Federal Reserve & Interest Rates

Investors are demanding an increasingly higher premium over Treasury yields as spreads on investment grade bonds have widened recently.  If spreads stay this wide, it will be more expensive for many corporate and government entities to raise capital through bond issues.

The gap climbed 3 basis points to a record 311 basis points today, according to Merrill Lynch & Co.’s U.S. Corporate Master index. It was the third time the spread reached a new high this week, surpassing the gap of 305 basis points set March 20, just after the government brokered a takeover of Bear Stearns Cos.

During the current credit crisis financial firms have scrambled to raise hundreds of billions of dollars in capital to cope with the half a trillion in writedowns they’ve taken since last fall.  The continuing weakness in credit and housing markets have many investors predicting that the Fed will keep interest rates at 2% at least until the end of the year.

You have some analysts saying the housing slump could continue well into 2010 if not longer.  Home prices are expected to fall another 15%-20% before it’s all said and done.

Right now the problems in both sectors are feeding off each other.  Defaults and foreclosures are causing more writedowns, while weak credit conditions have caused mortgage rates to rise and is making it difficult for prospective home buyers to enter the market.

Just last week American Express issued 5-year notes at close to junk bond levels despite it’s relatively high credit rating.  You’re seeing spreads rise this high because realistically no one know how close we are to the actual bottom.

The settlement brokered by New York Attorney General Andrew Cuomo with investment banks to buyback billions in auction rate securities will only help a fraction of the investors that bought into the trouble market.

The deals so far announced total about $56 billion of the auction-rate securities market — but there are $210 billion of such securities unredeemed, according to research firm Restricted Stock Partners.

Basically unless you were a client of one the brokers running the auctions you could be out of luck.  Investors that bought from discount brokerages could be stuck holding the bag, since their brokers had no knowledge of the breakdown in the auction rate market and for the most part have not been considered liable.

The investment banks that underwrite the actual auctions are only agreeing to take care of their own clients and even then there are still some gray areas.  Short of legal action it will be unlikely the majority of investors will see any of their money anytime soon.

With investment banks desperate for capital they will probably fight tooth and nail to buyback as little as possible.  However, these investments aren’t really in danger of failing, as much of it is made up of relatively safe municipal bonds.

The sticking point and the crux of the government’s argument with investment banks is that auction rate securities are in actuality long term investments but they were marketed as “like cash”.  Interest rates reset on the securities usually every 7 or 28 days so that investors were able to quickly get into and out of the market until auctions started to fail back in February.

Earlier today, securities firm Lehman Brothers posted a $2.8 billion loss for the second quarter, much larger than analysts were forecasting.  The company also announced plans to raise $6 billion in new capital from the sale of stock to cope with their exposure to the residential mortgage market.

Despite their plans to raise additional capital,  Fitch downgraded them to AA- from A+ while Moody’s changed their credit outlook to negative and is considering doing the same for the other investment banks as more writedowns are expected for the sector.  Trouble with the bond insurers isn’t helping matters as a ratings downgrades for their insured bonds will lead to additional writedowns for the companies that hold them.

The financial sector is continuing efforts to de-leverage themselves but are forced to sell highly illiquid assets in an increasingly depressed marketplace.  Foreclosures and delinquencies have also continued to climb as the housing market worsens.

There are serious doubts in the minds of investors for when the sector will return to profitability.  With the securitization market all but dead, the once highly profitable originate to distribute model for mortgages has ceased to be viable.

Financial stocks have fallen recently with the Fed starting to place more emphasis on inflation and sending signals to the market of a future rate hike.  European central banks are also considering raising rates which would further depress the dollar if the Fed doesn’t do the same.