Taking Stock / Your Banker Sleeps Just Fine at Night

You, dear customer, probably shouldn't. On interest rates, retirement funds and monopolies

1 - The governor of the Bank of Israel has a problem. He sees housing prices rising by the day. He understands that a large part of that increase is caused by the low level of interest rates. He is aware of the dangers lurking in real interest rates remaining negative over time, meaning that once inflation is factored in interest rates are actually less than zero. But his hands are tied.

Stanley Fischer's counterparts at central banks around the world are keeping their interest rates low, and he has little wiggle room to raise rates here.

sleeping - Ayala Tal - August 31 2010
Ayala Tal

In the wake of the global financial meltdown the world's central banks recognize the dangers of negative real interest rates, of keeping the price of money low, which led property prices to soar.

But while the central bankers maneuver between their terror of financial bubbles and their terror of recession staging a comeback, the general public does not understand the dangers that lie in bottom-crawling interest rates.

Even though the steamy month of August is usually quiescent, as Israelis roast on the beach or go abroad, this August Israeli mutual funds raised a billion shekels, lifting their managed assets to record heights. Most of the public money in mutual funds is invested in bond funds. They are hawked to the public as a relatively safe, solid vehicle, a solution for people who don't want to see their money rotting in a bank deposit, earning next to nothing.

The adviser at the bank branch surely explained that with a slight increase in risk the customer could earn annual returns of 2%, 3% or possibly 5%.

The months went by, the bonds continued to rise, the value of the fund increased by 5%, 8% or whatever, and the customer feels vindicated. He played it safe and made five times what the same amount would have earned in a bank deposit!

But there's no reward without a risk, and a mutual fund that can gain 5% in a year can also drop 10% in half that time. The age of bottom-crawling interest rates may last a long time. But the day interest rates start rising again, the losses will hurt.

Investors can be divided into two types: the ones with short memories, and the ones with no memory at all. Two years ago, when stock markets collapsed, investors blamed the government and the media for failing to warn them of the risks of putting their money into provident funds, mutual funds and whatnot. Yet now they are returning to that very same risk profile. The proportion of shares and corporate bonds in their portfolios is approaching previous records.

Naturally, one cannot rule out the scenario of real interest rates, short- and long-term alike, remaining low or even negative for years to come. But that scenario would cost dearly too. Negative interest rates lasting years would destroy value in most pension funds. Pension fund managers may promise their clients real returns of 3% to 4% a year, but if interest rates are in negative territory for years, chances are those promises will be empty ones.

For nearly all of the 20 years that have elapsed since the government sent the public into the open market rather than protecting its pension savings, real interest rates have been in the range of 2% to 5%. Even after deducting management fees, the returns can assure a comfortable retirement.

But if interest rates are zero or negative for years, one of two things will happen. Either the government will assume the burden of supporting retirees, or retirees' standard of living will drop.

2 - Retirees who are accustomed to living off the interest on their meager savings saw their income drop by as much as two-thirds in the past few years, as interest rates fell. Perhaps they would be happy to know that there is one group of workers that found a solution to the drop in interest rates. I am talking about employees of Israel's banking oligopoly.

As interest rates fell and risk went out of fashion, the banks' income took a hit. The more interest rates fell, the more the spread narrowed - the spread being the difference between the interest the banks collect on overdrafts and the interest they pay on deposits.

A normal business operating in a difficult, competitive environment would have to either become more efficient or develop new sources of income. But not Israel's banks. As a case in point, let's look at a memorandum issued this month by the head of the trade union at Bank Hapoalim to bank employees. It's in Hebrew, so we'll translate parts of it.

Due to the "difficult macroeconomic reality" in recent years, writes the union chairman, "including the unprecedented low interest rates ... the bank management decided to reduce the minimal return [on equity] entitling workers to bonuses to 7.5%, from 8.5%, and to increase the bonus based on return on equity levels out of capital adequacy ratio to the bank's goals." That convolution boils down to this: The bank is lowering the grading curve for itself so that employees will continue to receive bonuses despite the decline in the bank's performance. Employees previously received bonuses only when the bank's return on equity was at least 8.5%; now that threshold is being reduced to 7.5%.

To put it even more simply, there is no competition among the banks and our customers have no negotiating power. We have no intention of streamlining, and cutting our NIS 15 billion in annual payroll costs. We've put a new twist on Israeli banking: Since times are hard we're lowering the bar, the better to skip over it and waltz home with our bonuses.

The memo was from Hapoalim but nearly all Israeli banks, with their combined workforce of 45,000 workers, operate on the same principle. You know what? It's a great idea, everyone should adopt it. Who doesn't want a warm, cozy work environment?

The problem is that it only works for monopolies, that don't have to compete and can pass on their costs to their customers, or to their shareholders.

3 Last week the police gave prosecutors the results of their investigation into the loan scandal at Menora Mivtachim. If you have an executive insurance policy (bituah minhalim ) with any of the big insurance companies you may be wondering whether the case, which was first reported in TheMarker last year, could affect you. Should you be concerned?

Yes. You should be very concerned. While provident and mutual funds were thrust into the spotlight because of the Bachar reform, life insurance policies have remained in the darkest corner of the capital market. Mutual funds hold mainly liquid, transparent assets, but life insurance policies have been steadily increasing their holdings of illiquid, opaque assets.

What are illiquid, opaque assets? They are assets that you, the customer, cannot know whether the company bought at market value, fair value or completely insanely inflated value. They are assets that should have been bought only after due diligence, review by the audit committee, analysis and thorough study, but probably weren't - and in any case you don't know.

What's happened in recent years is that profit-sharing policies have turned into clearing houses for favors to friends of the controlling shareholders.

The Commissioner of Capital Markets, Insurance and Savings in the Finance Ministry, Oded Sarig, doesn't appear to be particularly perturbed by the turn of events at the insurance companies. The penalties he's imposed on insurers who err have been laughable, considering how much trust their customers must have in the institutions that hold their money for decades. Sarig would do well to consult with his predecessor, Yadin Antebi, who toward the end of his term began to grasp the scope of the threat posed by the conflicts of interest and cozy relations between the people managing money at the insurance companies.

Antebi missed the chance to do anything about it. By the time he understood the danger, the global economic crisis had erupted. He feared that a sweeping investigation followed by heavy penalties would destabilize Israel's financial system. But Sarig can still shine a light on the sector and throw miscreants into prison. It's the least he could do for the people who allow a company to manage their money for 30 or 40 years, at triple the fee a mutual fund would charge.