Sunday, September 16, 2007

US Commercial Paper Markets: A Run on The Shadow Banking System?

``Federal Reserve independence is not set in stone…The dysfunctional state of American politics does not give me great confidence in the short run…and there may be ``a return of populist, anti-Fed rhetoric,'' Alan Greenspan ``The Age of Turbulence: Adventures in a New World” quoted from Bloomberg

In the financial sphere, it has been one heck of an interesting week where some ironic developments persist to unfold…

One, global central banks debate on how to resolve the present juncture…

Two, global equity markets continue to crawl higher despite the barrage of negative developments (are these salutary signs of “climbing the wall of worry?”) amidst conflicting messages seen across different markets and…

Lastly the Phisix survived the week with some bruises from an onslaught of foreign selling worst than during the August lows (!).

The Bank of England seemed to have assumed the “principled” path of central banking by adamantly refusing to go along the way of its peers in rescuing the money markets. It even rebuked the US FEDERAL RESERVE and the EUROPEAN CENTRAL BANK for “moral hazard” or by acting to bail out some banks last Thursday, from which we quote UK Central Bank governor Mervyn King (highlight ours), ``The provision of such liquidity support undermines the efficient pricing of risk by providing ex-post insurance for risky behavior, that encourages excessive risk-taking and sows the seeds of a future crisis.” Mr. King’s view was supported by Canada’s Central Bank Governor David Dodge.

Well, such rhetoric was good until Northern Rock, UK’s fifth largest mortgage lender, came knocking on its doors for liquidity support. Of course, there always has to be some justification; here is Bank of England’s statement, ``the FSA judges that Northern Rock is solvent, exceeds its regulatory capital requirement and has a good quality loan book.”

Incidentally, the problems at Northern Rock has NOT been due to US subprime papers but rather from banks reluctant to lend to each other, this from the Economist (highlight mine),

``Yet Northern Rock appears to be less of a protagonist in the current credit crisis than a bad case of collateral damage. Its problems were caused not because it risked its shareholders’ money on poorly judged investments linked to American subprime mortgages, as many far bigger and more international banks have. Instead, it has been hit by a failure to borrow from other banks to fund its mortgage lending practices. The interbank market where such borrowing usually takes place has partially seized up in recent weeks because big banks are hoarding as much capital as they can to pay for the cost of their own bad investments.”

As you can see, the ongoing liquidity drought in the credit markets has begun to affect the peripherals, as banks load up on their reserves to prepare for portfolio adjustments (losses).

Yet, much of today’s liquidity seizure has been seen via the US $2 trillion commercial paper markets.

Commercial paper markets are short-term (unsecured) debt instruments or promissory notes issued by financial and non financial companies with maturities ranging up to 270 days and an average 30 days ( Such instruments are usually used by companies to fund their day-to-day operations such as inventory purchases or manage working capital.

These papers are usually bought by money market funds or by mutual funds that invests in short term papers.

The problem lies with the asset-backed commercial paper market or short term vehicle issued by financial institutions backed by physical assets such as receivables (mortgages, bonds, credit cards, car loans or other trade receivables), some of which had been collateralized by subprime mortgages.

Where many of the pooled investment vehicles as the Structured Investment Vehicles (SIVs) used by banks and sold to the public had been borrowed in the form of asset-backed commercial papers, the losses in the US subprime sector has resulted to a freeze in financing due to the questionable valuations of these vehicles.

In effect, the liquidity freeze in the commercial paper space has crimped on the access to financing by corporations to manage their day-to-day operations. This has likewise raised the cost of borrowing, and increased the risks of corporations raising cash by selling other assets in order to raise cash.

PIMCO’s managing director Mr. Paul McCulley labels such developments equivalent to a bank run but in the form of “The Shadow Banking System”, where in his outlook, Mr. McCulley wrote (highlight mine),

``Technically, that’s called systemic risk. And in the current circumstance, it’s called a run on what I’ve dubbed the "shadow banking system" – the whole alphabet soup of levered up non-bank investment conduits, vehicles, and structures.

``Unlike regulated real banks, who fund themselves with insured deposits, backstopped by access to the Fed’s discount window, unregulated shadow banks fund themselves with un-insured commercial paper, which may or may not be backstopped by liquidity lines from real banks. Thus, the shadow banking system is particularly vulnerable to runs – commercial paper investors refusing to re-up when their paper matures, leaving the shadow banks with a liquidity crisis – a need to tap their back-up lines of credit with real banks and/or to liquidate assets at fire sale prices.”

In Friday’s commentary, the cautiously bullish BCA Research (see figure 1), seeing the continued pressures in the credit markets, now joins the ranks of those calling for rate cuts…

Figure 1: BCA Research: Monitoring the Credit Crunch

Quoting BCA Research, ``The price of credit remains elevated in many areas. The asset-backed commercial paper market remains locked up, with investors seemingly unwilling to buy at any price. Term financing is difficult to get and this, along with nascent banking sector concerns, has contributed to the ongoing elevation in LIBOR rates and the fed funds-LIBOR basis swap. The 2-year swap spread also continues to widen towards the previous peak. Similarly, both corporate bond and CDS spreads are grinding higher. Perhaps most worrisome, the price of debt for some consumers has also surged, as indicated by the recent blowout in the 30-year fixed jumbo mortgage rate. It is when creditworthy customers cannot access credit that the Fed must step in and deliver relief.”

So how are rate cuts supposed to help?

The lowering of rates aims to reduce the impact of higher borrowing spreads and potential loan losses. Remember, in a highly levered financial system, marginal moves reverberate! Yet, rate cuts cannot be taken with certitude that confidence will be restored, especially if the damage has been widespread.

All told, despite the gradual progress seen in the equity markets, the credit markets tell us that ALL IS NOT NORMAL and that the present liquidity drought has been seen affecting a broader part of the global economy. This suggests to us that the downside risks are far greater than what the consensus expects.

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