyle. So, in theory, wealth barely matters. At 0.25%, the return on a million dollars of savings is just $2,500 per year. Why bother being a millionaire? The typical firefighter earns that much every two weeks. (Of course, it doesn’t really work like this. Because, in practice, you have to have a lot of money to benefit directly from NIRP.)
There’s a wide spread from the lowest Fed rate to the top junk bond and payday loan rates. For example, if you are an Argentine airport and you want to raise money, you’ll pay 10% or more to get it. The average yield on high-yielding US corporate bonds, though, is only 6% or 7%. Auto loans are at about 4%. The interest rate on student debt is about 7%. Credit card debt typically costs 10% to carry.
Private borrowers can’t get a mortgage loan at a microscopic rate. But a private equity fund can. The financial industry can get money for nothing too. This ability of large borrowers to get super-cheap money has changed the entire world. It’s a big part of the reason why the 1% has done so well. Those who are financially well-connected can borrow below the rate of consumer price inflation.
The Cantillon Effect
As Irish-French economist Richard Cantillon observed in the 18th century, when they are handing out free money, it pays to be in the front of the line. That’s because as more dollars are created, each one translates to a smaller slice of all goods and services produced. So expansionary monetary policies constitute a transfer of purchasing power away from those who hold old money to those who get new money.
You can see that by looking at the real estate numbers in the US. You’ve heard that there is a big rebound in real estate. What you may not have heard is that it was only at the upper end, where people have access to this free money.
“Among homes sold to the top 1% of households, volume is up by 20% to 100% in most markets,” writes former White House budget director David Stockman. “By contrast, transaction volume during the last four months was down for the entire remaining 99% of the market in 26 out of 30 cities.”
On Long Island, for example, sales to the top 1% rose 72% over the four months to the end of April. For everyone else, sales were down. The weather has been widely blamed for a slowdown in the housing market this past winter; maybe the sun shines more brightly on the rich than it does on the poor.
Capital is cheap for everyone; but for the rich and well connected… capital really is free.
Never, Never Stocks
What can you do with free money? How about this: automobiles, built by an Internet search company, with no drivers, foam-rubber bumpers, two electric engines and a top speed of 25 miles per hour?
Google has already spent $7.4 billion on its driverless car project. Imagine the capital cost of manufacturing and putting these cars into service, en masse? Tooling up a factory alone would cost $8 billion or so. But imagine the cost of the roadway infrastructure… the service and maintenance facilities… the lawyers… the lobbyists. In a normal world, the cost may be prohibitive. In a world where capital is free, why not?
Is it worth doing? Who knows?
Let’s look at Amazon.com. I see this company from several directions. I’m in the publishing business, and have been for 35 years. I’ve seen the effect Amazon has had on our business. Today, we can’t choose to ignore Amazon. We have to negotiate with it. And we know that Amazon can crush us any time it wants. It’s our biggest customer.
I’ve also followed Amazon as an investment. Many years ago, I dubbed Amazon the “River of No Returns.” Because it took in cash from investors who were excited by its business plan. But it never seemed to make a profit.
A lot of people have made a lot of money out of Amazon. It’s been a great investment for those who got in early. At least on paper. But look at what really happened. The company raised and spent some $347 billion. It sold $340 billion of goods. It reports net post-tax income since it came into existence of $2.3 billion. So, that’s a return on total capital of about 0.6%.
And how much has it given back to investors? Zilch. Not one dime.
How is it possible to absorb and use one-third of a trillion dollars in capital… with nothing to show for it other than a big dent in the balance sheet? Is it because investors still believe that Amazon is going to make good, make money, and pay off? Or is it because capital is free?
There is an entire class of companies whose shares people on Wall Street call “never, never” stocks. They’re called this because they will never return cash to investors. Grant’s Interest Rate Observer had a list of some of the likely “never, never” companies. At the top of the list was Amazon, where it belongs. Also on the list were Facebook, Salesforce, Zillow, the New York Times, Yelp and LinkedIn, among others.
They’re all companies—with the exception of the New York Times—that have been turned into billion-dollar financial powerhouses thanks to the availability of free money. But many of these companies will never make any money.
Profits don’t matter much either. Financial engineering can be relied on to boost stock prices. In the first quarter of this year, the biggest buyers of US companies were the companies themselves. You have to wonder: A company that cannot use its capital should normally give the capital back to its owners—the shareholders.
From the first quarter of 2009 through the first quarter of 2014, S&P 500 companies have bought back $1.9 trillion of their own shares. Indirectly, this benefitted shareholders, by reducing the number of outstanding shares and raising the price of the ones that remained. More directly, it benefitted the people who made the decision to buy back shares—with stock options and bonuses based on stock prices.
Where did the S&P 500 companies get the money to buy their own shares? Going back to 2012, IBM’s total corporate debt issuance has been about $32 billion. Putting the round pin in the round hole, we find a snug fit between borrowing, stock buybacks and stock price increases. And IBM’s total stock buybacks have totaled $34 billion during that same time.
A Better-Than-Free Rate
But here is where it gets more interesting: Why stop at buying your own stock?
Imagine a company that makes widgets. There are only so many buyers who want widgets. So the company comes up with the novel plan of buying its own widgets with its own capital.
Investors notice rising sales and profits. They buy the shares and the stock rises. This sounds crazy, but this is my point. In a NIRP world, it’s hard to know what is crazy and what is not. In the first quarter, IBM spent $8 billion on share buybacks and only $1 billion on capital expenditures (stuff like upgrading buildings and equipment).
We checked Morningstar. IBM bonds maturing in 2017 are yielding all of 1.78%. This puts it at about half the real (not official) rate of consumer price inflation. IBM is getting the money for a very NIRP-y, better-than-free rate. So why not use it to boost sales and profits?
Let’s say IBM borrows $1 million at 2% interest. It buys its own products. The computers have a gross profit margin of 25%… giving the company $250,000 in gross earnings. It can pay the $20,000 interest on the debt and clear $230,000 in gross profit. Its share price rises with increased sales and profits. In fact, the capital value of the company might go up more than the amount borrowed.
Let’s look at how that works. IBM borrows $1 million. It buys its own products. It makes, say, $100,000 net profit on the sales. IBM is trading at 13 times earnings. So the $100,000 additional profit translates into $1.3 million in capital value! Shareholders come out ahead by some $300,000.
Taking the economy as a whole, businesses, government and individuals borrow… and spend money.
So, the cash from one borrower turns up as sales and earnings on the books of another. In the Neverland of free money, anything is possible.
Tune in for Part 2 next week. And if you enjoyed Bill's essay, he recently launched a brand new monthly newsletter you can subscribe to right here.