On the Fragile State of the Credit Markets

Despite the evidence of some recovery in the credit markets, such as the sale of some formerly-hung LBO debt (at admittedly lower prices) and the return of buyers to the structured credit market, the patient is far from healthy. An article “Is the storm over? Credit market conditions look changeable,” by Gillian Tett in the Financial Times and a joint post by London School of Economics professor Willem Buiter and professor Anne Sibert of Birkbeck College point to the tenuous nature of this rebound. In particular, both worry about the high rates for three month LIBOR, which says banks don’t trust their counterparties to be solvent even over a comparatively short term.

Why such a cautious stance? Many banks gave backup lines of credit to secured investment vehicles (SIVs), which were off balance sheet entities that lent long (they held mortgage paper, in some cases subprime) and borrowed short in the commercial paper market (using something called ABCP, or asset backed commercial paper). After two German banks had to be rescued due to subprime exposure, suddenly no one wanted to hold ABCP, and these vehicles could no longer roll their CP. They had to use their backup lines of credit (in some cases, the parent bank might not have be required to support the SIV, but have decided to anyhow out of concern for their reputation). Thus the belief is that these banks are hoarding cash for their own needs, to the detriment of normal market operation.

First, from the Financial Times:

But the problem that haunts both the politicians and banks is that while the signs of a rebound may be tangible, they remain patchy – and, above all, decidedly fragile. That suggests that the current apparent calm could quickly give way to another bout of turmoil if any new shocks emerge.

“Fragile” is probably the best word to use,” says one central banker. Or as a senior private sector banker admits: “We are on a knife-edge … there are still worrying signals in the markets.”

One issue provoking worry is that there is still alarmingly little evidence of genuine trading under way in many of the complex securities that were at the heart of the summer credit storm. While bargain hunters, such as hedge funds, have started snapping up corporate debt, the same does not appear to be happening much in derivatives linked to mortgage securities. Meanwhile prices in that sector – insofar as there are any prices – are still falling. Last week, a derivatives index linked to US mortgage loans touched a new low.

Another – potentially more pernicious – problem is the state of the interbank market. In recent weeks, the cost of borrowing funds overnight has dropped in Europe and the US as central banks have flooded the money markets with funds. However, in the three-month money market, rates remain very high because banks are apparently hoarding their funds rather than lending them out.

“Overall, central banks have been successful in stabilising conditions at the short end of money markets,” says Lena Komileva of Tullett Prebon, the inter-dealer broker. “But persistent tightness in [three-month] funds suggests that developments in the overnight market create an illusion of normality.”

This is alarming for those central banks that have been flooding the markets with money, since it will be hard for the financial system to function healthily again while the interbank market remains frozen. It also has troubling implications for investors: the interbank freeze in effect suggests that banks do not believe their own rhetoric that the outlook is improving. In public, in other words, they may seem upbeat but they are not putting their money where their mouth is.

Some observers hope this discrepancy simply reflects technical phenomena that should disappear soon. More specifically, one reason why banks are hoarding funds is that they fear that a flood of assets, such as loans, will roll back on to their balance sheets because these instruments can no longer be sold in the credit markets.

But while the scale of this potential roll-back is huge, it should not continue indefinitely: Société Générale, for example, thinks that once the current financial year has ended, banks will become more willing to lend to each other. “We expect the pressures on the money markets to reverse [soon],” it says.

But the problem with this optimistic projection is that there appear to be other factors that are also provoking unease – not just among bank treasurers but other investors too.

One is the continued uncertainty as to where all the rot related to the subprime mortgage sector now lies. Although some banks, such as UBS and Credit Suisse, have already revealed losses, there are widespread suspicions that other large and small banks and asset management groups are still concealing problems – not least because it remains hard to value complex credit securities while markets remain paralysed.

“There is still an information logjam in term of ‘who owes what to whom?’ and ‘what are the assets really worth?’ ” says Andrew Milligan, head of global strategy at Standard Life Investments. Or as Marco Annunziata of Unicredit echoes:“At the root of the current crisis is an information crunch that cannot be easily resolved.”

A second set of concerns revolves around “deleveraging” – the banking term for the process by which investors and institutions cut their levels of debt. This issue is crucial because in recent years many investors and financial institutions have sharply increased their borrowing in order to buy loans and other assets. Many are now cutting this, either because they have suffered painful losses on their investments or because the banks themselves are no longer willing to supply funds, and the cost of capital is rising.

