VENDEMIAN, France (Reuters) - It will take considerably more than the Federal Reserve’s cut in the discount rate, and its likely upcoming move to cut the Federal Funds rate, to pull the market’s fat out of the fire.
While the Fed was right to cut its discount rate by a half a percent and take other steps to improve liquidity, the factors that scared bankers and money market managers into hiding under their desks haven’t gone away.
It is clear from market action that nothing approaching calm has returned to credit markets.
Commercial paper markets have in parts frozen and a rush to safety drove some U.S. government bond yields down on Monday by the most since the crash of 1987.
The underlying bad loans in housing haven’t gone away either. And with mortgage finance in a very severe credit crunch, the subprime problem will continue to spread, driving house prices lower and prompting still more defaults and consumer retrenchment.
It is hard to see how the U.S. economy can avoid a hard landing — or even, whisper it, a recession — even if the interest rate cuts the markets have already banked come through.
Because of that, and because of the opaque and complex way risk has been spread through the use of derivatives and structured finance, no one knows what or who constitutes a good risk, even for very short term loans.
This has driven breathtaking moves in markets.
The asset backed commercial paper market, through which financiers who make loans or collect debt for securitization finance themselves for short periods, has ceased to function properly and is in what can fairly be described as a panic.
Money market funds and other investors are refusing to buy short term debt associated with subprime lending, rightly aghast that much of this very highly rated paper is anything but sound.
Thornburg Mortgage TMA.N, which specializes in the now tainted jumbo mortgage sector, sold $20.5 billion of securities at a discount to pay down debt it was unable to refinance.
Thornburg said it accepted bids of about 95 cents on the dollar for mortgage-backed securities with triple-A ratings.
The move away from asset backed paper has driven yields on U.S. government debt down very sharply, as investors who would have bought commercial paper for a small amount of extra yield plow their money into the safest instruments they can find.
The three-month T-bill yield ended at 3.27 percent in New York on Monday, down 44 basis points from late Friday. Earlier, it fell 126 basis points, double its largest one-day decline of October 1987, according to Reuters data.
The spread between T-bill yields and the London interbank rate, a good barometer of fear of default, briefly touched 3 percentage points, an unprecedented level and about twice that seen during the 1998 LTCM hedge fund crisis.
The three-month T-bill was yielding 3.46 percent, up 18 basis points, at around 6 a.m. EDT on Tuesday.
If we escape the liquidity crunch that central banks have been fighting, that is well and good. But there will still be a repayment and bad debt issue, and — fundamentally — an issue about how borrowers and lenders of all types do business with one another.
Much of the current securitization model, which has been a huge supplier of liquidity and one of the big causes of dropping risk premia, will have to be rethought. So will investors’ reliance on credit ratings and the agencies which give them.
Don’t get me wrong — securitization and ratings agencies are good things. If they function correctly they help capital reach the places where it will produce most and they greatly aid efficiency. But...
The implications of this are big.
If — and I think it will happen — the interrelationship between asset securitizers and leveraged investors, be they sophisticated hedge funds or some benighted European bank, is put on a permanently more conservative footing, many asset prices will have to fall.
The damage done to the economy by the bad loans already made and by the credit drought we face until the new model emerges will be very significant.
James Saft is a Reuters columnist. The opinions expressed are his own. At the time of publication Saft did not own direct investments in any securities mentioned in this article. He may be an owner indirectly as an investor in a fund