No one has replied to this yet, so I thought I would give it a bump.
Thanks for any insight that you can provide.
David
There's one thing I'd like to add.
Under the ongoing near-to-zero interest politics banks are always on the lookout for that quarter of a point more that will allow them to have better returns. Leaving "packaged mortgages", obligations from moribund/fraudulent societies (one above all: Parmalat) and dubious funds aside, let's focus on government bonds.
Back in the '90s banks stocked up on "tango bonds", bonds issued by the Argentinian government which had extremely high yield rates (between 7 and 9% if I remember correctly). Wise and cautious fund managers didn't want to have anything to do with them, no matter how good the return, since they knew Argentina was in such bad shape that it would default within a decade. Banks didn't share this caution. They loaded up on tango bonds and when they started get alarming signs from Buenos Aires, they just dumped the bonds on savers through an extremely aggressive marketing campaign.
Fast forward to around 2001, with banks again looking for that slightly better yield. This time they got their eyes on PIGS, the famous European countries noted for their government largesse. Greek bonds became particular favorites since the country was spending like a drunken sailor on shore leave to build Olympics infrastructures, hence it was generating debt faster than you can say "destruction of wealth". The fact that the ECB was accepting thes same bonds as collaterals and that it was implied that Germany would step in to guarantee the bonds from default (as it eventually happened) made these bonds a "win-win" situation. Now Spanish bonds are getting the same enthusiatic tretament by investors. They know Spain is in really bad shape but who cares? If Madrid doesn't pay interests, Berlin will and the ECB will still be taking these bonds as collaterals without blinking. Failing that a bailout plan will be hastily patched together.
Awesome post! Thanks for the historical insight. I will be sure to look into the tango bonds and Greek bonds further!
1. A general intro to the subject:
I've heard Peter Schiff say that the low interest rates on long term bonds are a fiction. They are low only as long as the gov't doesn't actually try to get some money issuing long term bonds. But the moment they do, the interest rates will have to jump in order to get people to buy them.
The thinking being that interest rates on long term bonds are determined by what people think the rate of inflation will be. And nobody really thinks inflation will be low in the long term, given Obamanomics.
2. Could you please provide links to where these arguments are set forth? Because I don't really understand some of them.
How do low interest rates prove the govt should be spending more money?
I can understand that they may prove that inflation is not a threat, given Peter's explanation that long term interest rates on bonds are based on anticipation of inflation. But this was refuted in 1. The rates are low only because the bonds are not actually being issued.
How is the bond market a check on govt spending? I assume this means that the govt gets money to spend by borrowing it, meaning issuing bonds. And if nobody wants the bonds, the govt cannot borrow money, and therfore cannot spend.
But whoever says that forgets that the govt has a printing press. If no one will lend the govt money, the govt will just up and print new money for itself. No one can stop them, certainly not the bond market.
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It's easy to refute an argument if you first misrepresent it. William Keizer
These were particular situations: tango bonds were particularly favored by Italian banks while Greek bonds were particularly favored by French banks.
The Italian case is still open: lawsuits are still flying with people openly accusing large banks of having willingly dumped bonds on individual depositors when they knew the situation had become irrecoverable. Banks first tried to dump the blame on some "unfaithful" employees but then, backed by government muscle, offered a settlement: we'll give you a 60% refund, not a penny more. At last notice lawsuits are still open. This is very similar to what the same banks did with Cirio and Parmalat (two food colossi built on shifting sands) obbligations: when the situation became dire they started dumping them on their own "customers". here the blame was totally dumped on the CEOs while the banks got away without even a slap on the wrist. Enron anyone?
The French case is a bit different. When the Greek crisis exploded in March-April French banks (Casse d'Epargne, Credit Lyonais etc) had a whooping 21% of their portfolio in Greek bonds (if I remember correctly Dutch banks were the next in line with 11% of their portfolio in the same bonds). They made no attempt to dump these bonds or even sell them at market price. In short they knew the bailout was coming and now are quietly swapping the Greek bonds for the new, German-backed ECB bonds. Yield is marginally lower but are making up the difference by happily buying Spanish bonds (unbelievably AAA rated, better than Italian ones which are AA2 rated and have lower yield). In a few years time Spain will be in the same situation as Greece and logic dictates more German-backed ECB bonds will be swapped for "toxic assets".