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Nasty things lurk in bank deposits

By Simon Murray

It is not surprising to hear that some asset-rich family offices have cash-flow concerns. A number of family offices need to generate more cash to support family expenditures. Every office has its own reasons for this: marriages, divorces, births, illnesses, deaths etcetera…

At the same time, family offices are dealing with a unique combination of historically low interest rates and inflationary pressures. A lack of liquidity, not just yields, in some markets and asset classes has also become a key investment concern for family office executives.

Not so long ago, family offices could earn attractive returns from cash deposited with banks – sometimes greater than yields from high-risk/high-return stock market instruments.

Although never reaching anywhere near the 19%-plus FED rates seen in the early 1980s, interest rates increased in the run up to the financial crisis in 2008/2009, as banks competed for private investors’ cash. Unfortunately, the era of attractive cash returns was short-lived. Courtesy of quantitative easing, many banks have cheaper sources of liquidity.

There is no doubt the cost of living is increasing for families of all kinds. Over the past few years, family members with children, for instance, have needed to find significantly more money to cover escalating private school and university fees, and the costs of buying homes, not to mention day-to-day expenses.

Under normal circumstances, governments would increase interest rates to tackle inflation. But the “new normal” is very different, and policy-makers have been driving down interest rates. On 9 August 2011, Ben Bernanke, the head of the Federal Reserve, pledged to keep interest rates low for “two years”.

Of course Bernanke has to say this, as US debt levels would be unserviceable if interest rates increased dramatically. Low or zero interest rates are central to making debt affordable. Governments can issue billions of dollars of debt, keep the interest payments to a minimum, and when the time comes to pay back the principal, simply issue new debt.

A system of perpetual debt based on ultra low interest rates supports governments and troubled banks, and it helps individual and corporate borrowers in the private sector. It is one of the tools that governments use to stimulate the economy – putting money back into the pockets of individuals struggling with debt interest payments, and reducing the cost of bank loans for businesses investing in the future (if the loans are approved).

However, low interest rates are bad news for savers and investors, who face a prolonged period of negative real interest rates from cash deposits, as inflation rates outstrip interest rates. Family offices can no longer make their surplus cash work by simply placing it in a deposit account with a credit worthy bank offering the highest rate of return.

Older/retiring family members find it much harder to switch from longer-term investments to more liquid fixed interest instruments without eating into their (and the next generations’) capital.

In addition to negative real interest rates, some banks in the US and Europe are starting to charge, or are considering charging, clients for holding cash deposits. One could argue that paying a “safe” bank to look after one’s cash is a better option than earning interest from a potentially insolvent bank, irrespective of government deposit “guarantees”.

You could also argue that paying banks to hold cash is no different from paying asset managers an asset management fee to hold cash, as part of a diversified investment strategy. But the difference is that banks do not sit passively on your cash held in client accounts. They leverage and re-cycle the cash in financial markets to make more profits.

How cash is leveraged is one of the more worrying aspects of the current market for family offices. Before the recent financial crisis large investors were offered relatively high short-term cash returns by providers of enhanced cash vehicles.

For a while many of these vehicles – based on a mix of low, medium and high-risk/short-maturity cash investments, combined with high levels of liquidity - worked well. But not all of these vehicles survived the financial crisis, and a handful of others were exposed as ponzi schemes and frauds.

Today, the situation is repeating itself. Investors, starved of yield are again being sold products designed to generate enhanced short-term cash returns. All the core ingredients are in place. It’s not hard to cook-up products when Greek 1-year bonds (for instance) offer 50%+ yields.

All you need to do is mix investments in distressed debt instruments with “safer stuff”, season with some derivatives, and sell it as a sophisticated financial product. It’s a familiar and dangerous approach, finessed to ultimate destruction by manufacturers of mortgaged-backed securities. For family offices considering these products: buyers beware.

You’ll only have yourselves to blame if one or more of these vehicles collapses or restricts liquidity, as a few may do. It is vital to understand exactly what you are really buying into, or look elsewhere for cash-generation opportunities.

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