Malt Liquidity 35
The ZIRP edition
Customer retention is overrated
A couple weeks ago, we had Texas power wholesalers asking their customers to leave them, and today, we have German banks inducing clients to either quit saving or leave through negative savings interest rates. This is an inevitable result of ECB pressure:
Banks in Europe resisted passing negative rates on to customers when the ECB first introduced them in 2014, fearing backlash. Some did it only with corporate depositors, who were less likely to complain to local politicians. The banks resorted to other ways to pass on the costs of negative rates, charging higher fees, for instance.
The pandemic has changed the equation. Savings rates skyrocketed with consumers at home. And huge relief programs from the ECB have flooded banks with excess deposits.
As a refresher, I wrote a couple months ago that
When the yield is negative, it can be viewed as the government trying to raise short-term funding. The goal is to encourage the large financial institutions that need the liquidity of government offerings to facilitate their cash flow to lend more and not sit on debt that will ensure a negative return. So, inherently, issuing negative yield debt is the government’s way of inducing growth by negative reinforcement through penalizing savings, rather than the positive reinforcement of cutting taxes, which would cost the government funding.
When you are a bank and already holding negative-yield debt, excess deposits are almost a liquidity crunch through excess supply: when your lending opportunities are solely low yield and everyone is already flush with cash, additional cash on top of the lending you need to do just to break even doesn’t generate interest, because the only debt purchasable with that size is negative yield, creating a feedback loop. The institutions forced to purchase negative-yield debt are unable to find sufficient liquidity to lend with a yield. Germany in particular is culturally fiscally conservative almost to a fault - on top of being flat cash holders, the typical investment vehicle is low-yield, high grade fixed income, indicating a weak market for higher yield lending.
With central banks flooding bond markets with liquidity provision and exponentially increasing the monetary supply, it is noticeably concerning that the incentivized
wealth creation mechanism is mark-to-market returns built off of market participation speculating on the beneficiaries of cheap leverage. Though the Germans remain staunchly resistant to volatile speculation, clearly this is not the case for the rest of the world, and I feel this rationale is generally correct: if your argument for longing crypto is simply “cash doesn’t generate a return, so I might as well put it somewhere where it can”, I think this is unassailable logic! The same is true for meme stocks, Pokemon cards, NFT, sneakers, or whatever else you can get your hands on, because the spot price for something being exponentially out of whack does not define something as exponentially sillier as a result. I tend to not use economic, fundamental arguments when building cases - as a liquidity purist, I believe that a price is solely defined by where the bid and the ask meet and work up from there. So it is kind of troubling when I find myself meeting at the midpoint and agreeing with fundamental purists like Paul Singer as holding cash becomes nearly wholly worthless.
ZIRP concerns aside, it is worth keeping in mind the principle that “subsidized artificially low cost of capital causes serious risk transferral externalities”: while negative rates and fiat currency theoretically work out just fine, the basis of the financial system is “let’s just have it work this way” at its core. If people stop believing that financial products account for risk properly, the quantification of risk is immaterial.
Speaking of ZIRP…
While incompetent CFOs have made the news recently, I have always held a respect for Domino’s as a business, and their CFO recently made some comments that I think are straight “spitting fax”, as the kids who have never seen a fax machine (or a real interest rate) would say:
“In 60 years,” CFO Stuart Levy said on Thursday, “we’ve never made a dollar delivering a pizza. We make money on the product, but we don’t make money on the delivery.”
“So we’re just not sure how others do it,” he added.
I have always reviled the marketing of the gig economy as “entrepreneurship” when the reality is much closer to “preying on people desperate for income”. Remember that axiom about risk transfer externalities a few sentences ago? Well, the flood of cheap VC funding into “gig economy” companies transfers the risk of making ends meet from the business itself to the services it inserts itself into delivering and the people who facilitate the deliveries themselves. As Levy correctly notes, there aren’t sufficient margins in delivery - while food delivery startups such as Grubhub or Doordash command 10-11 figure valuations, they don’t actually make any reliable profit; rather, they are enabled by artificially subsidized cost of capital allowing them to show explosive revenue growth. Thus we arrive at a situation where a 50 billion dollar company ($DASH) has to diversify its business operations to even turn profitable. If Domino’s spun off their delivery business, would the combined public companies have a much larger market cap than the current stock itself?
Domino’s typically keeps its prices down on delivery in part to sell more of those pizzas. But if a company as data-driven and as experienced at delivery as Domino’s can’t make a profit off of that service, it makes us wonder whether anybody can…
Yet consumers are already paying enormously high prices for these items to be delivered, both in the form of fees to delivery companies, tips to their drivers, and charges from restaurants that also pay high fees to aggregators. The premium is substantial.
The Restaurant Business editorial staff has in recent weeks tested chicken sandwiches from various fast-food concepts, with staff getting these items through a combination of pickup or delivery. Some editors were paying $15 or more for a single sandwich to be delivered.
We arrive at yet another risk transferral externality. The Fed, by continuing the advent of ZIRP, has created a business environment where the exit strategy is not to make money, but rather to be acquired by a larger player (again, on more cheap debt) like Uber did with Postmates, because it’s cheaper to just buy a competitor rather than compete through further subsidizing the already money-losing business, and the pandemic reinforced the staying power of gig economy food delivery because so many people were prevented from leisurely outdoor activities.
“We’re just not sure how it all plays out,” Levy said. “We think as long as we’re providing a great product with great service at a great value, we’ll let everything else shake out. We don’t know how long it will take.”
A common frustration of mine with ZIRP markets is that you can see what the problems are, but it is fundamentally impossible in real time to see how exactly this situation fixes itself. There exists a catch-22 when the lender of last resort has to act: if central banks exist to provide liquidity in last resort scenarios and successfully do so, then markets then can quantify and account for this course of action, thereby creating continuous last resort scenarios which rely on central bank liquidity provision. As far as I can tell, it can work as long as people continue to believe in it, but believing in infinite liquidity provision when reality dictates that liquidity is finite feels like ontology rather than analysis.
On that note…