Federal Reserve & Interest Rates

Commodity prices, especially oil took a nose dive over the summer as sagging world wide demand finally took it’s toll on a speculative bubble which had built up since the fall of 2007.  After falling to the mid-thirties, the price of oil is starting to slowly creep back up.

As everyone knows, the U.S. is building up an extraordinarily large amount of debt during the current financial crisis.  To finance that debt, they will have to sell an unprecedented amount of Treasury securities.

Treasuries have been a safe haven for wary investors the past few months but the amount of Treasuries about to enter the market has many people worried.  All the money the government is spending can’t help but add inflationary pressure to a commodity market that took a beating in the last six months.

Sometime in the next few months, I wouldn’t be surprised if commodities started making a comeback.  Despite the recession gripping the world, commodities could become a safe have again if inflationary pressure builds too much.

Now this doesn’t mean the Fed will raise interest rates anytime soon but they are definitely keeping an eye on commodity prices.  As long as prices stay fairly low, they can continue to inject liquidity into the financial system through their balance sheet operations.

The key is timing, when the economy starts to improve, the Fed will have to tighten it’s monetary policy fairly quickly, otherwise commodity prices could quickly get out of control again like it did last year.

As President Obama takes office, all of Wall Street will be watching to see if his new proposed stimulus package will be enough to turn around a floundering economy.  Estimated at somewhere around $850 billion, together with the second half of the bank rescue funds of TARP, they will try to stabilize a financial system that has been frozen since the fall. 

Lending has ground to a halt as many financial institutions try to shore up capital because their balance sheets are filled with hard to value assets with the breakdown of securitization markets.  As financial institutions continue to de-leverage themselves, the existing credit pool will continue to shrink.

The flow of credit needs to be re-established and a portion of the TARP funds is planned to be used to forestall rising foreclosures.  The recovery of the housing market will be an essential first step for any turn around of the economy.

Consumer spending has taken a big hit as Americans’ confidence in the economy continues to wane.  Once funds from the stimulus package reach the general public, spending should be propped up for a few months as was the case with the previous stimulus package. 

Unemployment figures are also quickly becoming a major concern with the economy losing jobs for the twelfth straight month.  Those figures would have skyrocketed were it not for the government rescue of the auto industry in December.

We haven’t seen this kind of government involvement in the economy since the Great Depression and despite the increasing similarities to a state run economy, there is widespread public support for the government’s actions.  Many Americans have lost trust in the system and it will be up to the government to regain that trust.

The price tag for the government keeps going up, this time it’s coming to the rescue of Bank of America, currently the largest U.S. bank by assets.  In order to salvage the Merril Lynch takeover, Bank of America is set to receive $138 billion in government support.

Treasury and the Federal Deposit Insurance Corporation will provide protection against the possibility of unusually large losses on an asset pool of approximately $118 billion of loans, securities backed by residential and commercial real estate loans, and other such assets, all of which have been marked to current market value. The large majority of these assets were assumed by Bank of America as a result of its acquisition of Merrill Lynch. 

The assets will remain on Bank of America’s balance sheet. As a fee for this arrangement, Bank of America will issue preferred shares to the Treasury and FDIC. In addition and if necessary, the Federal Reserve stands ready to backstop residual risk in the asset pool through a non-recourse loan.

In addition, Treasury will invest $20 billion in Bank of America from the Troubled Asset Relief Program in exchange for preferred stock with an 8 percent dividend to the Treasury. Bank of America will comply with enhanced executive compensation restrictions and implement a mortgage loan modification program.

Bank of America was stung by higher than expected losses at Merril Lynch this quarter, estimated at over $15.3 billion and it’s stock has plunged ever since the merger was announced.  Coupled with the Countrywide takeover earlier in the year, investors have shown their disapproval with Bank of America acquiring the two losing companies.

Confronted with the realization that Bank of America was about to walk away from the Merril takeover, the government moved to support the bank in order to prevent another Lehman Brothers situation.  In order to protect financial market stability the government moved to guarantee losses on a pool of toxic assets like it did with Citigroup earlier in the year. 

2008 will be known as the year investment banking died, where all the major players collapsed, were taken over or converted to commercial banking institutions.  Investment banking couldn’t survive the current credit climate, known for it’s highly leveraged profits during good economic times, they reported staggering losses this year as capital sources dried up.

The government has been hard pressed in trying to restore confidence to a financial market that is seemingly in a free fall but as long as the housing market keeps falling, asset write downs and losses will continue to accumulate and with it the government’s bill.