Newsletter July 2, 2016

Why Interest Rates Are So Low

In a recent edition of this newsletter I suggested that low interest rates are explained by the laws of supply and demand and that there has been a high supply of money to be loaned in comparison to the demand for loans.

A large supply of lending comes down to a high degree of willingness of banks and other lenders to lend money.

Canadian banks have three main choices of where to invest their assets. They can i) place money on deposit at the Bank of Canada, ii) invest in safe government bonds and other very safe bonds and fixed income securities, or iii) loan out money to businesses and individuals.

Lending out money provides the highest rate of interest but also incurs higher administrative costs and involves the risk of loss if the loans are not repaid.

As we are all aware, interest rates are at historic lows. The lowest rates in Canada for a five-year fixed rate mortgage are in the range of only 2.3%. Banks can make attractive profits while lending money at 2.3% because they now pay little or nothing on deposits and because banks are highly leveraged. A typical bank may earn a net 1% on its loans but that can translate into a 15% return on owner’s equity due to leverage.

The Bank of Canada, like central banks around the world, has sharply lowered the rate of interest that it pays upon funds that the commercial banks keep on deposit at the central bank. I understand that this rate is currently 0.50%. If the central bank was paying banks 4.0% on money deposited at the central bank, then banks would certainly not be offering mortgage money at anything close to 2.3%.

Central banks have lowered the rate of interest they pay to banks in order to encourage banks to lend out money, which stimulates the economy, rather than keep it on deposit at the central bank.

However, banks have also chosen to invest heavily in government bonds as an alternative to lending out money and this has driven the interest rates on government bonds down to record lows as the banks and other bond buyers compete with each other and drive down the interest rate that they are willing to accept on government bond investments.

But banks have also been liberal in providing loans to customers and competition to obtain borrower customers has driven down lending rates. It is popular to suggest that Canadian banks form an uncompetitive oligopoly. That is simply not true and a 2.3% five-year mortgage rate is a testament to the fact that banks do compete aggressively on loan interest rates.

Banks will continue to be liberal in lending money and will continue to offer low rates until i) the central bank raises the rate it pays to banks making it more attractive to simply leave money on deposit at the central bank, ii) banking regulators reduce the capacity and profitability of lending by raising capital requirements which lowers leverage, or iii) the banks begin to fear higher default rates and loan losses causing them to increase interest rates to compensate for the higher risk.

The bank of Canada could increase its interest rate paid to banks if inflation rises and the Bank of Canada wishes to cool the economy by encouraging less lending.

Banking regulators could also cause an increase in loan interest rates if they decided lower the amount of leverage that banks are allowed to employ. For example, banks could be required to hold a higher percentage of equity capital as a percentage of their assets.

It is also entirely possible that loan default rates will rise due to a recession (higher unemployment rates) or due to a mayor decline in house prices. In that case, banks will raise interest rates on loans. If banks begin to reduce lending due to fears of higher default rates this could actually cause additional customers to default. Many businesses and consumers have been borrowing new money to pay old debts. Any reduction in lending could push such borrowers into defaulting causing more fear of defaults and a further lowering of lending. It is evident that this could turn into a nasty negative self reinforcing cycle.

The bottom line is that interest rates are low because central banks are encouraging commercial banks to lend and because commercial banks and other lenders are highly willing to lend even at low rates because loan default rates have been so low.

Low interest rates have been beneficial for investors. Wise investors should keep a close watch out for any material rise in interest rates since a material rise in interest rates would cool the economy and likely push down stock prices.

A Battle Brews Between Credit Card Companies and Merchants

There is a battle (rightly) brewing between credit card companies and the merchants who accept credit cards for payments. My belief is that credit card fees to merchants are far too high. Until recently it did not appear that any change was likely. But the system is ripe for change and it now appears more likely that change could indeed occur.

This has implications for investors in Visa Inc.,  MasterCard Incorporated and American Express Company. It also has major implications for all the retailers and merchants that accept these cards and their investors and may have implications for consumers as well.

