Personal Finance Advice

Earlier this morning Ambac Financial Group Inc., the world’s second largest bond insurer, posted a $1.66 billion loss for the first quarter as well as operating losses that were over three times worse than what many analysts expected.  This will have a negative impact on the over $500 billion worth of bonds that Ambac insures.

Credit default swap spreads surged for the embattled bond insurer as traders increased bets that Ambac won’t be able to meet it’s bond guarantees.  It also casts serious doubts as to whether the worst of the credit crisis has finally passed, which many financial experts were claiming.

While Ambac survived it’s last threat of a ratings downgrade of it’s financial strength by raising $1 billion in cash in a sale of stock, it will grow increasingly difficult for the company to raise additional capital.  Ambac is currently seeking shareholder approval to nearly double it’s shares of outstanding stock to 650 million shares up from 350 million.

A ratings downgrade would have serious repercussions in the entire bond market.  Certain institutional investors like government pension funds are required by law to hold only AAA rated securities and would be forced to sell any Ambac insured bonds at a loss.

The flood of these bonds on the market would further drive up yields as prices fell.  Financial institutions that continue to hold these bonds would also have to revalue their portfolios and realize these investment losses on their books.

It will also increase calls for a government bailout of the bond insurance industry, like the Fed did with Bear Stearns.  However, this would do little to alleviate the underlying problems in the financial sector and would only serve to shift the risk of loss from investors to taxpayers.

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.

Earlier today, Treasury Secretary Henry Paulson released his Blueprint for a Modernized Financial Regulatory Structure, a study that was commissioned back in March of 2007.  The 212 page proposal would overhaul the nation’s banking system and give the Federal Reserve broader regulatory powers.

The report acknowledges the diminished role of the Fed’s discount window lending as a “market stability” tool.  The Fed’s normal purview are commercial banks but in today’s financial markets, regular banks have a much smaller role as credit intermediaries than they used to.

In the current financial crisis, the Fed has had to step in to lend credit to financial institutions that are normally under the regulatory control of the Securities and Exchange Commission.  The proposal would legitimize the actions that the Fed has already taken and broaden it’s lending powers to non Federally Insured Depository Institutions.

The proposal also calls for a modern streamlining of regulatory powers that would eliminate the inefficient overlapping of regulatory control that we currently have.

“Due to it’s sheer dominance in the global capital markets, the U.S. financial services industry for decades has been able to manage the inefficiencies in it’s regulatory structure and still maintain it’s leadership position.”

“The United States can no longer rely on the strength of it’s historical position to retain it’s preeminence in the global markets.”

The Fed would basically become the head of this new regulatory structure and would broaden it’s market stability function in order to better cope with systemic risk.

Many of these regulatory changes will require legislative approval and because this is an election year it is unlikely that any these changes will take place under the current administration.