Interest Rate Roundup

Tuesday, September 16, 2008

Another wild day shaping up

What more can I say? The chaos continues. AIG is the area of biggest focus in the credit market, given the gigantic size of its portfolio and the risks it is facing. From Bloomberg:

"American International Group Inc.'s ratings cut drove the cost of default protection on Wall Street banks to a record on speculation the insurer needs more cash to back $441 billion of credit derivatives.

"AIG may have to post as much as $17 billion in collateral after the company was downgraded yesterday, UBS AG analysts said. The biggest U.S. insurer by assets is seeking as much as $75 billion in loans arranged by Goldman Sachs Group Inc. and JPMorgan Chase & Co. after posting $18 billion in losses over the past three quarters, according to two people familiar with the situation.

"If AIG goes under, there could be a domino effect,'' said Andrea Cicione, a credit strategist at BNP Paribas SA in London. "AIG is very connected to the financial system and it is very connected to the real economy.''

"Credit-default swaps on the Markit CDX North America Investment Grade Index jumped 25 basis points to a record 220, according to Phoenix Partners Group prices at 7:50 a.m. in New York.

"Sellers of protection on AIG demanded a record 49 percent upfront and 5 percent a year, according to Phoenix. That's up from 33 percent yesterday and means it costs $4.9 million in advance and $500,000 a year to protect $10 million in bonds for five years.

"Credit-default swaps, contracts conceived to protect bondholders against default, pay the buyer face value in exchange for the underlying securities or the cash equivalent should a company fail to adhere to its debt agreements. A rise indicates a deterioration in the perception of credit quality; a decline signals the opposite."

Meanwhile, the U.S. Fed and other global central banks are injecting tens of billions of dollars in liquidity into their respective financial systems. Again from Bloomberg:

"The Federal Reserve added $50 billion in temporary reserves to the banking system when it arranged overnight repurchase agreements, or repos.

"The rate for overnight loans between banks had opened at 3.75 percent, above the Federal Reserve's targetrate, as American International Group Inc.'s credit rating cut increased banks' reluctance to lend. The rate dropped to the central bank's target of 2 percent after the cash injection.

"The Fed added $70 billion in reserves to the banking system yesterday, the most since the September 2001 terrorist attacks, to bring borrowing costs down after the bankruptcy of Leman Brothers Holdings Inc. triggered a hoarding of cash. Funds opened at 3.5 percent yesterday."

Speaking of the Fed, policymakers meet today. Given all the carnage out there, they could decide to cut interest rates -- in fact, a 25-basis point cut is currently all-but-priced in (in the futures market), with the possibility of a 50-point cut rising. The federal funds rate target is currently 2%, and has been there since late April.


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