Recently, Walmart Canada announced that it would no longer accept VISA cards citing the high fees charged by VISA.

When a merchant accepts a credit card payment they effectively receive somewhere between about 97 cents and 99 cents on the dollar. The credit card company receives about one to three cents for each dollar spent on a credit card. This one to three cents ends up flowing (directly or indirectly) in part to consumers in the form of rewards, and in part to the issuing bank (and perhaps to certain companies associated with the bank including “merchant acquirers”) and in part to VISA inc. or MasterCard incorporated or America Express. (In the case of America Express there is usually no issuing bank as they mostly issue cards directly rather than through banks.)

Credit card companies provide two main things for merchants and consumers. 1. They act as a payment mechanism. The merchant gets paid immediately (albeit an average of about 98 cents on the dollar) and the customer usually pays off the credit card bill at the end of the month. 2. The credit card offers long term credit to those consumers who don’t pay off the bill at the end of the month.

Some Rough History

Widely accepted credit cards did not exist until the 1960’s. Bank of America got things started in Fresno California in 1958 but it was not until the 1970’s that general purpose credit cards became relatively ubiquitous. Perhaps contrary to romantic notions of life in the 50’s and 60’s, many people did in fact use credit back then. It was extremely common practice for both large and small stores to allow their customers to buy now and pay later. Many people had “accounts” at the grocery store and the hardware store and even the corner store.

By the 1970’s and 1980’s credit cards became the retailer’s best friend. Credit cards eliminated the need for stores to offer credit and the associated losses and costs. As credit cards became ubiquitous the need to accept personal cheques was also eliminated. Credit cards also boosted sales. For a merchant, getting an immediate and largely risk free 97 or 98 cents on the dollar was better than having to offer credit or accept a personal cheque. And it was certainly better than failing to make the sale because the customer did not have sufficient cash.

Credit cards also facilitated the reserving and guaranteeing of Hotel rooms and airline seats. They were greatly useful for the mail order industry and later were essential for the development of online shopping.

Credit cards were a major boon to businesses and were highly convenient for customers.

By the 1980’s however and increasingly today, and especially in Canada, merchants found a new best friend – the debit card. In Canada the transaction fee for a merchant accepting a debit card payment is (usually) just a few pennies – no matter how large the transaction. There is also a monthly rental charge for the debit card reader but overall the costs that a merchant faces for debit card payments is far lower than for credit cards.

Merchants might be tempted to steer customers towards paying cash or using debit cards. But the credit card companies have strict rules against that.

Credit cards also became more expensive to merchants with the introduction and widespread adoption of various Gold and reward cards through the 1990’s and continuing through today. At some point the credit card companies started charging higher discount fees to merchants when these reward cards were used.

Nevertheless, credit cards remain a good friend of retailers even though the debit card is a better friend and is far less costly to the merchant.

The Current Situation and Problems

I have long said that VISA and MasterCard are not only a duopoly but for merchants are each monopolies. Most retailers have virtually no choice but to accept both VISA and MasterCard. They are captive to whatever fees are charged. Customers expect and even demand that retailers accept credit cards. Many customers seem to think they have a “right” to pay by credit card, failing to understand that this is tantamount to demanding a right to pay 97 cents on the dollar.

Monopolies are usually regulated as to the prices they can charge. But credit card fees have been largely unregulated in North America. It is certainly possible that legislators will move to regulate credit card fees as they have done in other parts of the world.

Reward cards have raised merchant discount fees. This results in higher prices for everyone. Those who pay by cash and debit card are basically subsidising those who pay with reward cards. Overall, I suspect that lower income consumers are subsidising higher income consumers. Reward cards result in a sort of alternate “currency” in the form points. These rewards are not subject to income tax. I view reward cards as having features of a kickback scheme. Overall, I think the government would be justified in banning reward cards. An indirect way to do that might be to simply limit the merchant discount fees. The reason we don’t see much in the way of rewards for using debit cards is that the low fees on debit cards cannot fund rewards.

