Over the past few years I have been watching Commercial Paper (CP) with interest. It’s the lifeblood of the credit markets and responsible for the ability to create the financial innovations in derivatives.The issue of various types of CP, i.e short term lending, allowed the channelling of funds into SIVs  and Conduits to purchase longer term assets whilst rolling over the CP. 

This worked well as long as the returns from the long term assets covered the cost of the CP.  Of course, other types of derivatives are involved such as Credit Default Swaps (CDS) as “insurance” and many of the long term assets bought with the CP lending were CDO, MBS etc.

Problems arose as default rates on the CDO, MBS etc bought by the SIV/Conduit structures climbed and the ratings were cut. Banks and others became wary of lending funds in exchange for CP when those funds were to be used to buy CDO/MBS. The chances of a default occurring had increased and Banks themselves found a need to hoard cash to ensure adequate capital as the CDO/MBS they owned became toxic.

As we see today the problem has spread wider and further than the Establishment expected (but not the bloggers and independents) causing distress in the Insurance sector (ACA,MBIA etc) and putting pressure on the ratings of municipal bonds.

Watching CP issuance can give us clues as to the level of distress either felt or perceived by the Banks. Here is a chart showing the latest CP information as collated by The Federal Reserve:

Thanks to Doug Noland I don’t have to add up the totals each week, Doug does it in his excellent weekly round up:

“Total Commercial Paper rose $14.4bn to $1.813 TN. CP has declined $411bn over the past 22 weeks. Asset-backed CP added $4.8bn (22-wk drop of $417bn) last week to $779bn. Over the past year, total CP has contracted $177bn, or 8.9%, with ABCP down $290bn (27%).”

 Asset backed CP continues to struggle although it did see an uptick in issuance as at the 10th Jan, with financial CP still rising from the low in Aug 07. More worryingly is the renewed downturn in nonfinancial CP.

I read this quite simply as Banks allowing issuance for themselves, probably for their own benefit whilst an ongoing aversion to lending, which maybe accelerating, exists for everyone else. Why though is nonfinancial CP suddenly seeing a large reversal? I suspect it is combination of 2 circumstances.

Firstly timing, the latest drop happened as the year rolled over. I suspect a lot of NFCP maturing was not rolled over. We may well be seeing the effects in stock markets as positions have been unwound with the withdrawal of leverage.  I’m wondering how many Hedge Funds had “margin calls”?

The Second circumstance is less clear and might be an attempt to front run a problem. Again I owe Doug Noland a drink as he too picked up on the problem facing Corporate Debt. This from Bloomberg:

 “January 9 – Bloomberg (Hamish Risk and Shannon D. Harrington): “The risk of companies defaulting on their debt soared to a record after Goldman Sachs Group Inc. said the U.S. economy is probably slipping into recession and bond insurer MBIA Inc. said it will cut its dividend to preserve its top credit rating. Credit-default swaps tied to…MBIA and …Countrywide Financial Corp. rose to all-time highs, while the Markit CDX North America Investment Grade Index and Markit iTraxx Hi Vol index both jumped to the widest since they were created in 2004.” ”

I suspect the days of market players ignoring widening spreads are over. Rather than trying to convince themselves and others that problems will be contained within a distressed debt sector, warnings like the one above can now only cause fear for market participants.   Indeed rather than wait for further evidence of deterioration, I suspect the Corporate Debt market may well see an imminent and prolonged period of selling.

The pressure on stock markets, as corporate spreads widen, could become intense.  

Market Snippets

 HEDGE FUNDS: Hedge Fund Research notes that inflows into hedge funds rose 54% or by $194.5 billion to $1.87 trillion in 2007, Institutional Investor’s Hedge Fund Daily reports. However, over the
last quarter, inflows were at a quarterly low of $30.4bn, and “well behind the pace of each of the first three quarters…,” the report says.

Merrill Lynch’s January portfolio manager survey asked hedge fund managers whether they had taken specific steps over the past month to increase or decrease exposure to volatility. a net 17% of managers said there were looking to decrease exposure, compared to 5% in Dec, 8% inNovember, and October, where a net 24% of managers were looking to increase their exposure to volatility.  

 NEW YORK (AP) – Bond insurer Ambac Financial Group Inc. said Wednesday it will issue at least $1 billion of equity and securities as part of a plan to boost its capital reserves and maintain its vital “AAA” financial strength rating.  Ambac also slashed its dividend by two-thirds to 7 cents and replaced its chief executive.

Ambac and other bond insurers make payments to cover principal and interest on bonds when issuers are unable to meet their payment obligations. Bond insurers essentially need a “AAA” rating to continue booking new business. Fitch Ratings warned it would downgrade Ambac if it was unable to raise at least $1 billion to cover potential future losses.

Commentary by Mick Phoenix

on behalf of An occasional letter from The Collection Agency

Please Note: This article is to inform your thinking, not lead it. Only you can decide the best place for your money, and any decision you make will put your money at risk. Information or data included here may have already been overtaken by events – and must be verified elsewhere – should you choose to act on it. The views in the article are for informational purpose only.