Federal Reserve & Interest Rates

The Federal Deposit Insurance Corp. stated that it’s list of troubled banks grew by 30% to 117 in the second quarter.

Regulators are adding to the list as bank assets, liquidity and other fiscal measures weaken. Nine banks have failed this year, including California-based mortgage lender IndyMac Bancorp Inc., which the FDIC is running as a successor institution, IndyMac Federal Bank FSB.

It’s a difficult time for the banking sector, lower earnings and difficulties in raising capital are the primary concerns.  The disintegration of the mortgage securitization market has  put a major crimp in the originate to distribute business model.

Troubled banks are having to offer high interest rates on certificates of deposit(CD) in order to attract new capital.  Just a few months before the FDIC took control of IndyMac, it had one of the highest CD rates in the country.

Many experts feel the banking sector needs to consolidate but with the investment firms having their own problems it will probably continue to be slow on the merger’s and acquisitions front.  One thing currently in their favor is that the yield curve is relatively steep at the moment but in order to take advantage of that they need to start lending.

The Fed has tried it’s best to inject liquidity into the system but banks haven’t followed through.  Like other firms in the financial services sector they have been forced to hoard capital in order to deal with writedowns while at the same time attempt to de-leverage their balance sheets.

They do have a little more time to get their houses in order.  With the commodities market retreating and inflationary pressures losing some of it’s steam, it’s unlikely that the Fed will raise rates until sometime next year.

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.

Yields on Treasury Securities with maturities of between one and five years have climbed at least half a percent since the start of the month as investors have begun fleeing the safety of government fixed income securities despite the fact the economy continues to worsen.  Investor flocked to Treasuries in earnest back in March in the wake of the Bear Stearns collapse but now inflation concerns have overridden fears about a recession.

It seems that Wall Street isn’t buying into the Fed’s reassurances that it is committed to combating rising inflation expectations and right now they have about as much creditability as the administration does in it’s commitment to the “strong” dollar policy.  The steepening yield curve is actually beneficial to the struggling financial services sector at the moment as it borrows short and lends long.

American consumers are also starting to feel the brunt as high energy prices are beginning to bleed into the general economy with core inflation starting to creep up the last couple of months.  The weak dollar as also had a significant effect as America’s insatiable appetite for imports has also become more expensive.

With the Fed looking to delay raising rates for as long as possible with the housing and financial markets still a major concern, inflation will most likely continue to grow for some time due to the lag effects of Fed policy actions.  It is unlikely they will take any action next week at their regularly scheduled meeting and most analysts aren’t expecting any kind of change at least until September.

Oil exporting countries have resisted calls to increase production, calling current prices unjustified based on supply and demand dynamics.  As investors have continued to flock to the commodities market as an inflation hedge, prices have risen in an ever growing bubble that many are calling for the Fed to burst in order to give some sort of relief from soaring energy prices.