The costs of processing a credit card transaction must have plummeted as the process became fully electronic and as the volume soared (economies of scale). Yet merchant discount fees have risen. The cost of proving a month’s worth of credit has also plummeted with today’s vastly lower interest rates. The notion that the credit card industry should charge anything close to 2% for simply providing a month’s credit and electronically paying the merchant and collecting from the customer beggars belief. Many customers are paying by credit card simply to collect points. It would be far more efficient (to the economy) for these customers to use debit cards. To the extent that credit card companies need to charge these kind of fees to offset the credit losses, they could tighten up the process of granting credit cards and credit limit increases. It is simply highly inefficient to have credit card companies standing between customers and merchants and collecting anything close to 2% on every dollar. As a matter of public policy, it would be preferable for credit cards to be used only when the customer needs credit for several months or more and for debit cards to be used when the customer does not require credit as such.

Credit card company profits are far higher than they need to be. For example, by my calculation VISA earned a return of 93% on tangible common equity in 2015. VISA came on the market trading at about $16 in 2008 and now trades at $75. This huge increase came in spite of cash flowing out for dividends and stock buy backs. American express earned about 33% on tangible common equity in the past year. Its stock has not done well presumably because investors had been pricing in even higher returns and/or growth. While it would hurt investors if the earnings were driven down through regulation of fees, the return on the actual assets invested in providing service would still be fair. Investors have bid up the share prices of credit card companies to very high multiples of tangible book value due to an expectation of very high returns on tangible equity. The public interest does not require that investors be protected from a share price decrease associated with more reasonable fees.

Investor Action Recommended:

Credit card companies remain extremely profitable. They may continue to be good investments based on growth and the current light-handed regulation. But there is some risk that a sort of retailer revolt, as seen with Walmart Canada, or regulation could lead to far lower profits. More nervous investors could consider getting out of these shares. More aggressive investors could continue to monitor the situation.

Go Trades, Young Man, Go Trades

150 years ago it was popular to advise a young man to “Go west” to seek opportunity. This has applied even in recent years as witnessed by the huge numbers of eastern-born folks living in Alberta.

In the 1960’s it certainly would have been popular to advise young men, and increasingly young women, to head to university. This advice  continues though with somewhat less enthusiasm as Starbucks probably has all the post-graduate-degree workers that it needs.

Trades have usually been somewhat less respected as a career choice even though well qualified trades people often out earned a large percentage of university graduates.

As of 2016, I would encourage young people to consider a career in the trades for several reasons:

1: There is often a glut of university graduated and finding employment in your field is often difficult.

2: University graduates often end up in jobs that really are not that intellectually stimulating at the end of the day. There tends to be limited autonomy.

3: Many university graduates will be at risk of being displaced by artificial intelligence and software. Accounting is increasingly automated. Engineering may no longer involve much in the way of original calculations when software can be programmed to do the math.

4: Many university graduates may be at risk of their job being off-shored. By its nature “brain work” can be done in other parts of the world and the results sent back over instant communication lines.

5: Trades can often be healthier as they involve physical work and yet also these days have a large component of intellectual aspects to stimulate the mind.

6: Many trades are far less susceptible to being “off-shored”. For example, plumbing, carpentry and electrical work, especially repairs and modifications, will need to be done on-site for the foreseeable future.

7: Trades also specifically train workers to do a useful job. In contrast what job specifically can a new science graduate actually do?

8: Trades often allow for far more autonomy and less micro management along with the satisfaction that comes from seeing the tangible results of the work performed.

9: Trades usually involve far fewer years of training and far less cost.

The bottom line is that young people would be well advised to consider the wide variety of trades. They may well find that there are better employment opportunities with better job security and better all around working conditions as compared to the university route.


Shawn Allen

InvestorsFriend Inc.

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