A New Risk to the Credit Markets


Forget about subprime. With billions in asset-backed commercial paper about to expire, the U.S. debt market is facing yet another challenge

The shaky U.S. credit markets will face a critical test over the next few weeks, as companies try to find buyers for hundreds of billions of dollars in short-term debt that is set to expire. Corporate borrowers are expected to struggle in refinancing their debts, and the repercussions may go far beyond the companies in question. As they pay higher interest rates or turn to expensive alternatives to short-term debt, the higher costs are likely to be passed on to consumers and businesses throughout the economy, potentially pushing up the costs of everything from credit-card debt to auto loans and mortgages.

The tightest squeeze may come in what's known as the asset-backed commercial paper market. While the most creditworthy companies, such as General Electric (GE), can raise money through short-term commercial paper without putting up any collateral, riskier issuers such as mortgage companies pledge assets against their debts, hence the asset-backed name. About $417 billion worth of asset-backed commercial paper is scheduled to come due during the weeks of Sept. 10 and Sept. 17, or about half of the $959 billion market, according to Sherif Hamid, an investment-grade credit strategist at Lehman Brothers (LEH).

Feeling the Heat

The overall commercial paper market is about $2 trillion. Companies from mortgage lenders and credit-card issuers to industrial manufacturers and auto lenders issue the notes, which typically come due in about 30 days. The largest issuers include GE, Morgan Stanley (MS), Ford Motor (F), AT&T (T), Johnson & Johnson (JNJ), and IBM (IBM).

While few people outside of the world of finance have heard of the asset-backed market, that may soon change. Edward Yardeni, economist and strategist with Yardeni Research, says it is displacing the subprime mortgage market as the "epicenter" of the credit crunch (BusinessWeek.com, 7/27/07).

The signs of trouble are already clear. The asset-backed commercial paper market has shrunk markedly in recent weeks, declining nearly 20% from the $1.2 trillion total this summer. Maturities are also on the decline, dropping from an average of nearly two months to about one month. And average interest rates have risen from the 5% range to the 6% range, according to the credit-rating agency Moody's (MCO). In other words, corporate borrowers are feeling the heat from all sides: They're finding fewer investors willing to hold their debt, and when they do, the borrowers have to pay more for less favorable terms.

The question now is whether the fears explicit in this one market will spread throughout the economy, and if so how far. If investors grow skittish about other kinds of debt, it may make borrowing by consumers and businesses more expensive and difficult to obtain. "The question now is, How badly does it impact other parts of the market?" Hamid says.

Downward Spiral

Concerns about the asset-backed commercial paper market are regarded as a major factor in the Federal Reserve's stance on interest rates. The Fed is expected to lower the federal funds rate, which banks pay one another on short-term loans, at its meeting on Sept. 18. One reason is that banks are being forced to put debt that is forced out of the asset-backed market onto their own balance sheets. That's because banks are often the lender of last resort for issuers that can't sell their commercial paper elsewhere.

The Fed will give the banks a break by dropping rates, thereby reducing the cost of carrying commercial paper on their balance, which will require the banks to incur borrowing costs and set aside larger cash reserves. "Fed accommodation can be helpful, though it can take time for liquidity to work its way back through the system," Hamid says.

Credit analysts and investors are concerned about the lower-quality tiers of the asset-backed market. Among the lower tiers are pools that only include a single kind of debt, such as paper from one company, or a particular industry. It also includes pools known as structured investment vehicles (SIVs). Banks issue SIVs as a form of off-balance sheet debt. One SIV, known as Cheyne, already has been forced to unwind (BusinessWeek.com, 9/10/07).

Pumping Up Reserves

Analysts such as Hamid expect more SIVs to unwind. But it is difficult for them to know which ones are at risk. SIVs do not issue registered securities, which makes it tough to identify those with the most exposure to the mortgage market, where fears about subprime debt are depressing the market value of prime and subprime mortgages alike.

Moody's placed a number of SIVs, including Kestrel Funding, Axon Financial Funding, Rhinebridge, and Victoria Finance, on credit watch with negative implications. "It is highly likely there will be a few more in that position, but it is difficult to say which ones, because many of them have bank sponsors that could bail them out," says Paul Kerlogue, senior credit officer at Moody's office in London. "Certainly, the ones that were downgraded are in the most difficulty," he says.

Banks such as Citi (C), which has $100 billion worth of exposure to SIVs, will have to lend money to some SIVs and put those loans on their balance sheet. The reserves for losses from loans are likely to increase, JPMorgan (JPM) banking analyst Vivek Juneja said Wednesday in a note on Citi. A spokesman for Citi took issue with that assertion. "We are very comfortable with the quality of the highly rated assets in the SIV portfolios managed by Citi Alternative Investments, as well as the multi-seller conduits managed by Markets and Banking. We employ rigorous credit thresholds for both," said the spokesman on Sept. 12 in a statement to BusinessWeek.

Debt Market Jitters

If more issuers of asset-backed commercial paper follow in Cheyne's footsteps and are forced to sell parts of their portfolio at low prices or close up shop, the impact on the broader credit market could be severe. The fear isn't really about the fate of the funds themselves. They have access to a certain amount of cash, enabling them to sell their assets in an orderly fashion over a period of months. The fear is that the sale would make investors reluctant to buy any sort of credit, driving up the cost of loans that have nothing to do with asset-backed commercial paper.

There is some evidence the process has started. That isn't good news for an economy that is slowing at best (BusinessWeek, 9/17/07) and heading toward recession at worst. Citi expects subprime-related issues to have a negative impact on the economy and drive higher consumer loan losses. Juneja noted that the expectation of a slowdown in the consumer economy has led banks to boost reserves against credit-card debt, even though credit quality in cards is currently stable.

That pushes lending rates higher. Because money that's held in reserve isn't generating returns for banks, the banks need to charge more interest on the money that they do lend out. When the cost of providing credit rises so much, it must be passed along at some point, says Moody's Kerlogue.

Fear is now a reality in the short-term debt markets. The next two weeks may determine how far it will spread in the broader credit markets and how the U.S. economy will fare in the months ahead.


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