Federal Reserve & Interest Rates

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.

The three major investment banks were all downgraded today by Standard & Poor’s and remain with a negative credit outlook as more write downs are expected.  Some experts are predicting over a $1 trillion in write downs for credit markets before it’s all said and done.

Today’s news has probably put an end to the speculation that the Fed will raise interest rates before the fall to combat high energy prices.  The Fed is quickly entering into a no win situation as fears of stagflation begin to take hold of the economy.

When a central bank has an uncomplicated recession to deal with, it can cut interest rates. When it faces a clear-cut case of inflation, it can raise them. The worst nightmare of any central banker – especially one with a tradition of political independence to defend – is stagflation, when raising interest rates to curb inflation will provoke a recession or deepen one that has already begun…

The economy sags under the combined weight of house price falls, consumer confidence at a 25-year low, the credit crunch and a still widening financial sector squeeze. Nonetheless, soaring prices for oil and other commodities, not to mention the higher cost of imports thanks to a devalued dollar, are pushing up inflation and (especially) expectations of inflation.

With the housing slump far from over it is a real possibility that the credit crisis could last well into next year.  As long as home prices keep falling, all mortgage related assets will be at risk from defaults and foreclosures despite the Fed’s attempts to prop up the banking system.

Treasury yields fell to their lowest level since March when investors were coping with the Bear Stearns collapse.  As investors shed risk and take shelter in Treasuries, the flight to quality is also mirrored in the general banking system.

Right now financial institutions don’t trust anyone except the Fed.  They definitely don’t want to lend to each other and only to individuals with the highest credit ratings and because of this mortgage rates are creeping up again.  With the mortgage market in disarray, any possibility of a housing recovery seems farfetched at the moment.

While financial executives put a positive spin a month ago that the financial crisis was getting better due to the actions taken by the Fed, the fact remains that there is still no end in sight to the credit crunch gripping the U.S. banking system.  If the housing market doesn’t start to improve soon, the economy could be gripped in stagnant growth for years.

As long as home prices remain deflated, banks will be at risk from defaults and foreclosures.  This article in MarketWatch explains how the Federal Depository Insurance Corporation(FDIC) is preparing for a surge in bank failures in the next couple of years.

While loan growth soared in 2004 and 2005, most regulators failed to scrutinize many banks or restrain this heady expansion of credit. Now that the loans have been made and delinquencies are climbing, some banks may already be doomed.

At least 150 banks will fail in the U.S. during the next two to three years, according to a projection by Gerard Cassidy and his colleagues at RBC Capital Markets.

That’s a staggering number of lending institutions and brings back the bitter memories of the Savings & Loan era.  All these banks that mismanaged their risk perhaps deserve to fail but the economic fallout could be considerable.

I don’t see the Fed being able to do for all these prospective bank failures what they were able to do for Bear Stearns.  The most likely occurrence is that taxpayers will once again take it on the chin like they did for the S&L debacle.