‘There is nothing new on Wall Street or in stock speculation. What has happened in
the past will happen again, and again, and again. This is because human nature does
not change, and it is human emotion, solidly built into human nature, that always
gets in the way of human intelligence. Of this I am sure.’ – Jesse Livermore
The profitability of lending/investing money is a function of both the rate of return on the money loaned/invested and the return (payback) of the money. The historically low interest rates are squeezing lenders by driving the rate of return on the loan toward zero (note: ‘lenders’ can be banks or non-bank lenders, like pension funds investing in bonds).
As the margin on lending declines, lenders, begin to take higher risks. Eventually, the degree of risk accepted by lenders is not offset by the expected return on the loan – i.e. the probability of partial to total loss of capital is not offset by a corresponding rate of interest that compensates for the risk of loss. As default rates increase, the loss of capital causes the rate of return from lending to go negative. Lenders then stop lending and the system seizes up. This is what occurred, basically, in 2008.
This graphic shows illustrates this idea of lenders pulling away from lending:
This post was published at Investment Research Dynamics on December 12, 2017.