Problems in the Credit and Stock Markets Are Not Over Yet

The article below from the Financial Post (Canada) gives another perspective on the markets. I prefer the views from outside the US, they tend to be less inclined to see the world through rose colored glasses.

Stock and bond markets regained a modicum of stability yesterday, but ongoing gyrations in the commercial-paper market indicate the U.S. subprime crisis is far from over and the risk of further financial-market contagion remains high.

Short-term U.S. government paper remains the haven of choice for rattled investors as they wait to see whether the Federal Reserve's discount rate manoeuvring and liquidity injections will be enough to prevent a seizure of the financial system or damage to the underlying U.S. economy.
Economists, who only weeks ago almost uniformly predicted the subprime-mortgage mess would remain "contained," are now all over the map with their prognostications, (my emphasis) while interest-rate futures predict the Fed will ultimately have to ride to the rescue with cuts to its more influential target rate.

Stock markets, usually considered more flighty than the more cerebral debt markets, may hold the key to how the drama unfolds.

On the pessimistic side, Stephen King, group chief economist at HSBC in London, wrote in a note: "Should the panic exhibited over the last few days turn into revulsion, the markets may never be the same again. The implied liquidity drain might leave the financial system, and the broader economy, more vulnerable than we currently believe."

The world economy "is now at risk from financial market seizure," he added.

Debt-rating agency Moody's Investors Service Inc. is adamant, however, that the global financial system can absorb the massive deleveraging going on.

"We continue to believe that, notwithstanding possible earnings depression due to asset impairment, higher funding costs and lower business volumes, the 'core' of the system is comfortably shock resistant."

While there may be problems at the periphery -- two small German banks have already triggered a bailout -- Moody's said core financial institutions such as the largest and most sophisticated U.S. and international financial firms have a "pretty high" pain threshold, higher even than in 1998 when the system was also under stress.

Still, it is clear that financial institutions all over the globe are now scrambling to off-load tainted debt. Yields on three-month U.S. T-bills tumbled more on Monday than on Black Monday in October, 1987, as investors fled money-market funds that may have exposure to debt linked to subprime loans or asset-backed commercial paper.

In the United States, half the US$1-trillion asset-backed commercial-paper market comes due in the next 60 days and buyers are likely to be scarce.

Dominic Konstam, head of interest rates at Credit Suisse First Boston in New York, said parts of the debt market are already constricting. "Illiquidity is showing up everywhere, even in the rates market, the swaps market, he repo market is going ballistic," he said.

Banks are getting unwanted collateral on their balance sheets. "Either because a [commercial paper] program fails or because there's a hedge-fund margin call and hedge funds are liquidating positions or ... because they've got a pipeline of corporate loans they can't get rid of because they can't collateralize them anymore, so they're having to finance these assets."

To ease the constraints, the Fed cut the rate it charges to banks to borrow to 5.75% from 6.25% on Friday. But interest-rate futures are still expecting it to cut the rate banks charge each other by at least 25 basis points on Sept. 18., or even sooner.

However, Mr. Konstam said the Fed will hold out as long as possible to see if its liquidity moves work.

"At the end of the day, you're probably not going to see that much borrowing going on [at the discount window] and that means that for all the panic and screaming out of Wall Street, banks are finding ways of financing themselves without too much stress, without sort of wholesale liquidation of these assets at rock-bottom prices."

Companies, which have had robust profits, have not really had to borrow much this cycle, except to fund their takeover binges, he said. It is only when they start having trouble finding funding to build a factory or expand a plant that the liquidity crisis turns into a crunch, which could hurt the underlying economy.

With debt markets now wrapped in a blanket of fear, it is share prices that are probably now in a better position to sniff out whether this is happening. If they start to seriously crumble again, the Fed will likely move forward with a cut to the fed funds target, moral hazard be damned.