Personal Finance Advice

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.

While municipal bonds are becoming an increasingly attractive investment, that’s not really good news for the municipalities themselves.  Their history of low default rates, much lower than even AAA rated corporate bonds, have not stopped municipal bond yields from soaring, causing many communities to pay millions more in increased borrowing costs.

These increased borrowing costs are causing many state treasurers to bring into question the ratings system which has them paying more than their corporate counterparts.  The fact of the matter is though that a government entity is more prone to operate in debt than a corporate entity and thus usually has a lower credit rating.  This also means though that any community that is currently running a budget deficit is going to find it increasingly expensive to finance that debt.

The current credit crunch and the troubles of the bond insurance industry have played havoc with their efforts to borrow money and refinance debt.  Even big time players in the market like the State of California and the New York Port Authority have had their bond auctions fail due to a lack of bidders.  The NYPA has had to raise toll and fare rates to compensate in order to fund their building projects.

The renewed fear of inflation has also helped to drive up interest rates in recent weeks.  It may even be the inflation scare that’s most to blame for driving away bidders as investors are starting to flock to inflation hedges such as commodities.  Coupled with the fact that the dollar is trading at record lows, it is becoming increasingly obvious that no one wants to be tied to fixed rate securities denominated in dollars no matter how attractive the yield.

Wall Street enjoyed a nice four day winning streak before renewed stagflation fears sent investors scurrying.  Economic reports that were released showed that growth had stalled along with increasing signs that unemployment may be on the rise.

All eyes have to turned this week to Fed Chairman Ben S. Bernanke as he speaks to congressional hearings on the state of the economy.  He said while he doesn’t expect a return 70’s style “stagflation”, he does concede that with the continuing housing slump, some smaller banks could begin to fail.  Some analysts expect conditions in the credit markets to worsen further in the short term as lending institutions continue to write down losses.

With the dollar hitting record lows the price of energy and commodities continued to rise with oil and gold trading at record highs.  Overall consumer spending rose in the month of January but much of that can be attributable to the higher prices.  On a positive note, the weak dollar has spurred a growth in U.S. exports with the nation’s trade deficit shrinking for the first time since 2001.

Even with the specter of rising inflation and a falling dollar, many believe that the Fed will cut rates once again after it’s next scheduled meeting on March 18.  Financial markets have already priced in a half percentage point cut in futures trading.

Unless other central banks follow suit and lower their rates you can expect more downward pressure on the dollar and a rise in prices for dollar denominated commodities.