Market improvement but still hidden credit IEDs

While there has been improvement in the credit markets, the problems are still not solved. Some positive improvement has been the more rational pricing in the Treasury market. The flight to quality has slowed so that the almost irrational Treasury yields of the last week have moved closer to normal. The relationships between Treasury bills and repo rates have also improved. The problem is still the high spread for commercial paper and the significant declines in financing. You can see the reduction in CP outstanding from the Fed. It may be an understatement to say that Investors have not returned to the CP market.

What is stopping the investors from picking up "attractive" yields? They are not attractive! There is too much uncertainty that cannot be quantified especially with what could be characterized as credit IEDs. There are a number of complex structures in the ABS CP market. For example, SIV-lite deals whereby the long-term sub-prime mortgages are financed through the CP market. This is the classic borrowing short and lending long problem. There is no financing available and the collateral has fallen into the tank. Should we have expected any different given a slowing economy and flattened yield curve?

The credit IED problem is made more difficult through the re-rating of deals by the rating agencies. It is not clear what the new rating standards will be, so all deals are at risk. You cannot avoid the price revaluation if the rating falls. There are few people who would be willing to stand in front of the rating truck that is adjusting their views on structured deals.

While not an expected scenario, one of the advantages of structured finance is the belief that there will be limited event risk. A deal is stress tested and the rating will be based on these tests. The expectations is that the rating agencies when they provide their rating would account for different economic and markets scenarios. Fitch has now stated they are re-rating their sub-prime structured deals. S&P and Moody’s have also started this process. Where will the next credit blow-up occur? Who knows? All we know is that the rating agencies, in an attempt to right past wrongs, will be contributing to the uncertainty and create the potential for more credit explosions. However, are there any alternatives?