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Hard Money, Rising Rates, Lower Profits

In uncertain times where even the Fed is taking unprecedented steps in efforts to jump-start the economy, finance executives need help. In this and two following stories, economists weigh in on credit risk, global inflation and profit potential.

By David Wyss | Updated on August 01, 2008

Financial markets are still turbulent, but there are signs that the waters are becoming a little calmer. Credit spreads remain unusually wide, however, and this has raised the cost of borrowing to individuals and corporations. The financial sector has been more affected by the problems than nonfinancial companies. The losses in mortgage-related securities have eroded capitalization of the banks. Although banks have been able to replace that capital more easily than many feared, they still need to add more, both to replace the capital lost and to increase their capitalization to allow expansion of their loan portfolios. The weakness in securitization markets means that bank must operate in a more old-fashioned manner, making loans and taking in deposits. That requires a larger capital base, but it could be more profitable in the long run, since it reduces competition from non-banks.

We believe most of the write-downs have been taken, but note that “most” does not mean “nearly all.” Credit default swaps, the cost of ensuring against default of a bank, have become very expensive. The Counterparty Risk Index from Credit Derivatives Research now shows an average cost of 125 basis points (bp) to insure debt of major banks, up from only 30 bp a year ago. Risks remain less than at the peak of Bear-Stearns’ problems in March, when the index rose to 250, but the fact that it has been rising again over the last two months makes us nervous.

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