Citigroup estimates that back in January a hedge fund that owned an AA rated debt instrument could typically post that as collateral with an investment bank and borrow 10 times that value of funds. Now it can typically borrow only five times the value of this collateral, or less for riskier assets. “From one asset class to another, everyone is strapped for cash,” says Matt King, analyst at Citigroup.

This shift could force many investors to sell assets in the coming months. Worse, it is difficult to tell how this deleveraging process will play out, since many of these markets and their investors are opaque: little is traded publicly. Thus, while some observers hope the worst of the deleveraging is past, others fear the full impact will emerge only over the next year.

This, in turn, creates a third huge uncertainty: the impact of this summer’s turmoil on the real economy. Thus far, there have been few signs that the credit upheavals and the associated rise in funding costs have triggered corporate panic. That may be because the global economy remains in a healthy state and most companies are enjoying strong balance sheets and good earnings. Moreover, while borrowing costs have risen, they are not at all high by historic standards – not least because they were so abnormally low last year.

But this sense of calm could be illusory, owing to a time-lag effect. Financial history suggests that whenever funding costs have risen in previous cycles, it has typically taken several months for the full impact on companies or consumers to show up. Indeed, behind the scenes, banks are preparing to cut their lending. A survey of loan officers in the US by the Federal Reserve, for example, suggests that banks are imposing the tightest lending criteria in their mortgage business for 16 years.

Merrill Lynch believes, on the basis of research among its own client base, that two-thirds of lending officers in Europe and the US are planning to cut credit. “The days of cheap and easy money for sub-investment grade companies are over,” says Merrill’s Karen Olney, who points out that “normally defaults follow tightening by about 12 months”.

Most economists think the global economy will be able to weather a moderate rise in corporate defaults or fall in house sales. But if anything else hurts sentiment, such as an associated crash in house prices or the dollar, the panic could rise.

That, in turn, might create a vicious feedback loop, where a decline in economic activity leads to more credit losses – which prompt the banks to tighten lending further, triggering further borrower pain. There is risk, in other words, that the developments of this summer were merely the first chapter of a long saga of pain.

Almost nobody in the political or banking world will publicly admit that they are preparing for this worst-case scenario. But if nothing else, the events that started in August have reminded investors that the worst-case scenario can sometimes play out, however unlikely.

Investor psychology, in other words, has changed. As long as uncertainties remain about issues such as deleveraging, subprime losses and the risks to economic growth, a sense of fragility will endure. The days of ultra-easy credit will not return soon – on the JPMorgan trading desks or anywhere else.

From Buiter and Sibert:

There are four explanations for the sizable spread of three-month LIBOR over the Bank Rate. The first is an expectation that the Bank Rate will rise over the next three months, but this highly unlikely. Second, there could be a pure term premium, but this must be tiny over such a short horizon. Third, there is a risk that borrowers will default. This is clearly not zero, but it is difficult to believe that there is a one percent probability that a typical UK money centre bank will default with a zero recovery rate during the next three months. Finally, there is a liquidity risk and we attribute the lion’s share of the recent spread of three-month LIBOR over Bank Rate to liquidity factors.

Currently liquid banks may be reluctant to make three month loans, not because they are afraid that their borrowers will be insolvent in three months, but because they are afraid that both they and their borrowers will be illiquid in three months. If enough banks have these fears, an interbank ‘lending strike’ results.

Banks everywhere are gearing up to take on their balance sheets the illiquid assets of conduits, other SIVs and other off-balance sheet SPVs that they are exposed to through credit lines or reputational considerations. Fear of future illiquidity is widespread and banks are hoarding excess liquidity rather than lending it out in the interbank market, even at nearly seven percent. The Bank could address this unfortunate situation by injecting liquidity, through repos with, say, a three-month maturity to eliminate the liquidity premium. Such repos are likely to be more effective if they are against a wider range of eligible collateral that what the Bank currently accepts, including illiquid assets.

Note that the entire post, which is wide-ranging, is very much worth reading. It has a very nice recap at the beginning of why securitization hasn’t turned out to have unexpected pitfalls (short answer: information loss); a summary of their “market maker of the last resort” recommendation, and interesting tidbits on the Northern Rock failure and Bank of England and ECB actions to address the credit crunch.