For those who stop short of stuffing their mattress with banknotes, money-market funds are meant to be the next best thing. They invest their clients’ money in supposedly safe and liquid short-term instruments. But as America’s mortgage malaise has spread with shocking alacrity from one corner of the credit markets to another, even these staid creatures have been sent into spasms. This week they took centre stage, dumping potentially toxic securities and fleeing for the safety of government bills.
Though the markets had calmed down a little by August 22, central bankers cannot afford to be complacent. They have pumped large amounts of liquidity into the system over the past fortnight, and continued to do so this week. The Federal Reserve has cut the discount rate—the charge it makes for emergency lending to banks—from 6.25 percent to 5.75 percent, and lengthened the term of these loans to 30 days. It has also urged banks not to be shy in coming forward. To show there is no shame in turning to the Fed, four big banks—Citigroup, JPMorgan Chase, Wachovia and Bank of America—all this week announced they had taken the central bank up on its forceful offer.
Will this be enough? In a statement, the Fed’s rate-setting committee left the markets in little doubt that it would cut its main policy rate if their ongoing ructions hurt spending and jobs. And Ben Bernanke, the Fed’s chairman, was quoted by the head of the Senate Banking Committee as saying that he would use “all tools available” to quell the crisis. Elsewhere, Japan’s central bank put off a rate rise it had long been itching to implement; and, despite hints to the contrary, the European Central Bank could still find itself in the same position when it meets on September 6.
Stock markets have been reassured by all this. But the “locus of concern”, as the Fed’s Jeffrey Lacker put it this week, remains the more obscure market for “asset-backed” commercial paper.
Some commercial paper is easy to understand: a big company sells an IOU, which it repays in, say, 90 days. This stuff got the American financial system into trouble in 1970, when Penn Central Railroad defaulted on $82m-worth. The recent problems stem from a different brand of paper, backed not by the good name of a big company, but by assets, such as mortgages or credit-card receivables. Mostly held off-balance-sheet by bank-sponsored “conduits”, this market has boomed in recent years. It now accounts for roughly half of the more than $2 trillion of commercial paper outstanding. But issuers have been caught out by a cashflow mismatch, says Louise Purtle of CreditSights, a research firm. Funding is short term but the proceeds are invested in longer-term assets, leaving issuers vulnerable when investors start to doubt the quality of those assets and want out.
That is what happened at the start of this week as money-market funds sold these IOUs, causing rates to spike as never before. This paper suffered from two main layers of mistrust. First investors are worried that the banks won’t always be able to support the conduits.
The second worry, about the mortgage collateral, is particularly stark. Rating agencies badly misjudged default rates in subprime mortgages and are now having to downgrade reams of securities linked to them. With the credibility of ratings in tatters (there have even been calls for Warren Buffett to take over Moody’s), investors have been left without a compass. For the time being, many would rather pull back than trust in their own analysis of credit risk. They are staying on the sidelines because they can’t work out what securities are worth, not because they don’t have the money to buy them.
Ratings may be in doubt, but they remain powerful. The Fed has been offering 85 percent of face value for AAA-rated paper presented at its discount window, even collateralised-debt obligations stuffed with subprime mortgages (as long as they are not—yet—impaired). Josh Rosner, a critic of the rating agencies, thinks it extraordinary that, despite their obvious flaws, they “continue essentially to regulate the behaviour of even the central bank”.
Even if stability returns to markets, the repricing of risk is likely to continue. How far it goes will depend largely on the state of the mortgages that serve as collateral for many of the newfangled instruments that were, until recently, hawked with glee on Wall Street. The outlook is not good. Not only do subprime delinquencies continue to rise, but defaults on prime and Alt-A loans (those to good- or middling-quality borrowers) have started to climb too. Figures released this week showed foreclosures in July up by 9 percent compared with June, and by 93% over the year before.
It may be little comfort to overstretched mortgage-holders to know that the lenders are also sharing the pain. Accredited, a subprime lender, said this week it would stop taking loan applications and let more than half its workforce go. And Lehman Brothers became the first investment bank to close its subprime-lending arm, at the cost of 1,200 jobs.
Only the best borrowers—those taking out prime mortgages that conform to criteria set by Fannie Mae and Freddie Mac, the government-sponsored housing giants—can still get loans with any ease. The market for jumbo loans, which are safe but too large for Fannie or Freddie to guarantee, ground to a halt last week, although conditions have eased a bit since.
This contamination up the mortgage food chain was not unexpected. But Fed officials are said to have been taken aback by the speed with which large non-subprime lenders, such as Countrywide and Capital One, have been hit. Countrywide is America’s biggest mortgage provider, and one of its best managed. But it was still forced to draw on bank credit lines after struggling to fund itself through the usual channels. On August 22nd a rescuer arrived: Bank of America said it would make a $2 billion equity investment in Countrywide.
A jam in the flow of credit to homebuyers threatens an already vulnerable economy. If consumers seek to pay down debt in response to falling house prices, spending will suffer, especially with unemployment creeping up. If the economy falters, that should relieve price pressures too. Oil prices dropped below $70 this week from a recent peak of around $78. Richard Berner at Morgan Stanley reckons that market turmoil will itself trim inflation since “it will make buyers hesitate and sellers worry that prices won’t stick.”
Many now expect a cut in the Fed’s benchmark rate from 5.25 percent at its next policy meeting on September 18th. Some think the Fed may act sooner. But it may yet disappoint them. “Financial-market volatility, in and of itself, does not require a change in the target federal funds rate,” said Mr. Lacker this week. The Fed is anxious to calm the credit markets, so that the economy’s funds are allocated in line with risk and reward. But even if it succeeds, risky assets are likely to hold much less appeal than they did. The central banker’s task is to unscramble price signals distorted by panic, not to protect the markets from a signal that they do not like.