Sep 17, 2008

The James Bond Market

So, the demand for 3-month treasury bills skyrocketed, pushing interest rates to their lowest since that whacked-out guy with the Charlie Chaplin stache was dancing across western Europe. What on earth does that mean? Well, fortunately for you (all three of you that happen to come upon this post), I have an economics degree. OK--fine--it's a math with specialization in economics degree, but whatever.

Here's the deal. U.S. Treasury securities (in common parlance, bonds) are issued by the U.S. government. They come in many variants, but here are the main three: Treasury bills (which mature in one year or less), Treasury notes (two to ten years), and Treasury bonds (ten to thirty years). There is also the inflation-adjusted bond, but that doesn't matter so much here. Now, bonds are sold by the government to raise money. They pay a certain (usually non-adjustable) interest rate over a period of time. At the end of that time, they mature and stop earning interest. You then present the bond to your local bank, and they cash it in for you using a handy chart provided by the feds (an exciting activity that I used to do as a local bank teller). If you cash it in early, you don't get the fully matured amount. Your grandparents probably own a lot of bonds or gave you a lot of bonds when you were growing up. They often earn good interest in the long run (assuming inflation stays low), and they can keep stupid teenagers from buying an iPod instead of paying for college or a house.

Well, then, what does this all mean, and why is it relevant in any way to the current financial situation? Good question. The Treasury likes to sell its securities. People like to buy them. Then, as enterprising entrepreneurs, they like to sell them on the open market. Right now, people want to play it safe with their money, which means that short-term bond rates have been pushed very low (as you can see here). It makes sense. More people want bonds because they are a safer investment than volatile stocks (still with me?). That means demand for bonds increases. Those with bonds, who also want safe investments, basically say to those who want to buy their bonds: "will you pay me this super-low rate for my safe investment? You won't make much, but it will be safe. How low are you willing to go for it?" Rates (the interest for the bond) drop. Bonds become less appealing. Demand levels out to a nice, comfy equilibrium.

That's how it works. But what are the practical effects? Treasury bonds are safe investments, remember? They are backed up by the government, which doesn't default (even when trillions of dollars in debt). The problem, however, is that by buying the government bonds, investors are moving away from company bonds (or company debt) and company stocks, since they don't trust the company on the return. For today's example, AIG got too involved in the suprime market; they insured homes against default (meaning that they agreed to pay the company with the insurance policy if the people holding their mortgages couldn't pay). Oops! Suddenly, people are defaulting on their (out of their means expensive) homes. The financiers are trying to cash in on their insurance policies. AIG doesn't have enough money on hand to cover it. What do they do? They try to sell bonds, asking investors to temporarily trust the company and give it money, which will be returned with interest in the future. Problem is, no one had trusted AIG to keep running and making money (at least in the short-term), so they said "no thanks, AIG. I'll go to a safer investment." Ta-da! Government bond demand goes up, interest rates are driven down. Effectively, investors would rather trust the government right now than the finance company.

So, in the end, what does it mean? It means that people want to run under the umbrella of the government because it keeps out all the rain. It means that people don't want to invest in companies because they perceive those companies as struggling. It means that I'm glad that I have no stake in any of these financial firms.

No comments: