Thursday, November 13, 2008

Arbitrage Opportunities

So, interest rates may soon drop to 0%.

This creates an interesting opportunity.

Let's imagine two people:

Person A: Has a mortgage at a fixed rate of interest (say 6%)

Person B: Has some money to save.

If the savings rates on offer are low - say 2% - it would benefit person B to lend the money to person A instead.

Person A could offset this money against their mortgage and avoid paying the 6% interest charge on that money.  They could, therefore, afford to pay person B a competitive rate of interest - perhaps 4% - and still come out ahead.   One might imagine that there could be lots of people like Person "A" out there (mentioning no names...). I'm sure they'd be interested in such a scheme.

There are three problems, all of them solvable:

1) Person B is likely to be liable for tax on this income so interest rates may have to fall quite far for it to be an attractive deal

2) Person B will worry about the possibility of default by Person A

3) Persons A and B have to find each other.

Problems 2) and 3) could be solved by the introduction of some sort of intermediary. Let's call it a bank.

The bank will wrap up the default risk with their fee for providing the matching service and other administration and capture it as a spread between the rate they'd pay to person B and the rate they'd expect from person A.

So this idea would actually only work if rates fell so far that unsecured bank *lending* rates fell below 6%.

Does anybody see that happening any time soon?

2 comments:

Darren said...

I'm sure I saw some tracker mortgage offers last year that did 1% under the base rate. If that were to fall to 0.5%, would the bank actually pay you interest on your outstanding mortgage? I'm sure they were clever enough to set some limit in the small print, but still.

Richard Brown said...

Yes... that would be rather fantastic. I keep reading that *some* banks have floors written into their contracts.... which makes me think that some *don't*.

I guess it would be a good way to kickstart the economy in the event of deflation: pay people to be in debt and charge people to save their money!