It’s that time of year when Americans from coast to coast start trembling with fear as they approach Thanksgiving dinner – and not just because of Aunt Ethel’s pumpkin kale casserole. This dinner table has regrettably become the annual moment most associated with awkward conversations, as everyone’s political, parenting, and pecuniary choices come under the microscope. “I cannot believe you voted for that crook!” “Our little Bobby never got a C in his math classes.” “How much did you invest with Madoff?” These words just send chills down the spine, don’t they?
Well, dear reader, we don’t want you to have to endure such torment this year. Instead, we’d like you to be the hero of your Thanksgiving dinner, by equipping you to talk about something that will not promote strife, but instead edify and enrich everyone there – finance. The key is to make these topics accessible and interesting, so we’ve decided to produce a little primer to prepare you to insert informative factual tidbits naturally. Here we go:
Uncle Jim asks: “We are thinking about refinancing our house. Why do some home mortgages offer a floating rate and others a fixed rate?”
Knowing Uncle Jim’s passion for football, you respond: “It partly depends on people’s tolerance for risk. Some individuals want the inherent predictability of a known fixed rate for budgeting, and they are willing to pay a higher interest rate (on average) to have that predictability. It’s a lot like the Manning brothers. Peyton is the responsible older brother who precisely manages every aspect of his job and those of every other organization member; this season he actually took time during a press conference to rebuke Denver’s scoreboard operator (yes, you read that right!) for having an off night. By contrast, Eli is the mercurial younger brother whose year-to-year results are fiendishly difficult to predict. In 2011, he tied the all-time NFL record for most game-winning drives in a season with 8; two years later, he led the NFL with 27 interceptions, 5 worse than the next quarterback! Over the last eight seasons they both played, the standard deviation on Peyton’s completion percentage was a metronomic 1.45 while Eli’s was a volatile 3.35. Of course, during that time Peyton picked up only one Super Bowl ring and Eli won two – so the question is, would you rather have Peyton’s predictably strong results (like a fixed rate loan) or Eli’s sometimes tremendous, sometimes troubled results (like a floating rate loan)?”
Cousin Jane asks: “I heard your company uses derivatives to manage risk. Weren’t derivatives the source of all the problems during the recent financial crisis, problems we still live with today?”
Knowing Cousin Jane’s penchant for worrying about unlikely events, you respond: “It turns out that’s just a popular misconception. In fact, a Bloomberg analysis shows that of the roughly $2 trillion in direct financial losses caused by the crisis, only 3.2% were from CDS and other derivatives; a much larger share (44%) came from loan write-offs, increased provisions for bad debt, and other such costs. In short, loan and credit losses were fourteen times as large as those stemming from derivatives. Statistically speaking, on an order-of-magnitude basis, focusing stringent regulatory efforts mostly on derivatives while giving loans a light touch would be equivalent to focusing national health education on preventing accidental poisoning deaths while ignoring the combined deaths caused by heart disease and cancer! You see, even though Aunt Ethel’s pumpkin kale casserole does bring the risk of accidental poisoning to mind, our far greater risk at this bountiful table is heart disease. Kinda makes you wonder why – as a direct consequence of the crisis – derivatives end users have significant new reporting and compliance costs with which to contend, while qualified residential mortgages still don’t require a 20% down payment and Fannie and Freddie will actually guarantee some loans with 3% down payments. Doesn’t it, Cousin Jane?”
Grandpa Bobby asks: “In my day, we used to be able to deposit money at the bank in a 1-year CD and earn 5% interest on it. Will we ever see interest rates like that again?”
Knowing Grandpa Bobby’s habit of dozing off right after (and sometimes during) dinner, you respond: “You are absolutely right that shorter-term interest rates have stayed low for years, hurting fixed-income savings instruments like CDs even as they’ve boosted equity markets. In fact, it’s been more than 5 years since 3-month-LIBOR, the most common floating rate on quarterly-paying loans, has been above 1%! Spending half a decade with rates that low has also caused many companies to become complacent about planning for and insuring against the eventual increase in their borrowing costs. It’s like this Thanksgiving dinner – the longer we sit here eating, the more likely we are to be lulled to sleep. The combined impact of serotonin-producing tryptophan in our turkey, together with massive amounts of carbohydrates’ releasing insulin and pulling nearly all amino acids out of our bloodstream except for tryptophan, can make us all want to curl up on the couch and fall asleep. And that’s what the Thanksgiving dinner of zero-interest rate policy has done to some borrowers, lulling them into complacency while a harsh wakeup call of significantly higher borrowing costs may be coming soon. Make sense, Grandpa Bobby? Are you still awake, Grandpa Bobby?”
Have fun talking turkey this Thursday! And please watch out for the pumpkin kale casserole – we’re very thankful for our clients, and we look forward to working with you for many more years to come.
Call 610.925.3120 or email us.