Commercial Paper Market Could Lose US$500B by Thanksgiving

Bad economic booms tend to produce bad results…like runaway indebtedness and a plummeting currency. Do you happen to know of any large Western economy with these characteristics?

Sometimes, the difference between a good boom and a bad boom is very subtle and subjective. A “bad boom,” for example, might simply be a good boom that you failed to participate in. But usually, key fundamental differences differentiate the good from the bad. Bad booms tend to rely upon credit, for example, rather than earnings and savings. Therefore, when the inevitable bust occurs, credit becomes a four-letter word: Debt.

When a nation of debtors finally exhausts all its sources of additional credit, it chokes on debt. The nation of debtors can no longer sell a house to repay it creditors. Instead, the debtors must simply work to satisfy their creditors. And that’s not all. Sometimes the debtors must work for cheapened money, but repay their creditors with expensive money.

Let’s consider a simple illustration: A European creditor who loaned 100 euros to an American in 2001 will expect to receive 100 euros in repayment. He does not care that 100 euros will cost the American 65% more dollars than they did in 2001. But the American will care…especially if he loses access to easy credit.

Since bad booms rely upon ever-larger doses of credit to sustain themselves, what happens if credit creation lurches into reverse? Usually, the booms go bust…in a big way.

In fact, credit may be lurching into reverse right before our eyes.  The lenders are simply refusing to lend, which is why the commercial paper outstanding is plummeting. In a perfect world, asset-backed entities, known as “structured investment vehicles” (SIVs), borrow short-term money in the commercial paper market, then invest the proceeds in debt instruments like mortgages, credit card receivables and collateralised debt obligations (CDOs). But the borrowing part of this formula has dried up completely.

The asset-backed issuers of commercial paper cannot find any lenders to finance their toxic cocktails of lousy mortgages and “new math”.

Over the last six weeks, the (formerly) US$1.2 trillion US asset-backed commercial paper market has contracted by a whopping US$245 billion dollars. In other words, one fifth of this market has simply disappeared. Unfortunately, the SIVs still need the US$245 billion that nobody will lend them. Without the money, they must liquidate their illiquid portfolios of subprime mortgages and credit derivatives. “We’re dumping all our collateral into the market and it becomes a death spiral for the assets,” moans Brian McManus, head of collateralised debt obligation research at Wachovia Corp.

To avoid dumping their collateral on the market, however, some SIVs will try to “move back home” like an unemployed college grad. Where is home exactly? On the balance sheets of the biggest banks and brokerages firms in the US (we’re talking about the same folks who are already reeling from overexposure to various other piles of financial compost). According to the fine print in many SIV formation documents, the underwriters who issued the SIVs must provide the financing of last resort.

So far, the slow-motion crisis in the commercial paper market is unfolding behind the veil of institutionalised obfuscation. That’s because all of Wall Street wishes to keep it that way. The cold, hard truth might hold some interest for short-sellers and academics, but not for the folks who are on the hook for billions of dollars worth of mortgage-backed securities. But even a very bad boom is not so bad if an individual prepares for the bust.

Preparing would include reducing debt and diversifying savings into foreign currencies and “hard assets”. But the American financial system is not merely an “SIV problem”, it is also – and more importantly – a financial system problem. In addition to the US$250 billion of short- term financing that has already disappeared form the asset-back CP market, another US$300 billion will come due before Thanksgiving. It will come due, and it will probably not find willing lenders. So where will this US$550 billion of credit and/or collateral end up?

Probably not in a place that will please stock-market investors, or bond investors or stock market investors…especially, dollar-holders. Here’s the problem in a nutshell. Since homeowners are defaulting in record numbers, mortgage-backed securities of all types are tumbling in value. And since the prices of mortgage securities are tumbling – and since know one knows what these things are really worth – no one wants to provide financing. And since no one wants to provide financing, hundreds of billions of dollars worth of credit drops out under the asset-backed securities market.

You get the idea. As credit disappears, therefore, SIVs and other mortgage-loaded entities must either liquidate their portfolios or obtain new financing from some other channel…or dump their portfolio back on the underwriters. And the numbers involved are extremely large. The US$500 billion that might disappear from the commercial paper market before Thanksgiving could be a very big problem…for the mortgage market, for the banking system…and especially for the US dollar.

Bad booms produce bad results. That’s just the way it is. Maybe it’s time to prepare for the bust.

Eric Fry
for Markets and Money

Eric J. Fry
Eric J. Fry has been a specialist in international equities since the early 1980s. He was a professional portfolio manager for more than 10 years, specializing in international investment strategies and short- selling. Mr. Fry launched the sometimes-abrasive, mostly entertaining and always insightful Rude Awakening.
Eric J. Fry

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1 Comment on "Commercial Paper Market Could Lose US$500B by Thanksgiving"

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Coffee Addict
Eric I agree. May I add the following. The Federal Reserve is well aware that the US dollar will continue to tumble and with it the true value of US debt which is of course is mostly denominated in $US. This is akin to a “slight of hand” card trick in a high stakes game. The other players will NOT be impressed and the impact will be global. The Federal Reserve is also aware that a higher inflation rate can be the debtors friend. The true value of the debts simply gets eaten away. This is particularly the case for… Read more »
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