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Increasing credit risk will push up interest rates

Gijsbert Groenewegen | Groenewegen Report
Posted Jul 1, 2011

Increasing credit risk will cause much higher interest rates across the borders

The Belgian/French bank Dexia, with a ¤4.3bn or $6bn+ exposure (according to S&P’s Corp) to government debts in Greece, has back stopped (guaranteed) $17bn in municipal bonds in the US according to an article in the WSJ. As a result of the problems in Greece interest rates of municipality bonds in small towns in the United States used to finance municipal facilities like schools, bridges, ice rinks etc are being pushed up. S&P warned last month of a possible downgrade of Dexia’s investment- grade credit ratings. It looks indeed like Lehman revisited when one of the victims of the CDO crisis in the US was a small town in Norway which had bought “triple A” CDO s. And don’t forget the exposure of AIG to the housing market through the Credit Default Swaps (CDSs) that were never going to be called because of the triple A status of the CDOs, and how it almost bankrupted Goldman and others.

While other investors are stepping in to buy those bonds, they are demanding sharply higher yields as compensation for the increased risk following a possible downgrade of Dexia’s credit rating. As a result, borrowing costs for some municipalities are now the steepest since the financial crisis. Some cost of borrowing are tripling and quadrupling in a matter of weeks.

Dexia is obliged to buy as much as $17 billion in municipal bonds if investors withdraw during the remarketing or rollover process. Some $400 million has already been taken back though in those cases, allowing Dexia to increase the interest rate paid by the municipalities whilst at the same time it can demand an accelerated pay back schedule. Some municipalities are trying to replace Dexia with other banks though the refinancing is likely to lead to much higher interest rates in some cases from 3% to 12% which increase borrowing costs by tenth of thousands of dollars which in turn leads to very high fees for the related facilities.

With the QE2 ending on June 30 (the Fed has bought 85% of all treasury issuances this year!!) and higher credit risks higher interest rates could bring down the markets. If we break above the 4.80% level on the 30-y Treasury bond we will break out of the downtrend since 1981 and could see much higher interest rates with all its obvious consequences for the financial markets and economies.
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