Philadelphia Reflections

The musings of a physician who has served the community for over six decades

Related Topics

Investing, Philadelphia Style
Land ownership once was the only practical form of savings, until banking matured in the mid-19th century. Philadelphia took an early lead in what is now called investment and still defines a certain style of it.

Health (and Retirement) Savings Accounts: Steps To Lifelong Health Insurance
If you are a fast reader, we will begin with a ten-minute summary of Health Savings Accounts. At first, it covers future revenue, then spending projections follow. No matter how medical care changes, cost and revenue must remain in balance.

Relationships: Bankruptcy and Bond Prices

The price of borrowed money includes a provision to pay for defaults on the loan. That is, the interest rate demanded includes a default provision assessed by the banker against what he thinks is the risk of bankruptcy. Since he wouldn't make the loan if he thought the risk was high, he insures a little more accuracy by assigning a general rate of risk for the class of debtor. But what of the creditor who wouldn't suffer much, no matter what the risk of default? Or who ignores the risk of default because he sees very little? That man would have no interest in supporting loans, except to obtain an adequate rate of return; a pure investor, who has the money and is looking for a place to earn a return. If you don't give him a fair return, he will simply pass bonds by, and invest in something else. If the banker feels the risk is greater than the offered return, he too will let the opportunity pass. The consequence is for a fair price to emerge from the marketplace for bonds. The debtor may cry and protest, talking about the unfairness of it all, and telling his wife that bankers are a greedy bunch of knaves. But in a modern bank, he would merely be offered a Kleenex for his performance. There are just times when loans are expensive, and this particular debtor has encountered one. Sometimes, a disappointed debtor visits his congressman, and sometimes the law is adjusted for him to borrow at a substandard rate. James Madison felt that debtors would always outnumber bankers, so there would be a tendency for interest rates to creep upward in a voting republic. Consequently, a mixture of strategies is employed to suppress interest rates. Sometimes the government subsidizes non-market prices, sometimes the risk of default cost is buried in the overall interest rate, sometimes the bank subsidizes the cost out of more obscure profits, usually by raising the rates for wealthier clients if they are numerous. If these simple strategies go on long enough, the default occurs and its cost is assessed as taxes from the bankruptcy courts. In a modern bankruptcy, the defaulted debtor may be entirely stripped of his other assets. If that's not sufficient to cover the loss, either the banking system collapses, or the government does.

There's another big player in this game: insurance companies. Insurance companies buy lots of bonds, trying to match their interest cost with their other expenses, notably their insurance liabilities. If the insurance commissioner of the state permits it, they may even issue some bonds to cover a shortfall. In recent years, they usually buy stock equities, and if they overdo it, the stock market may get them. The crooks in this business take in the premiums in the early years, and sell the company as the aging liabilities grow older, particularly if the Insurance Commissioner is friendly. Fortunately for them, the population has added thirty years to the life expectancies of their clients, so they have not had to resort to any of these strategies as much as they originally did. Insurance companies have been very profitable, and so bond rates have developed a great deal of slack. Whether they take advantage of their opportunities is not for me to say, but it would not be surprising if bond prices, hence bankruptcy laxness, have been both profitable and slack. The two are huge pools of money, operating in largely independent markets, which can operate comfortably and separately, for long periods of time. The last two stock market crashes have been real estate collapses, and real estate is all about mortgages, banks, and interest rates. And the Federal Reserve has responded to both crashes by artificially manipulating mortgages, banks and interest rates.


 

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