A Valuation Nightmare

Did you notice the news story that shook the foundations of our global economy last week? Although it didn’t receive much attention in the popular press, one doesn’t need to possess a PhD in Accounting or Finance to appreciate the potential threat that now confronts us.

You see, for the first time in the history of European finance, private corporations issued bonds with negative interest rates. Specifically, the corporations Sanofi and Henkel announced that they will charge investors to borrow money from them.

Although European government entities have issued securities with negative interest rates, never before have private corporations done so. Presumably, investors are now so nervous about the future of the European Union that they are willing to accept such terms from Sanofi and Henkel.

Why did this event shake the foundations of our economy? Because our global financial system is predicated on the assumption that it is worthwhile to invest for the future. Under normal circumstances, when a borrower pays interest to a lender, the interest payment represents an acknowledgment that the borrower is investing the principal in a project that is generating future value.

So what happens when interest rates turn negative? In essence, investors are incentivized to spend all of their money immediately, or to store their money in their proverbial mattresses, rather than investing in the private sector. And the calculation known as Net Present Value (NPV), which relies on positive interest rates to discount future payments to their current values, fails to function.

Furthermore, if we no can longer estimate the present value of future cash flows, many tangible and intangible assets will no longer possess calculable values. Commercial landlords, for instance, will no longer be able to estimate the values of their properties on the basis of their future rent receipts. And banks will no longer be able to estimate the values of their loans on the basis of their future repayments.

In other words, we’d experience a valuation nightmare. So why did the Sanofi and Henkel announcements garner so little public concern? Perhaps it’s because the financial press is assuming that their negative interest rates will prove to be isolated incidents.

If other private corporations start to issue debt at negative interest rates, though, there’s no question that we’ll start to hear about it. After all, if the practice of investing for the future is no longer perceived to be a generator of value, it’s difficult to envision how our economy will ever grow.

Negative Interest Rates: A “Real” (And Nominal) Conundrum

If you’re an extremely conservative investor, you’re grown familiar with the burden of negative real interest rates. When banks offer nominal rates of interest that are less than the rate of inflation, depositors are unable to keep pace with the cost of living and thus grow poorer in real terms.

For instance, during the past two years, investors in U.S. Treasury bills have been earning interest at rates below 1%. At such low levels of interest, even inflation rates below 1% can produce negative real returns.

A negative nominal interest rate, though, is an exceedingly rare condition. When banks charges depositors to do nothing but hold their funds, they are imposing negative nominal rates. Under such terms, for each $1 in deposits that banks accept from depositors, they withdraw fees from (instead of adding interest to) the deposits and effectively drive the account value below $1.

Last week, the Bank of New York / Mellon (BNY) became the first private banking institution in the United States to begin charging fees to hold certain corporate cash deposits. In other words, they decided to impose negative nominal interest rates on their depositors, a decision that reveals much about their future expectations regarding the markets and the economy.

A Few Precedents

The global banking industry has produced a few historical precedents regarding negative nominal rates, though none involved private banking institutions. For instance, during the economic crisis of late 2008, treasury bill yields became negative for the first time as panicky investors bid up the purchase prices of American governmental securities. But that situation involved a treasury auction process that permitted investors to bid up prices (and thus bid down effective rates) to extreme levels; the U.S. Treasury never actually insisted on charging investors negative rates.

During that same chaotic period of time, several private money market managers came very close to “breaking the buck” (and one actually did so), an industry expression that refers to funds that repay less than $1 for each $1 invested in them. But funds would never willingly “break the buck,” and once the federal government stepped in and temporarily guaranteed their solvency, the threat of negative nominal yields passed away.

In addition, at an earlier time during the 1970s, the government of Switzerland effectively pushed nominal interest rates into negative territory by imposing a surcharge on foreign depositors at a time when rates were already close to 0%. The negative rates, though, were an indirect outcome of a government taxation policy; they did not represent an intentional decision by a private banking institution.

So why did BNY decide to make that intentional decision last week? And what does it reveal about the future conditions of our global markets?

The Liquidity Trap

When it announced its decision, BNY explained why it must charge negative interest rates on large corporate cash transfers that are deposited into its coffers but that can be withdrawn at any time. According to BNY, because of the highly flexible withdrawal liquidity terms on those accounts, the bank is unable to reinvest the funds in an appropriate manner; thus, the cash itself represents a burden and not an investment opportunity.

In other words, from the perspectives of both the depositors and the bank, the primary concern is one of liquidity. Depositors are seeking to preserve the full liquidity of their cash balances in extremely volatile markets, and are thus willing to pay fees to financial institutions that can simply maintain their balances during times of extreme volatility. But the bank cannot profit if it permits its own liquidity position to be constrained by its “withdrawal at any time” account terms, hence its need to impose negative nominal interest rates.

In other words, any bank that agrees to function as a temporary “parking spot” for cash needs a method to earn income on such transactions. With profit making opportunities already constrained by a recessionary economy, the only way for BNY to do so is to levy charges, which flip its slightly positive (but near zero) nominal interest rates into negative territory.

Dismal Expectations

What do these circumstances tell us about BNY’s expectations of future market conditions? One is that its executives probably expect our nation’s recessionary conditions — and, by extension, our near-zero interest rates — to remain in place for some time to come. Another is that they probably expect their depositors to continue experiencing extreme market volatility — and thus to continue needing bank accounts to temporarily “park” their cash — for some time to come as well.

In other words, BNY probably does not expect our financial markets to return to normal historical levels of performance any time soon. When Federal Reserve Bank Chair Ben Bernanke recently promised to maintain interest rates near zero for at least the next two years, he appeared to endorse these rather dismal expectations of the American economy and its financial markets.