Posted by: Aaron Pressman on August 27, 2007
If you’re not holding securities backed by subprime mortgages, that is if you’re 98% of all investors, this summer has been a wacky ride for your portfolio but hardly a killer. The major stock indexes are still in positive ground for the year and Treasury bonds have done great. Even if you were in a money market fund with subprime exposure, there aren’t any losses yet. So why care at all? Isn’t this just the usual ups and downs the markets suffer now and then? Could be. On the other hand, problems like this have ways of spreading in the modern, interlinked global economy.
Exhibit A has to be what has happened in the commercial paper market. Used to be that banks provided all the money a business needed to function. That’s changed dramatically over the past few decades, thanks in part to the rise of the $2 trillion commercial paper market. Commercial paper consists of short-term (under 270 days maturity but mostly a week or less) securities issued by all kinds of companies and purchased by all kinds of investors including money market mutual funds. About half the market consists of companies putting up some of their assets — could be receivables, could be leases, could be mortgages — as collateral. Putting up the collateral means the companies pay a lot lower rate of interest, rating agencies grant higher ratings and the economy powers on.
But this month, especially after the failure of a money market-like fund run by Sentinel Management Group, fund managers have gotten very skittish about holding commercial paper backed by assets, subprime mortgage or otherwise (Sentinel was running a supposedly low-risk fund for big futures traders to stash cash). Which big mutual fund company, after all, wants to read about how they’re behaving recklessly or putting their customers in jeopardy? Hence, a flight to quality based not on the actual risks embodied in the asset-backed paper but on the fear of being tarred with the brush of scandal. The amount of commercial paper outstanding dropped by almost 10% in two weeks, including the biggest one-week decline in seven years, and yields on Treasury bills, the unquestionably ultra-safe, panic-proof investment of choice, took the biggest dip since…since a really long time ago (I’ll find that link yet). If there’s no demand for commercial paper, a lot of companies in all kinds of businesses will suffer and suddenly the subprime crisis has spread and you start to think the R word: recession.
-Total commercial paper outstanding according to the Fed
To that end, there’s an important story about the lending environment by my colleague Peter Coy in this week’s magazine. The Federal Reserve is trying to ensure that the subprime damage is contained, but as Peter notes, “the lending mistakes of the past several years were too serious to be fixed by a quick rewrite at the Fed.” Rates on commercial paper remain elevated, so it’s worth tracking how high those rates go and how much further the market shrinks to gauge just how deeply the pain will spread. The Fed’s next weekly release about the amount of paper outstanding comes on August 30. Fund manager David Merkel has been doing yeoman’s work keeping on trends in this neck of the woods on his blog lately.
A little update: Brett Steenbarger this afternoon looks for previous previous periods of commercial paper-visible anxiety since 1980. In all three prior instances he turned up — fall 1982, late 1987 and October 1998 — the market shortly zoomed higher.
As a final aside, and before we demonize all new ideas in finance, I’ll recommend that everyone read the excellent piece on the insurance industry by Michael Lewis in Sunday’s New York Times Magazine. With plenty of writing skill and space to explain, Lewis lays out how the financial markets could save the insurance industry from catastrophe. A single big earth quake or hurricane hitting a 21st century mega-opolis like Tokyo or New York could cost hundreds of billions and bankrupt major insurers. But losses on that scale are a drop in the bucket compared to the $59 trillion value of the world’s securities markets. Spreading the risk through increased issuance of catastrophe bonds makes a lot of sense, Lewis argues.