To no one's surprise, the FOMC left the Fed Funds rate unchanged. After all, the Fed Funds target rate is essentially zero (in a range between 0.00% and 0.25%). However, its statement indicates more economic trouble may lie ahead. In it's previous statement, the FOMC described credit as being tight. Today it described credit as being "extremely tight". This is not what was hoped four months into the TARP rescue plan.
The FOMC stated that the Fed will continue to buy MBS and agency debt and is "prepared to by longer-term Treasury securities" if such action is warranted. If the Fed does in fact begin buying long-term treasuries, that could help to keep long-term rates in check. However, at some point, possible a year or two from now, the supply of new bonds and renewed investor appetite for higher returns and stronger currencies are likely to push long-term treasury yields higher. This could also push commodities prices higher.
Will credit yields follow long-term treasury yields higher? Possibly, but there could be a crowding out effect. If investors believe they are being adequately compensated (I.E. the are happy) with higher yields on U.S. treasuries, corporations could be crowded out of the debt market. They would either have to raise their yields high enough to attract investors or find other means of funding. With credit spreads among some names and sectors at or near historical wides. some spread tightening is possible, even probable, but it may not entirely offset the rise of interest rates. I am one who believes that investors should underweight the long end of both the yield curve and credit curve at this time.
Bank stocks and bonds received a boost today after the government moved close to creating a so-called "bad bank" to take troubled assets off of bank balanced sheets. It is interesting how the equity markets become giddy without considering how bad assets would leave bank balance sheets.
Just because banks will be able to rid their balance sheets of bad assets does not mean they will not take more losses. It is unlikely (and foolish) for the government to purchase bad assets at inflated levels. That would guarantee losses for taxpayers (the RTC of the early 90s was a money loser). What it would do is eliminate further downside risk for the banks down the road. However, as some banks have not marked down assets to levels at which they can be sold, even to the government. Some banks have placed assets in the so-called Level III Asset bucket. This bucket is for assets which cannot be marked accurately (according to the owning bank) and have not been marked. Although the bad bank would increase transparency, troubled prophecies could be fulfilled as troubled banks will merely realize losses and end up being seized, nationalized or broken up. Remember, even the RTC permitted troubled S&Ls to fail. Positives came from the RTC's ability to calm fears that healthy banks may be holding on to troubled loans. The weaker banks may not come out of this unscathed.
I have previously mentioned that depressed prices of troubled assets is not just a mark-to-market phenomenon. As homes are foreclosed upon and auctioned off, these previously unrealized losses become realized. There was an article today on Bloomberg which discussed foreclosed properties selling for about 50 cents on the dollar at auction. Of course a spokesman for a consumer advocacy group derided these actions for lowering home values and making things more difficult for homeowners looking to refinance. It is high time that the public, advocates and government officials learn that a commodity or asset is only worth what someone is willing to pay for it. It is quite possible that one's $350,000 home is only worth $175,000.
The purpose of this piece is not to cast a pall over government efforts. I actually believe that a bad bank, RTC-like arrangement will keep most financial institutions intact and prevent nationalization of the banks. I do not believe that it will make all banks instantly healthy. There are some institutions which are sufficiently troubled that they may need more drastic intervention.
This brings us back preferreds (again). I do not believe that preferred dividends will be suspended,even preferred equity dividends of large, but troubled banks. However, it is not an impossibility. Why reach for 17% yield which could be wiped out by the government (for political as well as economic reasons), when one can earn 12% to 14% and be ahead of the government? What about non-cumulative preferreds trading at over 20%? These must be considered speculative investments at this time.
Those looking for a good explanation of trust preferreds should go here:
http://www.leggmason.com/privateclient/pdf/frcs.pdf
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