For those of you who have been following the turmoil in the money markets, the problem stems from a near-complete repudiation of asset-backed commercial paper, which constitutes roughly half of commercial paper outstandings. The reason for the concern is most asset-backed CP has mortgages as collateral, and some of those mortgages may be (hold your breath) subprime.
Even though the Fed has lowered the discount rate, and some commercial banks have stepped up to take loans, these moves were symbolic. There is considerable prejudice attached to using the discount window, and the banks that took avail of it, such as Citigroup, did so as a show of support (at some cost to them, since the discount window is still more expensive than regular interbank funding) rather than because they needed the money.
As we mentioned yesterday, the Fed’s actions hadn’t solved the CP problem. Outstandings are dropping, and people in the market report that no one wants to buy asset-backed commercial paper. That means issuers, who in most cases expect to be able to issue new commercial paper to replace maturing CP, are stuck. They have to cough up the dough to pay for the maturing CP. Many companies have back-up lines of credit for this purpose, but these are generally regarded as emergency facilities. The banks who provide these credit lines don’t expect a lot of companies to be coming to them at once to draw down funds. But that is almost certain to be what is happening now.
The refusal to touch asset-backed CP is clearly panic (or more accurately, fear of making a career-limiting move). Much of this paper is sound, but people on money market desks are paid to watch pennies and take no risks. They aren’t in any position to find out exactly what is behind a particular issue of asset backed CP. So their view is, better not to take any chances, and they aren’t.
As a result, the Fed has now taken what (for it) is a novel step, that of allowing banks to use investment grade ABCP, as it is known in the trade, as collateral. Greg Ip at the Wall Street Journal explains:
In another step aimed at unfreezing the commercial paper market, the Federal Reserve Bank of New York clarified its discount window rules with the effect of enabling banks to pledge a broader range of commercial paper as collateral.
Under the clarification, issued verbally by New York Fed officials to market participants in the last day, banks may pledge asset-backed commercial paper for which they also provide the backup lines of credit.
“This strikes us as a very big deal,” said Lou Crandall, chief economist at Wrightson-ICAP LLC….The clarification, he said, means if an issuer is unable to sell an entire portion of its paper, the bank providing the backstop can finance the unsold portion with a discount window loan, backed by the assets underlying the paper.
“We are comfortable taking investment-quality asset-backed commercial paper for which the pledging bank is the liquidity provider. This is a clarification of something that has become, over time, accepted practice at the Federal Reserve Bank of New York,” said New York Fed spokesman Calvin Mitchell…..
Several market sources however interpreted the action more as a change in, than a clarification of, policy. “Previously banks could not post such ABCP as collateral, that is ABCP for which the bank is a liquidity backstop,” said Michael Feroli, economist at J.P. Morgan Chase, in a note to clients. “While reluctant to characterize this as a major change in direction, our contact at the Fed noted that this measure was a means to ‘insert flexibility’ in the way the window deals with evolving needs,” Mr. Feroli wrote.
Another sign of how seriously the Fed is taking this matter is that it has quietly relaxed some of its rules around regulatory capital. Note that the Rodgin Cohen mentioned below is the dean of bank regulatory lawyers:
In the past week, the Fed gave temporary exemptions to three major bank holding companies from limitations on loans between their bank and securities dealers units, according to people familiar with the matter. It also notified banks, via a letter to Rodgin Cohen, chairman of New York law firm Sullivan & Cromwell LLP, that loans secured by debt and equity securities meeting certain conditions would attract a lower risk weighting than regular loans to private borrowers. That means the bank has to put aside less capital per dollar loaned.
“Less capital per dollar loaned” translates into, “You can lend more against that capital.”
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So far I’ve been okay with everything the Fed has done, but this begins to worry me. ABCP is being rejected by the market — precisely because it is not a uniform asset suitable for trade in a market. (If this weren’t the case there would no need to worry about what assets underlie it. Think about why futures trade in a market and forwards don’t — the former are all guaranteed by the same entity and the latter aren’t.)
The Fed should by all means support banks by accepting ABCP as collateral — if it was issued before, say, August 21. But to accept newly issued ABCP is just plain dangerous. The market cannot be strung along by the Fed in hopes that it will recover. These companies need to find a new source of — high-interest — credit even if it seriously weakens bank balance sheets.
Dear Anon of 10:23 PM,
I’m not quite as negative on the Fed’s move, but I am concerned that this action illustrates how limited their tools are.
Some things to consider: the Fed is accepting only investment grade ABCP. Unlike subprimes elsewhere in the bond market, which have been put in vehicles where you have tranching (and sometimes retranching, leverage, use of derlivatives, and God knows what other kind of financial voodoo, um, engineering worked on it that creates a ton of real and embedded leverage) these are whole loans used as collateral.
And mind you, unlike the MBS market, you have a ton of other type of security used for ABCP besides mortgages, such as credit card and auto loan receivables. So far, however, I haven’t seen any helpful stats on, say, how significant these other types of collateral are relative to mortgages (the auto companies are huge issuers of ABCP).
This may signal instead that people have lost complete faith in credit ratings, save for (perhaps) corporate and agency bonds. If so, this action will be futile. The Fed accepting ABCP as collateral won’t make anyone trust ratings on asset-related paper any more than before.
