Crunchy Credit

My head feels like mush.  I have been struggling over creating a CDO pricing model with the following features:

  • A knockoff of the KMV model, using equity market-oriented variables to price credit.
  • Uncorrelated reduced discrepancy point sets for the random number generator.
  • A regime-switching boom-bust cycle for credit
  • Differing default intensities for trust preferred securities vs. CMBS vs. senior unsecured notes.

Makes my head spin, but at least the credit model is complete.  The rest of the model can be done tomorrow.

Ugh, so what was I going to talk about?  Oh yeah, the short term lending markets.  So the ECB makes a splash by showering temporary liquidity on the short end of the market.  That will reduce Euribor-based rates, but not US dollar-LIBOR based rates.  Check with Dr. Jeff for more on that.  Now, Dr. Jeff and I might not agree on the significance of this move, because I discount temporary injections of liquidity.  What will happen to liquidity conditions when the temporary injection goes away?  My view is that they will go back to how they were before the temporary injection.  The only way that would not be so is if the temporary injection somehow changes the willingness of parties to take risk, and I think most large investors can see through the temporary nature of the injection.  The ECB can keep short-term Euribor down for a while, but unless they make some of the injection permanent, conditions will revert.  People and institutions can’t be fooled that easily.

Topic two: the WSJ article on the credit crunch.  The author posits two disaster scenarios:

  1. A financial guarantor going down, or
  2. Many money market  funds  “breaking the buck.”

Here’s my view:  The financial guarantors have been too profitable for too long.  There will be parties wiling to recapitalize them, though not necessarily at values that make current equityholders happy.  They are not going broke; the major firms will be recapitalized.

Regarding the second fear, a few money market funds will break, but the wide majority of money market funds won’t.  Most short term debt managers are highly conservative, and don’t take inordinate risks.  To do so would threaten their franchise, which would be stupid.

Things are not good, don’t get me wrong, but it would be very difficult to destroy most of the investment markets on the short end of the yield curve.  Away from that, the actions of the ECB will only have modest impacts on USD-LIBOR.