In times of economic distress, investors flock to safety.  The bond market usually acts as a safe harbor for many investors but the precarious financial position of many bond insurers has many shying away from corporate and municipal debt.

Since last summer, demand for treasury securities as well as the Fed’s rate cutting campaign, has steadily driven down yields.  Demand for 1 month T-bills has been especially brisk, with a number of money market funds reluctant to invest in short term commercial paper.

Back in March, in the wake of the near collapse of Bear Sterns, the yields on 1 month T-Bills fell to 0.27%, it’s lowest in over half a century.  Yields recovered slightly in the beginning of this month but are once again below 1 percent.

With many institutional investors feeling that the stock market hasn’t hit it’s bottom yet, the short maturing T-Bill gives them a safe haven to tide their money away until they feel the time is right to jump back into stocks while sacrificing very little liquidity.  The Treasury Department has also decreased the minimum face value of it’s securities to $100, down from $1,000 as of April 7, which makes it viable purchase for a larger number of investors.

Keep in mind that this is all taking place while inflation is on the rise and that the “real” yield is actually negative.  What we have now is an upward sloping yield curve, which is a favorable situation for banks.  Banks are able to borrow short at lower rates and lend long at higher rates.  Depending on how inflation plays out, long term interest rates may even rise further in the near future.

Financial institutions are in a mad dash to raise capital in an effort to avoid the fate that befell Bear Stearns when it ran out of cash and nearly collapsed.  Many of them have had to issue new stock at bargain basement prices which has angered existing stockholders because it will dilute their earnings per share for years. 

While some of this capital is being hoarded in anticipation for more write downs from additional sub prime defaults. another area that has many of them concerned is their exposure to credit default swaps(CDS).  One of the many financial innovations that came about in the last decade, the notational value of the fast growing market is estimated at over $62 trillion.

CDS are basically insurance polices sold by financial institutions to protect purchasers of bonds against the risk of default.  Many parties use them as hedges against their positions but because the only money that changes hands initially are the premium payments, it’s also a very popular tool for speculation.  Reconciliation payments take place only when a certain credit event is triggered like a ratings downgrade or default.

CDS were very popular during a booming economy when the default risk was low because it was basically free money for  the sellers of these instruments.  Now with credit markets in shambles, CDS have become an albatross around the neck of many financial institutions.

Warren Buffet spoke out against CDS as early as 2002 saying that they were a disaster waiting to happen.  Since it was pretty much an unregulated market, much of the risk exposure to sellers of CDS was unfunded.  Some analysts believe that it would only take one large financial institution to default on a CDS to cause a catastrophic chain reaction in the entire credit market.

CDS spreads ballooned during the height of the sub prime write downs and although they have recently tightened somewhat, they are still nowhere near their normal levels.  Some believe this may be an indication that credit markets are starting to improve or that at least financial institutions are now less pessimistic than they were a couple of months ago.

Nonetheless any money that’s being hoarded isn’t being loaned out, which serves to exacerbate an already tight credit market.

Federal Reserve officials and executives for JPMorgan and Bear Stearns were called in for testimony today before the Senate Banking Committee.  Lawmakers called for the hearings because of the controversy surrounding the fire sale buyout of Bear Stearns and the use of taxpayer dollars to finance the acquisition.

A run on the investment bank crippled the cash position of the firm, leaving it unable to meet it’s margin calls.  Fed officials vigorously defended their actions, stating that their intervention prevented further damage to an already weak financial system.

The initial $2 a share buyout offer was geared towards lessening the risk exposure to taxpayer dollars although it was raised to $10 a share a week later.  It doesn’t appear as if lawmakers will attempt to block the deal, accepting the Fed’s testimony on the economic consequences if they hadn’t taken action.

The Fed is reaching their lower limit on how much they can continue to cut interest rates.  Many investors are expecting another half a percentage point cut but after that who knows.  The dollar is being hammered on currency markets causing an upward pressure on the prices of dollar denominated assets like crude oil.

The Fed has also had to open up it’s discount window to investment banks something it hasn’t done since the Great Depression.  Bear Stearns CEO, Alan Schwartz remarked that his company may has survived if the Fed had instituted that policy sooner.

If this situation has proven anything, it’s that some institutions are vital to the financial system and are too big to let fail.  With the current financial crisis far from over, the Fed may be called again to use taxpayer dollars to prevent the further deterioration of the nation’s banking system.