So the wisdom of the Fed’s action depends on whether you view the market reaction as irrational or justified. I’m not such a believer in the sanctity of market prices to think they are infallible (after all, these same markets were pretty sanguine about subprimes as recently as April).
The reality is, though, as with cutting discount rates, they are likely to have few to no takers.
And a technical point: commercial paper is placed, not traded The buyer holds it to maturity. It just about never trades. So the prices are set when the CP matures and the issuer puts new paper out on offer.
Tony Cresenzi at Miller Tabak today published a list of securities classes the Fed routinely accepts as Repo collateral.
Included on the list are asset-backed securities.
And in at least three rather hidden press reports across the past two weeks I’ve seen statements that the Fed during the big week of credit “injections” (ala … heroin?) accepted RMBS as collateral.
This seems to be saying that the Fed was taking entirely illiquid securities, market value zero more or less, at PAR for collateral. (Or am I mistaken?)
If not mistaken, then how far is this from the “price control” regime suggested in the editor’s notes preceding the article posted at the URL below?
That is — a man in a big suit was pretending that the RMBS were worth what their marks said they were worth about a year ago — and encouraging the rest of the trading world to pretend right along.
The price control notion (somewhat tongue in cheek perhaps) was aired at:
http://www.newcombat.net/article_whats_a_cdo.html
Dear Anon of 11:19 PM,
I wish I could answer your question with certainty, but I can’t. But (at least now) rumors that the Fed is accepting worthless paper as collateral are almost certain to be incorrect.
First, we need to clear up a few things. RMBS cover a very very wide range of paper, including a lot of conventional, no debate about how to value it paper like simple pass-throughs and interest-only and principal-only strips.
Also remember that when a homeowner defaults, there is an asset, a very concrete asset, to liquidate and use to pay bondholders. In normal times, bank recoveries on foreclosures are (I think I am roughly right, any mortgage weenies please pipe up) 70 cents on the dollar. For prime mortgages, that number is still probably pretty good; for subprimes, given the frequently close to zero equity from the get-go, the number might be 50 cents on the dollar.
So why all the panic? It’s IMHO due to the widespread use of CDOs. If you have a high enough proportion of the underlying assets defaulting, that means the bottom tranches may be worth zero and even the AAA tranches look less solid. Not worthless, but maybe an only now an AA or even an A.
Now the Fed announcing that it would accept asset backed CP as collateral was treated as a news item. Per our post and our comment above, this is not crazy or speculative paper, if you do a little poking to find out what the collateral is. But the market hates it right now. Technically, it is illiquid (as much because CP doesn’t trade anyhow, it is placed and held to maturity).
And in general, liquidity and value are two different concepts. Divisions of companies are illiquid. It takes months to sell them. Ditto colored diamonds, Picassos, beachfront raw land. Those are highly illiquid, but no one would say they have no value.
However, as this central banker (Walter Buiter of the Monetary Policy Committee of the Bank of England) noted:
It is clear the Federal Reserve Act permits the Fed, under unusual and exigent circumstances, to lend or repo against any collateral, including dead dogs and illiquid CDOs backed by subprime mortgages.
Although they can do it, I see no evidence that the Fed is accepting either dead dogs or illiquid CDOs as collateral. And Buiter hasn’t either.
Only investment-grade paper? But what is or is not investment grade is determined by the ratings agencies, who are still using historical models to rate newly issued papers. Or has this changed in a month?
This may be relevant Fed proposed Capital Adequacy and risk pricing models. Nice sunday reading…
http://www.federalreserve.gov/boarddocs/reportforms/formsreview/FR4200_20060925_ifr.pdf
Just a quick reaction to the last two comments (and thanks for that link, hope to get to it soon).
I find a’s morning comment revealing and distressing because it confirms what I was worried about, that people are throwing all rating agency ratings in the trash heap, the good with the bad.
Where the rating agency ratings were (ahem) badly compromised was in collateralized debt obligations, which was very profitable to them.
Now this is very hairy arcane paper. The issuer in most cases is taking tranches of other RMBS deals and retranching them. Tons of assumptions, historical data of dubious relevance, credit-risk-only models used for pricing purposes, you’ve heard about the problems.
Commercial paper, by contrast, is comparatively straightforward. Now I am speculating here, but I would bet in the great GREAT majority of cases, you don’t have CDO tranches supporting it. You might have some simpler mortgage paper, or perhaps even warehoused mortgages (ie, being held to be securitized). That stuff can be valued, particularly over a short-term horizon (and remember, CP is short term).
Specifically, this article says there has been some CDO backed ABCP issued, but by all indications, it’s a very new development and constitutes only a quite small portion of the market:
http://www.ft.com/cms/s/0/d8ea9a64-5019-11dc-a6b0-0000779fd2ac.html
But one point that supports those that are avoiding asset backed CP: the rating agencies are slow to downgrade. This means that, say, paper they rated AA might really be AA- or A+. But that doesn’t mean it’s worthless, just worth less than true AA paper.
So the issue seems to be that everyone is running from asset backed paper that could conceivably have anything to do with residential mortgages (except traditional MBS, and agency paper) thanks to the rating agencies having lost all credibility. This suggests that a rate cut won’t help.