The Worst Is Over?

Over the past couple of weeks the Fed reported a slowing in the decline in the Asset Backed Commercial Paper market. Does this mean the worst is over?

Total nominal Asset Backed Commercial Paper outstanding peaked on August 8 at $1.17 trillion. I used the word “nominal” intentionally, because the reported totals represent face value. Since that time we became aware that a significant portion of the paper coming due in July and August paid neither principal nor interest. The holders of the remainder were FORCED to roll it over. They had no choice.

That suggests that a significant portion of the remaining paper is worthless, or nearly so. There will be no interest payments, no return of capital. Holders who have bills coming due and were counting on the return of that cash now face a dilemma. Where will they get the cash to meet their obligations? Some may still be able to borrow in the market or, if they are depositary institutions, from central banks directly. Others will need to liquidate assets. That could destabilize financial markets

This week the Fed reported that $918 billion of ABCP remains outstanding. That’s a $255 billion reduction in nominal value. It’s likely that all of that reduction was real cash that went somewhere else. In fact there’s data to support that.

Since August 8 institutional money fund assets rose by a spectacular $196 billion, and non transaction deposits in commercial banks rose by $68 billion. These are extraordinary increases, far above the preceding trend rates of increase. The total increase in these holdings was $264 billion. It is not a coincidence that this total is almost the same as the total reported drop in the ABCP market over the same period. This was real cash leaving the market going into alternative investments and parking places.

Click to enlarge

It’s no accident that money market interest rates plunged during the first 6 weeks of this cash flight out of the ABCP market. Money was flooding out of that market and there wasn’t enough paper to absorb it. Money rates and bond yields were forced down. Apparently some of the excess flowed through the stock market, driving stock prices higher. The gold and commodity markets also saw their share.

But over the past two weeks, money market interest rates and bond yields have been rising. What gives?

My guess is that this is a signal that the tsunami of cash coming out of the ABCP market is ending, and that what comes next may be a period of quiet, followed by a giant sucking sound.

In the 6 weeks from August 8 to September 19, ABCP outstanding dropped by $144 billion. At the same time, 13 week T bill rates dropped from 4.80 to 3.62, hitting a low of 3.60 on September 27. Since then the 13 week bill rate has risen steadily to 4.08 on Friday. Over the past four weeks the drop in ABCP nominal value slowed to $6 billion, apparently not enough to keep to offset the pressure on rates from those whose need for funds to pay current obligations was increasing.

This suggests that the gravy train out of the ABCP market has ended. That leaves $917 billion of nominal value on the books. How much of that is good paper? Nobody knows for sure. My Canadian banking contact told me that they were forced to roll over half the paper that came due in August. Is all of that paper bad? We just don’t know.

What we do know is that based on the slowing of the decline in nominal ABCP value and the rise in interest rates over the past several weeks, it seems likely that the one time flow of cash coming out of this market and boosting monetary aggregates and financial asset prices in the process is coming to an end.

Other evidence also suggests that is the case, not the least of which is the story being reported this weekend that 5 huge banks and the Treasury Department are in emergency talks to set up a $100 billion “super conduit” fund to keep the cash flowing and to keep bad assets off the bank’s books. Whether this gambit will enable the con to continue for another day is anyone’s guess.

The crunch in the ABCP market has now reached the point that many holders, including highly leveraged hedge funds, need to get their cash NOW. Otherwise they go poof, and the reverberations are likely to manifest themselves as waves of liquidation coursing through the financial markets.

Much of the dollar value being reported in money market funds and monetary aggregates consists of fictitious capital that has no value. We also know that a fragile daisy chain of obligations exists that, as with any giant Ponzi, must be funded by new players entering the market. Since the bad paper can’t be liquidated at a rate high enough to pay current obligations, once the Ponzi scheme begins to reverse, it becomes difficult to stop. Japan tried through the 1990s and even continues today, with only limited success.

Now the entire world faces the same problem. Unlike in the 1990s when the problem was mostly confined to Japan, bad commercial paper backed by bad collateralized debt obligations backed by bad mortgage debt, and soon to be proven bad credit card debt, has been spread throughout the world financial system by the Wall Street distribution centers.

In the 1990s Japan’s bad debt was concentrated in a few interlocking mega institutions which could be indefinitely propped by the BoJ. Today, with the bad debt so widely disseminated among countless thousands of banks, insurance companies, pension funds, and, most importantly, hedge funds, the potential for a chain reaction meltdown may be outside of the ability of the major central banks to keep from coming to fruition.

One of the few places in the world where the problems have been widely reported in the media is Canada (mostly Canadian media). A couple of months ago a number of Canada’s biggest institutions were forced to roll over commercial paper that could not be redeemed when it came to term. One of Canada’s biggest banks, National Bank, stepped in to guarantee this paper. However, my insider contact in a leading Canadian financial institution tells me the holders still have only gotten about 50% of the value due, with no end in sight. He says that the media is not reporting the whole story, that the potential losses are far larger than is being reported.

The Canadian media has also recently been reporting Bank of Canada has in recent days been furiously pumping reserves into the banking system there. This has all the earmarks of a crisis coming to a head. Is the problem confined to Canada? Not likely. We heard similar horror stories coming out of Europe in August. The ECB took action at that time to stave off an immediate crisis, but as a round of ABCP again comes due, there are pipers who must be paid.

With market interest rates again on the rise and the data showing the outflows from the ABCP market slowing, the one time boost to the financial markets, driven by the movement of cash out of the ABCP market has probably reached its zenith. The market must now come to grips with the fact that cash flowing out of that market is likely to slow to a trickle. The $917 billion in nominal value remaining in the ABCP market is a fiction. A large portion of that value is likely to never be returned to holders.

The evidence suggests that crunch time, if not here, is imminent.