by Aryeh987
The connection may seem totally random, why would the interest rates the Fed borrows and lends at make investments dumb? However, there seems to be a series of incentive structures that correlates the two.
The Federal Funds Rate dictates all market returns. Long story short on the math, bonds are priced at the current Federal interest rate plus extra for the default risk, and equity funding is priced so the average return is akin to a bond plus a bit extra for all the risk. Even dividend-paying REITs, where the price of the stock moves until the dividend yield offered matches the Federal Funds Rate plus an appropriate risk premium. This is all fair and efficient.
A bank’s business model is to take deposits, give loans, charge fees for originating the loans, collect interest for said loans, and use the spread between the low rate they borrow at and the high-ish rate they lend at to pay their workers. While not as heavily regulated as a commercial bank; investment funds, investment banks, private equity firms, and so forth have this same business model where they take money from one guy and invest it in another and make money off the returns and fees.
For obvious reasons, the amount of lending is inversely proportional to the Federal Funds Rate. Higher interest rates equal fewer people willing to borrow, while if interest rates are zero there is simply no reason in the world you should not borrow all you can. This is why in the past year with rising interest rates the number of new mortgages this year is a third of that of last year. Startups are being hit harder because the amount of funds offered to founders for a 50% stake of the business is a fraction what it was when the money printer was still running.
However, the profit margins of a bank and bank-like business are directly proportional to the Federal Funds Rate. Obviously, loans with better yields equal more profits, while near-zero interest rates equal razor-thin profit margins upon their loans whilst the number of loans goes up. Manhours cost money, due diligence takes manhours, ergo the incentive with falling interest rates is to do less due diligence. This appears to be true, as back in 2021 one major private equity firm averaged a deal a day. Likewise, with the FTX fraud, no one seemed bothered that SBF didn’t offer board seats to investors, almost as if the investors weren’t planning on using them anyway.
We all recall 2021 when it seemed that everything seemed to go up in stocks, including several major frauds and many firms that had no chance of succeeding. However, those prices may have all been fair at the time since growth stocks are valued at their expected future value, minus the return on Federal bonds, minus the risk of the venture. Since the Federal Funds Rate was near zero, all that was required for absurd valuations is the expected future profits to go up, or the investment is considered safe.
It is not necessary to ever become profitable, just keep announcing new ventures and SOMEONE will give more funding to keep the firm afloat. If that sounds like a Ponzi scheme, it is because it is. And since all Ponzi schemes eventually run out of money, when the expected returns are lower the scheme can go on for longer. There is even the potential for legal Ponzi schemes in the form of innovative startups. The founders may know for a fact there is almost no chance of getting anything marketable, but they also know they can do the science they love for a living for years until the firm runs out of money.
Why would anyone fund these regardless what interest rates are? Consider the story of the Barrett .50 cal. A reporter in Vietnam saw the heavy machine guns the marines were using and thought “I gotta get me one of those.” And so, with no engineering, business, or machining background whatsoever, this guy and some hired help managed to put together a bolt action rifle that used the monster-sized .50 caliber ammo. They were disappointed that there was little interest in the rifle in the civilian world on account the ammo costs 3-6 dollars a round, but several armies placed a bulk order and started calling it an “anti-material rifle.” What that means was they loaded it with explosive rounds and used it as a one-man cannon to chew up vehicles and stuff.
I bring this up because sometimes batty business ideas actually do take off and become wildly successful. So ask yourself, if you met this guy when you were starting out, how much cash would you have given him in exchange for half of all profits that came from the patents of the guns? When interest rates go down, the amount of cash that guy would receive from such a deal will go up.
I forget which investment bank it was that gave funding to funding to both Uber and Lyft, who immediately spent that money competing with each other. Zero-sum games seem to have been more common with lower interest rates, with a furry of people playing an expensive game of hot potato with monkey art and digital tokens. People bought into certain stocks because of the possibility of a short squeeze, again a zero-sum game. As interest rates go down, silly games like those become less unreasonable, and as we all see once interest rates go up you simply stop hearing from these guys.
So you see the incentive at a bank when interest rates are zero. Simply load up on risk and fund everyone just so you inevitably grab a winner. Don’t bother doing any fact-checking because you can’t afford to pay anyone to do that and it doesn’t matter anyway. The incentive for the entrepreneur is likewise to get equity funding even if you don’t know what you’ll do with it. Everyone will feel rich for a time while everything is going up in paper value, but when things start crashing down everyone’s returns will normalize to mediocre levels. Voila! Lower interest rates have created dumb investments.