Personal Finance Advice

CNBC reported earlier today that a bailout plan to rescue trouble bond insurer Ambac would be announced sometime early next week.  The news sparked a late rally on Wall Street even as investors cope with increasing signs of an economic slowdown.

Yesterday’s news that manufacturing activity was slowing as well as a bleak forecast on future economic growth had stocks trading down sharply until the CNBC report surfaced late in the afternoon.

There is a lot at stake for the financial sector in keeping Ambac and it’s rivals at their AAA rating level.  With the industry insuring over $2.4 Trillion in bonds that are in danger of being devalued, the ramifications of a ratings downgrade are incalculable. 

Already new bond issuance has slowed to a trickle and bonds that are being sold are doing so at sharply increased costs.  Municipalities are having an especially rough time of it, with many of them delaying their scheduled public works projects.

The biggest fear for investors is that a bond devaluation would lead to a new wave of write downs for an already beleaguered banking system.  Some analysts are estimating that bank write downs could go as high as $100 Billion.  It would pretty much signal a deathblow to any chance of our economy staying out of a recession.

Even with this bit of good news most analysts are remaining cautious.  The bond insurance industry still has a lot of exposure to sub prime debt that isn’t going to go away overnight.

As it has become increasingly difficult to find investments with positive gains, municipal bonds have begun to surge to the forefront. The yields on muni’s have become comparatively attractive in recent months due to a number of factors.

Although a shaky stock market tends to have investors fleeing into the warm embrace of the bond market, things are a little different this time around. The bond market is having it’s own little crisis at the moment.

Bond insurers are reeling from the fallout of the sub prime mortgage collapse with many firms in that industry having lost or are in danger of losing their AAA ratings. This has in turn added an aspect of volatility to a normally placid market.

This added uncertainty along with renewed fears of inflation, due to the Fed’s recent aggressive moves, have sent bond prices falling recently and yields up. These higher yields coupled with their tax free status have led many financial analysts to extol their virtues.

If anything, the recent troubles in the bond market have made muni’s even more attractive. While the short term risk has grown considerably, the long term risks are negligible.

This is due to the fact that historically, muni’s have a miniscule default rate, less than 0.01%. Even non AAA rated muni bonds have a lower default rate than their AAA rated coporate counterparts. As a long term investment, it’s one of the safest bets around.

The stock market made big gains last week on the strength of the recent rate cuts, only to give them back at the start of this week as more bad news on the economic front was released.  A major contraction  in the massive U.S. service sector led to a large sell off on Wall Street.

While The Fed had been much more aggressive in it’s monetary policy recently, inflation is still a major concern.  Philadelphia Fed President Charles Plosser earlier today stressed the hazards of rate cutting.

“Ignoring inflation during times of economic weakness risks undermining our ability to achieve economic growth over the long run.”

“It [monetary policy] cannot solve the bad debt problems in the mortgage market. It cannot reprice the risks of securities backed by subprime loans. It cannot solve the problems faced by those financial firms at risk of being given lower ratings by rating agencies, because some of their assets are now worth much less than previously thought.”

While the economy has been slowing recently, inflation numbers have been higher than expected and economists will be keeping on close watch on the January data.  On a positive note, while the price of oil broke the $100 barrier for the first time last month, it has been trading at under $90 recently.

Nonetheless despite the renewed inflationary concerns, many analysts believe the Fed will cut rates once more in the upcoming weeks.  They point to the fact that there has been little or no signs of wage inflation since the rate cutting campaign began last fall.