Paper losses
Aug 23rd 2007 | LONDON AND NEW YORK
From The Economist print edition
Central banks struggle to restore calm without breeding complacency
FOR those who stop short of stuffing their mattress with banknotes,money-market funds are meant to be the next best thing. They investtheir clients' money in supposedly safe and liquid short-terminstruments. But as America's mortgage malaise has spread with shockingalacrity from one corner of the credit markets to another, even thesestaid creatures have been sent into spasms. This week they took centrestage, dumping potentially toxic securities and fleeing for the safetyof government bills.
Though the markets had calmed down a little by August 22nd, centralbankers cannot afford to be complacent. They have pumped large amountsof liquidity into the system over the past fortnight, and continued todo so this week. The Federal Reserve has cut the discount rate—thecharge it makes for emergency lending to banks—from 6.25% to 5.75%, andlengthened the term of these loans to 30 days. It has also urged banksnot to be shy in coming forward. To show there is no shame in turningto the Fed, four big banks—Citigroup, JPMorgan Chase, Wachovia and Bankof America—all this week announced they had taken the central bank upon its forceful offer.
Willthis be enough? In a statement, the Fed's rate-setting committee leftthe markets in little doubt that it would cut its main policy rate iftheir ongoing ructions hurt spending and jobs. And Ben Bernanke, theFed's chairman, was quoted by the head of the Senate Banking Committeeas saying that he would use “all tools available” to quell the crisis.Elsewhere, Japan's central bank put off a rate rise it had long beenitching to implement; and, despite hints to the contrary, the EuropeanCentral Bank could still find itself in the same position when it meetson September 6th.
Stockmarkets have been reassured by all this. But the “locus ofconcern”, as the Fed's Jeffrey Lacker put it this week, remains themore obscure market for “asset-backed” commercial paper.
Some commercial paper is easy to understand: a big company sells an IOU,which it repays in, say, 90 days. This stuff got the American financialsystem into trouble in 1970, when Penn Central Railroad defaulted on$82m-worth. The recent problems stem from a different brand of paper,backed not by the good name of a big company, but by assets, such asmortgages or credit-card receivables. Mostly held off-balance-sheet bybank-sponsored “conduits”, this market has boomed in recent years. Itnow accounts for roughly half of the more than $2 trillion ofcommercial paper outstanding. But issuers have been caught out by acashflow mismatch, says Louise Purtle of CreditSights, a research firm.Funding is short term but the proceeds are invested in longer-termassets, leaving issuers vulnerable when investors start to doubt thequality of those assets and want out.
That is what happened at the start of this week as money-market funds sold these IOUs,causing rates to spike as never before (see chart). This paper sufferedfrom two main layers of mistrust. First investors are worried that thebanks won't always be able to support the conduits.
The second worry, about the mortgage collateral, is particularlystark. Rating agencies badly misjudged default rates in subprimemortgages and are now having to downgrade reams of securities linked tothem. With the credibility of ratings in tatters (there have even beencalls for Warren Buffett to take over Moody's), investors have beenleft without a compass. For the time being, many would rather pull backthan trust in their own analysis of credit risk. They are staying onthe sidelines because they can't work out what securities are worth,not because they don't have the money to buy them.
Ratings may be in doubt, but they remain powerful. The Fed has been offering 85% of face value for AAA-ratedpaper presented at its discount window, even collateralised-debtobligations stuffed with subprime mortgages (as long as they arenot—yet—impaired). Josh Rosner, a critic of the rating agencies, thinksit extraordinary that, despite their obvious flaws, they “continueessentially to regulate the behaviour of even the central bank”.
Home truths
Even if stability returns to markets, the repricing of risk islikely to continue. How far it goes will depend largely on the state ofthe mortgages that serve as collateral for many of the newfangledinstruments that were, until recently, hawked with glee on Wall Street.The outlook is not good. Not only do subprime delinquencies continue torise, but defaults on prime and Alt-A loans (those to good- ormiddling-quality borrowers) have started to climb too. Figures releasedthis week showed foreclosures in July up by 9% compared with June, andby 93% over the year before.
It may be little comfort to overstretched mortgage-holders to knowthat the lenders are also sharing the pain. Accredited, a subprimelender, said this week it would stop taking loan applications and letmore than half its workforce go. And Lehman Brothers became the firstinvestment bank to close its subprime-lending arm, at the cost of 1,200jobs.
Only the best borrowers—those taking out prime mortgages thatconform to criteria set by Fannie Mae and Freddie Mac, thegovernment-sponsored housing giants—can still get loans with any ease.The market for jumbo loans, which are safe but too large for Fannie orFreddie to guarantee, ground to a halt last week, although conditionshave eased a bit since.
This contamination up the mortgage food chain was not unexpected.But Fed officials are said to have been taken aback by the speed withwhich large non-subprime lenders, such as Countrywide and Capital One,have been hit. Countrywide is America's biggest mortgage provider, andone of its best managed. But it was still forced to draw on bank creditlines after struggling to fund itself through the usual channels. OnAugust 22nd a rescuer arrived: Bank of America said it would make a $2billion equity investment in Countrywide.
A jam in the flow of credit to homebuyers threatens an alreadyvulnerable economy. If consumers seek to pay down debt in response tofalling house prices, spending will suffer, especially withunemployment creeping up. If the economy falters, that should relieveprice pressures too. Oil prices dropped below $70 this week from arecent peak of around $78. Richard Berner at Morgan Stanley reckonsthat market turmoil will itself trim inflation since “it will makebuyers hesitate and sellers worry that prices won't stick.”
Many now expect a cut in the Fed's benchmark rate from 5.25% at itsnext policy meeting on September 18th. Some think the Fed may actsooner. But it may yet disappoint them. “Financial-market volatility,in and of itself, does not require a change in the target federal fundsrate,” said Mr Lacker this week. The Fed is anxious to calm the creditmarkets, so that the economy's funds are allocated in line with riskand reward. But even if it succeeds, risky assets are likely to holdmuch less appeal than they did. The central banker's task is tounscramble price signals distorted by panic, not to protect the marketsfrom a signal that they do not like.
