Tuesday, September 26, 2006

Lower Interest Rates? Not So Fast!

Two articles in today's LA Times highlight the issues that are driving the direction of interest rates.

In Problem Loans for US Banks Rise, regulatory agencies note that adversely rated credits — loans that are likely to result in some loss for the lender without corrective action — rose to 5.1% of all credits from 4.8% a year earlier.

In Cost of Corporate Debt on the Rise, Standard & Poor's says borrowers are paying about 50 basis points (one half of a percent) more for non-investment grade, or junk debt. Junk debt is debt ranked less than BBB-minus by Standard & Poor's or Baa3 by Moody's Investors Service.

The interest rate charged by lenders is comprised of both a benchmark rate and a risk premium. The benchmark rate is typically the fed funds rate, a treasury note, LIBOR or some other financial instrument in which the lender believes it can alternatively invest its money without incurring any risk. The risk premium is the increment the lender charges to compensate itself for the risk of whether or not the borrower will re-pay the loan.

These two stories tell us that the lenders are experiencing greater risk in their loan portfolios and are charging a higher premium as compensation for this risk. Notwithstanding the pundits belief that short term benchmark interest rates may decrease in early 2007, the interest rates paid by borrowers may still increase for the foreseeable future.

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