Explaining Last Week’s Credit Seize Up

If the Financial Times’ Gillian Tett were hit by a bus, I’d be in a lot of trouble. With all due respect to her colleagues, she is the best source of financial news.

Today, in “Structured investment vehicles’ role in crisis,” Tett probes what went wrong in the credit markets last week. As others have pointed out, the problem was that the commercial paper market, a short-term (typically under 90 day) market for corporate IOUs dried up. As these IOUs mature, they are often rolled (i.e., paid out of the proceeds of new IOUs) rather than repaid. Since commercial paper issuers are high quality creditors, this usually isn’t a problem.

However, in a case of innovation gone awry, a new product called asset backed commercial paper is a major culprit in last week’s crisis. Hungry for earnings, banks borrowed short and lent long by putting proceeds of their commercial paper issuance into structured investment vehicles that invested in, duh, structured credits (CDOs, anyone?). To assure that the CP could be paid off if necessary, these vehicles had backup lines of credit.

Things started coming unglued when German bank IKB had one of these vehicles that had some subprime holdings. Some counterpaties had gotten stringent about asset quality and refused to roll the CP. The sub tried to draw down the line of credit with its parent. IKB did not have sufficient cash and appeared unable to come up with it soon enough, which led the state bank to intervene and offer a credit facility.

The fact that one ABCP player was proven to have inadequate backup facilities ratcheted up the concern about counterparties up to a full blown panic. As Tett explains:

So early this month some European banks – and a few US institutions as well – quietly started trying to raise new credit lines themselves. That, however, triggered additional alarm, as rumours spread about the potential losses at SIVs – on top of problems in other corners of the financial world.

Consequently, by the middle of last week, some banks started shutting credit lines to a sweeping list of institutions. “Commercial paper is now being funded on an overnight basis. The banks will not roll paper for three months,” says Dominic Konstam, head of interest rate strategy for Credit Suisse.

And while it seems that European financial institutions were particular victims of this credit squeeze, the problems – perhaps ironically – were extreme in US markets, since SIVs typically raise a large proportion of their finance in dollars. One banker admitted last week: “The attitude is ‘Don’t show me anything east of a [New York] 212 area code’. If you lend to [those banks] it could be a career-ending experience.”

Policymakers hope that some of this panic will dissipate this week following the massive emergency injections of liquidity by the ECB and US Federal Reserve. And indeed, by the end of last week, borrowing rates were stabilising…..

However, nobody close to this sector expects to see a quick solution soon. Commercial paper interest rates have not yet fallen, irrespective of central banks’ actions. In New York on Friday, they closed at their highest level for six years.

There is deep uncertainty about what the central banks will do next – making ABCP players even more reluctant to start issuing and trading again. “Nobody is going to handle commercial paper if they think the Fed could be about to cut rates or do some thing else completely unexpected overnight,” explains one. 

However, the third, most pernicious problem is that it is becoming clear central banks cannot resolve the biggest problem – a lack of clarity about valuations in structured credit markets and the almost complete loss of confidence that is infecting even the biggest and most diversified of conduit-type programmes.

Here we have a hydra-headed problem. Central bank intervention has perverse side effects. First, it creates moral hazard by bailing out the miscreants and encouraging cavalier risk-taking. Second, it is prolonging the problem, since the possibility of further action is keeping investors on the sidelines.

Consider the views of a former central banker, Ian MacFarlane, who until 2005 was Governor of the Reserve Bank of Australia. He argued last year that instability was the greatest threat to the world economy, and suggested that the current framework was not well suited to contend with it:

Looking back at the evolution of monetary and financial affairs over the past century shows that policy frameworks have had to be adjusted when they failed to cope with the emergence of a significant problem. The new framework then is pushed to its limits, resulting in a new economic problem. The lightly regulated framework of the first two decades of the 20th century was discredited by the Depression and was replaced by a heavily regulated one accompanied by discretionary fiscal and monetary policy. This in turn was discredited by the great inflation of the 1970s and was replaced by a lightly regulated one with greater emphasis on medium-term anti-inflationary monetary policy. This has acquitted itself well over the past 15 years and is still working effectively, but over the next decade or two will probably face the type of challenges I have outlined.

No one is very good at picking the next major epoch, and we mainly react after the damage has been done. I am influenced by the fact that as the great inflation of the 1970s was building from the mid-1960s, no one, including the central bank, had a mandate to prevent it. As we struggled to come to grips with it, governments made decisions that effectively gave the central bank a mandate, and central banks worked out a framework that to date has been effective in dealing with it. No one has a clear mandate at the moment to deal with the threat of major financial instability, but I cannot help but feel that the threat from that source is greater than the threat from inflation, deflation, the balance of payments and the other familiar economic variables we have confronted in the past.