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Tuesday, August 28, 2007

The end of the beginning


The end of the beginning
Aug 26th 2007

Enjoy the relative calm, it may not last

THE relief is palpable, though it may prove short-lived. Efforts by central banks to jump-start stalled financial markets by injecting huge amounts of liquidity—and, in the Federal Reserve’s case, by cutting the lending rate at its banks-only “discount window”—have kept worst-case scenarios at bay. But uncertainty over who holds what assets, and what losses have hit where, should keep prudent investors on edge.

For better or worse, there are signs that investors are tiptoeing back into riskier assets, one toe at a time. On August 24th the yield on “safe-haven” three-month US Treasury bills rose for a fourth straight day, reversing an earlier collapse when money-market funds and others switched out of commercial paper and other short-term corporate IOUs (see chart).

The market for short-term inter-bank loans, where the crunch began, has also loosened up. Stocks ended the week on a high, cheered by rare good news from America’s housing market, where home sales were up 2.8% in July, and strong durable-goods orders. Bank of America’s $2 billion lifeline to Countrywide, America’s largest mortgage lender, was reassuring proof that the financial titans see opportunities as well as threats.

Still, some corners of the markets remain dysfunctional, and others appear to have been strangled in their prime. As recently as a month ago around half of the commercial-paper market was made up of asset-backed commercial paper, secured against mortgages, credit-card receivables and the like; and its share was growing. Now almost no one will touch the stuff.

That is why the central bankers, though reluctant to cut interest rates, need to lubricate markets. The New York branch of the Fed, which oversees Wall Street, has told banks they can offer a broader range of commercial paper as collateral for discount-window borrowing. It had earlier eased the terms on which it lent out government securities.

Such moves may buy time, rather than treating the roots of the crisis. Confidence has been as brittle as a brandy-snap, not because there is too little money to go round, but because securitisation and other feats of financial alchemy have made it as clear as mud where credit exposures lie and how to value them. This eats into trust. And, as J. Pierpont Morgan put it during the panic of 1907, “A man I do not trust could not get money from me on all the bonds in Christendom.”

Today’s ultimate lenders to American homebuyers are not local banks, but Australian hedge funds, Middle Eastern investment firms, German Landesbanks, and so on. (Two German lenders with large subprime-mortgage exposures have already had to be bailed out.) They piled into exotic asset-backed products, such as collateralised-debt obligations; now they are stuck holding illiquid securities bought with borrowed money that are devilishly difficult to value, and where sales, if buyers could even be found, would crystallise big losses.

Most have buried their heads in the sand. Bad news has emerged in dribs and drabs, with investors seemingly admitting to losses only when these can no longer be concealed. This is not how markets like to receive their news. Bank of China joined the list of reluctant confessors this week, saying it holds nearly $10 billion of securities linked to American subprime mortgages.

This lack of transparency makes the crisis one of confidence (and pricing) rather than one of liquidity, reckons Josh Rosner, a structured-finance expert at Graham Fisher & Co, a research firm. More information about institutions' positions would at least give counterparties a clearer idea of whether they were dealing with a basket-case, and might encourage distressed-debt funds to swoop in and buy. “Without clearer disclosure of the size and nature of holdings, I can’t even dream about untangling the mess out there,” says one vulture.

Rating agencies could help by disclosing more about their methodologies, and by being more consistent. They have been changing their criteria for what constitutes a Triple-A-rated subprime security, for instance, while leaving many of those rated under the older criteria in the top category. This has sown confusion and encouraged investors to stay on the sidelines.

The Fed has also muddied the waters, says Mr Rosner, by offering 85% of face value for any as-yet-unimpaired subprime paper presented as collateral at its window, regardless of the actual prospects of default. This could do more harm than good if it sets a false price for the securities that is far above what they are really worth.

Worryingly, the stock of paper infected by rising mortgage delinquencies looks set to rise. Subprime defaults continue to climb, and the situation is deteriorating in the Alt-A market (for good-quality borrowers who present little or no documentation). The next brick to fall could well be commercial mortgages. The process of flushing out losses among banks, hedge funds, insurers and others who devoured asset-backed debt during the securitisation spree may have only just begun. If so, the relief of recent days will prove fleeting.

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