Ten Notes on Our Crazy Credit Markets

This post may be a little more disjointed than some of my posts.  Recently I have been working on calculating the fair value for mezzanine tranches of a series of real estate oriented CDOs.  Not pretty.  Anyway, here are few articles that got me thinking yesterday:

  1. Let’s  start with CD rates.  Bloomberg had a nifty table on its system which I can’t reproduce here, except to point you to the data source at the Fed.  Note how one-, three-, and six-month CD rates have been rising, somewhat in sync with LIBOR, but widening the gap with Treasury yields. (Hit your “end” button to see the most recent rates…)
  2. As a result, I have been debating whether the FOMC might not do a 50 basis point loosen next Tuesday.  CDs aren’t the bulk of how most banks fund themselves, but they can be a way to get a lot of cash fast.  Remember that after labor unemployment and inflation, the Fed’s hidden third mandate is protecting the depositary financial system, particularly the portion that belongs to the Federal Reserve System.
  3. Now, I’m not the only one wondering about what the FOMC will do.  There’s Greg Ip at The WSJ, who speculates on the size of the cut, and whether the discount rate might not be cut even more, with a loosening of terms and conditions as well.  Bloomberg echoes the same themes.  Even the normally placid Tony Crescenzi sounds worried if the FOMC doesn’t act aggressively here.
  4. The US isn’t the only place where this is a worry.  The Bank of Canada cut rates yesterday, as noted by Trader’s Narrative, partly because of credit pressures in Canada and the US.  The Financial Times notes that Euro-LIBOR [Euribor] is also rising vs. Government short-term yields, which may prompt the ECB to cut as well.  Or, they also could cut their version of the discount rate, or liberalize terms.
  5. It doesn’t make sense to me, but the Yen is weakening at present.  With forward interest rate differentials narrowing as more central banks tip toward easing, I would expect the carry trade to weaken; instead, it is growing.  For now.
  6. As noted by Marc Chandler, the Gulf States have largely decided to keep their US Dollar peg.  I found the article to be interesting and somewhat counterintuitive at points, but hey, I learned something.  Inflation is rising in Kuwait after they switched from the US Dollar to a basket of currencies, because residential real estate prices are rising.
  7. Credit problems continue to emerge on the short end of the yield curve.  Accrued Interest has a good summary of the problems in money market funds.  It almost seems like Florida is a “trouble magnet.”  If it’s not hurricanes, it’s bad money management.  Then there’s Orange County, which has a 20% slug of SIV-debt in its Extended Fund.  It’s all highly rated, so they say, but ratings don’t always equate to credit quality, particularly in unseasoned investment classes.  Then there’s the credit stress from borrowers drawing down on standby lines of credit, which further taxes the capital of the banks.
  8. As a final note, both here (point 6) and at RealMoney, I was very critical of S&P and Moody’s when they decided to rate CPDO [Constant Proportion Debt Obligation] paper AAA.  I’ll let the excellent blog Alea take the victory lap though.  We finally have CPDOs that are taking on serious losses (and here).
  9. In summary, we are increasingly in a situation where the major central banks of our world are reflating their currencies as a group in an effort to inflate away embedded credit problems.  Most of the credit problems are too deep for a lowering of the financing rate to solve, though it will help financial institutions with modest-to-moderate-sized credit problems (say, less than 25% of tangible net worth — does the rule of thumb for P&C reinsurers apply to banks?).  This can continue for some time, and credit spreads and yield curves should continue to widen, and inflation (when fairly measured) should increase.  Some of the inflation will move to assets that aren’t presently troubled, perhaps commodities, and higher quality equities, which are doing relatively well of late.
  10. Quite an environment.  The big question is when the “free lunch” period for the rate cuts end, and the hard policy choices need to be made.  My guess is that would be in mid-to-late 2008, just in time for the elections.  Now, wouldn’t that spice things up? 🙂