Investors around the world today are looking for a place to park money. They know that the stock market is dangerous. They know that the real estate market is dangerous, and they know that gold is in a bubble because they heard it on CNBC.
So maybe they will take their mother's advice growing up and put it in the bank. Savings.
They stroll down to the local bank and discuss a savings option that will give them a strong but safe return on their investment. They decide on a 5 year CD, and they take a look at some of the rates they can earn with a bank today:
Citibank: 5 year CD: 1.5%
NorthernTrust: 5 year CD: 1.35%
Chase Bank: 5 year CD: 1.25%
Bank of America. 5 year CD: .95%
Gee golly this is swell. They hand over their cash and tell the bank they will be back in 5 years to collect their earnings. (Unless they want it earlier, which means they will have to pay a penalty to remove the funds)
Now what does the bank do with the money?
The first option is to call the federal government and tell them they want a 5 year government bond. What is the going rate on a 5 year government bond?
So the bank pays out 1.5% per year to the customer, and they collect 2.35% per year from the government. They pocket the difference, or the spread.
Why would the investor not just buy a 5 year government bond instead of a 5 year CD? Very, very, good question. The government bond is risk free. Remember, it is the government who back stops the banks.
However, the banks can do other things with this money to earn a higher return. They can lend directly to state and local governments for around 4%. They can lend to home buyers for around 5%. These loans are typically 20 to 30 years in length.
Doesn't borrowing for longer than 5 years create a problem if interest rates were to rise?
Yes. The problem is so large it is almost impossible to quantify. The banks know that if and when interest rates do rise it will wipe out the reserve base for all the Too Big To Fails across the board.
The government will once again have to step in with a bail out. In the mean time the focus is to generate the largest returns this quarter before the crisis comes. This insures massive bonuses for the banking managers who will just step away when it comes time for the tax payer to foot the bill.
Rinse, wash, repeat.