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.”