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Is Inflation Slowing? MoneyNews
(Headlines - scroll down for full stories)
GM is flirting with the possibility of the biggest corporate default in history, and investors are now waiting to see exactly how serious problems with the burgeoning credit derivatives market will impact the automaker's future. Derivatives are a contract between two parties that allows for the use of a derivative instrument to transfer credit risk from one party to another. The party transferring risk away has to pay a fee to the party that will take the risk.
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The 10 largest banks in the U.S. hold a combined $600 million worth of credit derivatives, while the overall market for these investment vehicles is worth an estimated $12.4 trillion. But "the possible bankruptcy of General Motors Corp. has exposed flaws in trading of so-called credit default swaps because the number of contracts has outstripped the bonds they insure," according to Bloomberg News. "The Federal Reserve Bank of New York last year warned deficiencies in credit-derivatives trading could threaten the stability of financial markets in the event of a major default." The trade association for the derivatives market convened this week in Singapore to iron out problems, implementing "computerizing recordkeeping and permitting contracts to be settled with cash instead of bonds," says Bloomberg. But experts say it is amazing that this trillion-dollar market has been run with such a lacking management system and that the problem is only now being addressing. "If there was a major credit event, or a series of credit events, it could really cost them," Tanya Azarchs, managing director of financial institution ratings at New York-based Standard & Poor's, tells the news service. "It's considered dubious risk management to build a market without setting up an infrastructure to cope with the volumes traded." The overall derivatives market is valued at a whopping $270 trillion. Credit-default swaps, the dominant part of that market, were implemented to "protect creditors against non-payment of debts and some investors now use them to bet on a company's credit quality. Contract buyers pay an annual fee and receive the full amount insured if a borrower defaults." But the market is largely unregulated. Contracts are traded over the counter and investors are not required to disclose their holdings. "With more credit derivatives being traded than bonds available, a default by GM could spark panic buying of the company's bonds, driving up prices. The contracts would be worthless if prices rose to 100 cents on the dollar because investors would have to pay the same amount for the bonds as they received in payouts," says Bloomberg. In the past two years the market for credit derivatives has grown to five times its original size, as investors use these vehicles as a cheaper method of betting on credit quality - better than bonds, which are relatively illiquid. Tim Frost is a pioneer of credit derivatives at JPMorgan who now helps run Cairn Capital Ltd., a London hedge fund that specializes in debt. He tells Bloomberg that "Credit derivatives raised returns on capital and gave the credit market the opportunity to develop beyond the buy and hold culture." But experts are now extremely concerned that an inundation of credit derivatives could skew bond prices, directly affecting investors. That is a very possible outcome, should GM go under. In an attempt to avoid such a fate, now the car giant is said to be mulling a $12.5 to $13 billion offer for the majority stake in GMAC, the company's financing arm, according to The Wall Street Journal. But the paper reports that GM is less than happy with some details of the sale and may opt to hold on to the auto-financing operation and instead sell off GMAC's home mortgage and insurance units. Says the Journal: "The automaker wants to sell a stake in GMAC in part to improve the finance division's ability to borrow money by separating its debt rating from the non-investment, or junk, rating that has been assigned to parent GM. Some major investors are prohibited from buying securities that carry a high-risk rating." Editor's Note:
2. Is Inflation Slowing? The Labor Department reported today that the Consumer Price Index, a measure of inflation, slowed sharply in February to 0.1% from 0.7% in January. And core prices, which exclude food and energy prices, also rose 0.1%. For the year, consumer prices have risen 3.6% - a drop from the 4.7% pace posted last month, while core prices are up 2.1%. The government cited falling energy prices and a moderate elevation in food and housing prices as the reason for the ease in inflation pressures. The tame inflation data is triggering speculation that the Fed will stop raising interest rates soon. The Fed is largely expected to raise its Fed Funds rate a quarter-point to 4.75% at its March meeting and again at its May meeting to 5%. Still, the government's CPI data are constantly questioned by economists who claim that the government's numbers don't tell the true story of rising prices. For example, the CPI data tracks rental prices on apartments rather than purchase prices for homes in calculating its cost of housing. Over the past housing boom, that number has been severely understated, say economists. Also, the government treats technological improvements as falling prices. For example, a computer that costs $1,500 today is considered less expensive than a computer that cost $1,500 in 2002, because today's computer carries more bells and whistles. "As seen in both Democratic and Republican administrations there has been a concerted effort to lower the reported level of the CPI. Given the original intent of the CPI - which was to measure a fixed basket of goods - this is nearly criminal," John Williams, author of a newsletter called Behind The Government's Numbers, tells the New York Post. The government's CPI numbers are the basis for Social Security cost-of-living adjustments. A low CPI means that Social Security checks will be little changed.
