28 April 2010

There’s no such thing as a free lunch. -Milton Friedman

It’s commonplace for crappy ideas and concepts to get cool sounding names in order for people to sell them more easily. Amway isn’t a pyramid scheme, it’s multi-level affiliate marketing! Many people are up in arms about the names of a string of products in the financial system which are being blamed for the collapse: CDS’s, CDO’s, equity tranches, “high yield” instead of junk, “distressed” instead of nearly bankrupt.

However, there’s a problem. There’s one awesome sounding name left, it’s the biggest baddest one of all, and nobody is talking about it. Before I get to it, let’s look at two different companies in the same sector applying for a one year $5 million loan.

Company A is a small, growing, and profitable company. They have revenues each year of $49 Million, are profitable, and have $20 million saved up in the bank. Generally, analysts think this company is on an upwards trajectory and will eventually be a star.

Company B is a huge incumbent that has dominated the sector for the past 50 years. They are by far the number one player, with $14 billion in revenues each year. However, they’ve had some tough times. They haven’t made a serious profit in 8 years, have had some major recent setbacks, and analysts are unsure how they will return to profitability. Also, they have nothing in the bank, and about $13 billion in debt that they already owe, however, most of that debt isn’t due for five to ten years, and they plan on refinancing rather than paying off the debt as it matures.

Imagine you only had $5 million to give to one company, at the same interest rate for either, and they had to pay it back a year from now. Do you lend it to Company B, the huge but unprofitable company to which $5 million is a measly amount, or do you lend it to Company A, the small profitable company that has enough money in the bank already to cover the loan?

Although I’m sure many of you said company A, there’s a strong argument that could be made for both companies. It’s very likely that both will pay back their 1-year loan, regardless of the long term prospects of the company, and since Company A is a smaller company, something unexpected and drastic could happen, which is less likely than company B. However, I’m guessing that for anyone who loaned the money to company B, it wasn’t a clear choice.

Now, get ready for the head-fake. Change the word company into country. Company A is China, and Company B is the US. Anyone who said they would rather loan the money to Company A is saying they would rather loan money to China over the US.

However, there’s more to it than that, because I messed with the scales. For US company revenue I divided our $14 trillion GDP by one thousand and our $13 trillion in debt by one thousand to get numbers for the fake company. For the Chinese company, I didn’t divide by one thousand, I divided by one hundred thousand. That means, that anyone who would rather loan the money to Company A, would be more comfortable loaning China one hundred times more money than the US (on a relative basis).

Finally, we come full circle to our three very scary words:

Risk Free Rate

For those who don’t know, the interest rate on short term US Government Securities is called the Risk Free Rate. It is called the Risk Free Rate because it is assumed impossible for the US to ever default on its obligations, and therefore, its bonds are considered risk free. The concept of the Risk Free Rate is taught in basic economics, accounting, and corporate finance classes, and it’s impossible to graduate with a business degree in the US without an understanding of the risk free rate.

Functionally, what this means is that entire generations have been brought up ingrained with the concept that US debt is risk free, even though many of them earlier in this blog post thought loaning 100X more to the Chinese was less risky.

Intuitively this should make sense. Anytime a friend or acquaintance comes to you with a “Risk Free Investment,” I’ll bet you get somewhat nervous and keep a hand tightly wound around your pocketbook. There simply is no such thing as a risk free investment. It doesn’t matter who is telling you there’s no risk, even the US Government.

Besides default risk, these securities are exposed to interest rate risk. Interest rates are very low right now, and when they go up, the value of all bonds, including US Treasuries, will go down.

Now, compare the “Risk Free Rate” to the current examples of what people consider nefarious wordsmithing. CDO’s, CDS’s, and distressed debt can only be bought by highly sophisticated professional investors, who get paid to ignore the hype and focus on the fundamentals. In comparison, US Treasuries are sold to retail investors en masse.

People argue that, since the US can just print the money, there is no risk of default. It’s a very bad argument. When people invest in treasuries, they are looking for a way to preserve their purchasing power. It’s not the thousand pieces of paper that are valuable, it is the fact that you can exchange those pieces of paper for a laptop. Yes, the government can print the money and give you back your pieces of paper, but you would be pretty pissed off if you went to spend the paper but could only afford a can of soda. Clearly this is extreme, but diminished purchasing power (5% or 10%) is a very real risk of treasury securities, and this risk is not understood by individual investors.

It’s important to note that I don’t think the US is going to collapse. If a family member asked me whether it was safe to invest their life savings in six month treasuries, I wouldn’t be able to offer anything safer. I would rather invest in US government bonds than the government bonds of pretty much every other country, and Europe is in far worse shape than the US. However, I think that calling any investment “Risk Free” is foolish at best and can be quite dangerous in the long run. Any championship team will tell you that it’s easier to get to the top than stay at the top. Every great society in history has fallen from grace, and the same thing could happen to the US. However, understanding that there is always risk can help guide people to make decisions that minimize the probability of a bad outcome. Whether those decisions are being made in the US is a topic for another post.