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.

http://www.federalreserve.gov/boarddocs/reportforms/formsreview/FR4200_20060925_ifr.pdf

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.

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

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.

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.