Editor's Note:
3. Fed Reports 'Steady' Economy The Federal Reserve's beige book is out - and it contains data showing that the U.S. economy continues to be on the upswing and that employment is robust. According to the Fed, just about every sector shows employment growth increasing, with many industries reporting a paucity of skilled workers to fill their needs. Industries that are particularly vulnerable are finance, construction and manufacturing. "Most districts characterized the pace of expansion as moderate or steady," the central bank said in its "beige book" summary of economic conditions. The Fed is also reporting that business input costs - defined as the costs of employees and goods and services needed to run companies - are rising as well. Companies are especially concerned with the skyrocketing costs of utilities and energy supplies needed to keep their businesses moving, the Fed says. Economic observers use the beige book as a barometer to determine whether or not the Fed will raise interest rates. Signs of wage and price growth signal an expanding economy, they say. And this time the news is good. "Markets reacted positively to the beige book news Wednesday, surging after its release as language in the report hinted that the Fed may not continue raising rates as long as analysts had expected," says Reuters. The Fed's Open Market Committee is set to meet on March 27 to decide whether to bump up rates to 4.75%. So far, the conventional wisdom says it will, but the beige-book data will make a case for leaving the status quo in place for another few months. The Fed also reported that consumer spending remains strong, with retail levels hitting the marks that the Fed has set. "Many observers are watching closely to see if consumer appetites slacken as higher interest rates shut down mortgage refinancing activity that has fueled spending," reports Reuters. Editor's Note:
4. Economist: Banks Facing Tough Times According to The Economist, life has been a bowl of cherries for U.S. banks over the past few years, with money pouring into bank coffers from mortgage loans, retirement-account savings and other financial products. And the numbers back that story up. According to the Federal Deposit Insurance Corporation (FDIC), American banks earned $135 billion in profits in 2005 - the fifth consecutive year of record earnings. That's some performance, the Economist notes, especially since the Federal Reserve has raised interest rates 14 times since mid-2004.
"But there are signs that the best days are gone," says The Economist. "Despite the profits, last year also saw banks' return on equity drop to 12.5% from a peak of 15% in 2003, according to FDIC figures. Are rising interest rates finally taking a toll?" The Economist answers its own question, noting that higher rates are keeping customers away and that this is obviously problematic. "Banks make money by taking short-term deposits and lending them for longer periods, and at higher rates, to companies, governments and households," the publication explains. "In recent years, the yield curve (the difference between short- and long-term interest rates) has been steep - and the lending business an easy one." But with a flattened - even inverted - yield curve, banks have seen profits squeezed from their lending programs. The FDIC reports that larger banks have taken it on the chin, with net interest margin squeezed from 4.06% in the first quarter of 2002 to 3.48% in the second quarter of 2005. The Economist cites Commerce Bancorp, a "recent high-flyer that saw its net interest margin fall to 3.77% last year from 4.28% in 2004, owing to what Vernon Hill, its chairman, called 'the worst interest-rate environment in recent years.' " With lending programs on the skids, banks face a fearsome profits predicament. Morningstar estimates that some banks - particularly smaller ones - make over 90% of their revenues from interest on loans. Even larger banks, like JPMorgan Chase, owe two-thirds of their revenues to interest payments. Slackening interest revenues also create something of a domino effect for banks, with lower interest payments leading to a housing slowdown, which would trigger a slump in the construction industry, which is a big borrower of bank funds. "According to the FDIC, in the last quarter of 2005 such lending was 33.2% higher than a year earlier, the fastest increase since 1986. Most of these loans have been for residential projects but, as Richard Brown, chief economist at the FDIC, notes: 'The best days are past for anything related to real estate, at least in this cycle.' " Banks are also suffering at the deposit box. After years of sustained growth in that area, banks have seen deposits largely dry up. The Economist points to an analysis of monthly deposit-growth rates at large commercial banks by Fox-Pitt, Kelton, an investment bank. "The data shows a slowing that started in August 2003 and became more marked in 2004 and 2005. Competition for deposits 'has intensified,' says Jon Balkind, a Fox-Pitt analyst, since the Fed started raising rates." But a bigger concern could be a decline in credit quality. "The FDIC puts the share of non-current loans (those at least 90 days late) in total debts outstanding at 0.74% in the third and fourth quarters of 2005, just above the second quarter's record low," says The Economist. "By way of comparison, in 1990 the rate was 3.5%." In short, it's a hellish environment that banks are facing. While The Economist doesn't point to any way out for bankers, it does say that banks have to do a better job of managing risk and hope for some good fortune from the U.S. housing industry, which just can't afford to buckle anymore than it has.
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