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Sunday, April 27, 2008 2:01 PM


Are Low Interest Rates Fueling Price Inflation?


Citigroup, Merrill Lynch, and Bank of America kicked off a Record Week of Bond Offerings.

Citigroup Inc. and Merrill Lynch & Co. led $45.3 billion of U.S. corporate bond offerings, the busiest week on record, as financial companies sold debt at the highest yields since April 2001.

Citigroup, the biggest U.S. bank by assets, sold $6 billion of hybrid bonds in the company's largest public debt offering, while New York-based securities firm Merrill Lynch raised $9.55 billion by issuing debt and preferred securities.

"Investors are feeling better about banks being proactive about raising capital,"said Mike Difley, who helps oversee $21 billion in fixed-income assets as a portfolio manager at American Century Investment Management in Kansas City. "They're trying to get their house in order."
My Comment: Banks and brokers may be trying to get their houses in order, but the emphasis should be on trying. They are not succeeding. A wave of commercial real estate defaults is coming (see Shopping Center Economic Model Is History). And on top of that wave will be a wave of credit card defaults. Target wrote off a stunning 8.1% of credit card debt in March (see Card Losses Soar at Target, Bank of America). Furthermore the walk-away crisis is just picking up steam. This is more like the eye of the hurricane than anything else.
Citigroup sold perpetual preferred shares after posting almost $16 billion in writedowns, increasing the New York-based bank's total capital raising since November to $37.2 billion, Bloomberg data show. The sale helps compensate for more than $40 billion of credit losses and writedowns since last year.

The perpetual hybrid bonds pay interest of 8.4 percent for 10 years. After that, if not called, the interest rate will begin to float at 4.03 percentage points more than the London interbank offered rate, or Libor, which is currently set at 2.91 percent.

Merrill Lynch, after writing down the value of $6.5 billion of assets, sold $7 billion of senior unsecured notes in its biggest debt offering, attracting investors with spreads as much as triple what it paid a year ago. Merrill Lynch, the third- biggest U.S. securities firm, also issued $2.55 billion of perpetual preferred shares that yield 8.625 percent, its largest sale of the securities.

Bank of America Corp., the second-biggest U.S. bank by assets, sold $4 billion of perpetual hybrid bonds that pay 8.125 percent until 2018, and French investment bank Natixis SA raised $750 million in an offering of perpetual subordinated securities yielding 10 percent.
My Comment: The idea that the credit crunch is over is pure fallacy. The Fed Funds Rate is 2.25%, LIBOR is 2.91% and Citigroup is raising money at 8.4%, Merrill Lynch is raising money at 8.625%, and Bank of America is raising money at 8.125%.
Merrill Lynch may now lose its A1 ranking at Moody's Investors Service because the credit rating service won't count the proceeds of the preferred sale as equity, Sanford C. Bernstein & Co. analyst Brad Hintz said today in a note to clients. Credit-rating companies typically don't allow more than 25 percent of a bank's capital base to be made up of preferred stock, a limit Merrill is "well over," he said.
My Comment: Judging reality by what credit rating agencies do or say is certainly fraught with error (see Nothing Left To Lose At Ambac), but it does look like Merrill Lynch has run out of free lunches by issuing preferred sales that count as equity.
The financial companies are "coming out with some pretty yieldy paper," Moini said. "That's why all these massive deals are getting done. And people still have a lot of cash."
My Comment: That cash is being burnt up like mad as is the destruction of capital that is fueling the issuance of preferreds. Those thinking "the bottom is in" and buying now are going to regret it later.
Four high-yield, high-risk companies sold $2.85 million of debt this week, the most since the week ended Nov. 30, according to Bloomberg data. FireKeepers Casino, owned by the Nottawaseppi Huron Band of Potawatomi, sold $340 million of seven-year senior secured notes at a yield of 13.875 percent, and Russian mobile phone company OAO VimpelCom raised $2 billion in the country's biggest sale of dollar-denominated debt.
My Comment: 13.875% sounds like a lot. But it's only a good deal if it doesn't default. And if I was trading fixed income I would not touch it.

Interest Rates Only Appear Low

Minyan Peter, an ex-treasurer for a major U.S. Bank, wrote last week:

"It would appear that interest rates are low, the reality is that for most borrowers the rates they are paying aren't - particularly in the financial services sector.

At least so far, it looks like less than 15% of the rate reductions are passing through the end user - whether that is in mortgages, credit cards or other consumer lending areas. And if you look at the spreads brokerages and banks are paying for money, their costs have clearly risen.
"

To that I will add that Jumbo Mortgages are going 2-3 points higher than conforming mortgages with puts jumbos at 7-8%, and even higher still in Fannie Mae and Freddie Mac distressed areas. And those mortgages now require substantial down payments that were not required before.

If one looks at what banks and brokerages have to pay for debt, what spreads junk bonds are yielding, and what jumbo mortgages are costing, the widely held idea that "Interest rates are low" is easily debunked.

Except for the paltry yields one receives on treasuries, savings accounts, and CDs, real interest rates are actually high as those who need to raise cash, finance an LBO, buy commercial real estate, or refinance a jumbo mortgage are finding out. And another thing stands out as well: It makes no economic sense for Citigroup to keep going back to the well raising money at 8.4% while paying dividends at a forward annual rate of 5%.

Fed Uncertainty Principle

This post is not an attempt to justify the current Fed Fund's Rate. To make that clear, I will repeat what I said in Fed Uncertainty Principle:
The Fed, in conjunction with all the players watching the Fed, distorts the economic picture. In a free market it would be highly unlikely to get a yield curve that is as steep as the one in 2003 or as steep as it was just weeks ago when short term treasuries traded down to .21%.

I don't know, you don't know, and the Fed does not know what to do. This is part of the "Fed Uncertainty Principle" and a key reason why the Fed should be abolished. After all, how can you give such power to a group of fools that have clearly proven they have no idea what they are doing?
Key Rate Is Not The Fed Fund Rate

The easily seen and often quoted interest rate is the Fed Fund Rate. However, the Fed Funds Rate is not a valid perspective from which to state "low interest rates are fueling price inflation".

On the other hand, if one wants to state that past interest rate actions by the Fed and past monetary printing by the Fed are still causing current economic distortions, I can embrace that. The Fed, by its very nature, causes economic distortions including price inflation.

But the key rates now are the rates it takes to get a deal done. And those rates have been climbing since last Summer. Clearly it's harder and harder to get a deal done. Credit has dramatically tightened. There are no more liar loans, covenant lite agreements, huge commercial real estate deals, etc.

Nonetheless, the market has been cheering lately simply because deals are getting done, even thought the cost (excluding the last week or so) has been rising. But don't be fooled, there is no bottom in sight. As professor Bennet Sedacca suggests, the bottom will come when the deals can't get done. That could be quite a long ways off. Economic Winter is setting in.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
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