Quarter Life Crisis

Structured finance has been a hot area the past few years. However, it is this same area that is getting hammered right now. Thanks to foreclosures due to people getting in over their heads with jumbo, piggyback, NINJA (no income no job or assets) loans, etc. It’s not just that, but private equity firms used to demand covenant-lite loans, in which there are less restrictions to the borrower. Structured finance basically deals with the securitization of assets. Assets, or collateral, comprise of debt instruments such as bonds and mortgages (2 types of loans). The product of this securitization is a collateralized debt obligation, or CDO.

Another area being affected by the credit crunch is the commercial paper, or CP, market. Commercial paper  are short term securities issued by big business with stellar credit ratings. They can usually at secure rates better than what they could get through a bank. Although CP is supposedly safe, it was discovered that CDOs that served as their collateral had bad mortgages as the underlying asset. This froze up the CP market, which is very problematic for business because they depend on this short term financing for day-to-day operations. On top of that, many corporations have conduits - subsidiaries which are funded through commercial paper, investing that money in longer-term, higher yielding bonds. Funding a long-term loan with short-term financing is very risky; now they face issues of paying back previous CP without being able to secure new CP funding, and trying to maintain their bond positions.

The Fed’s response has been to slash the discount rate. The Fed will make loans to banks while taking on their bad MBS (mortgage-backed securities) as collateral. This is controversial. In addition, instead of just an overnight loan it is now stretched to 30 days, which is quite lenient. Don’t get the discount rate confused with the federal funds target rate which is what is referred to when the media talks about the Fed raising or lowering interest rates. The Fed, as well as the central banks of other countries (such as ECB in Europe), have been trying to flood the markets with liquidity in order to revive the market out of this cash freeze and unavailability of funds. Banks have been unwilling to lend even with each other, as the actual federal funds target rate (the rate at which banks borrow from each other) has been lower than the actual rate. It means that banks are unwilling to lend to each other at the 5.25% target rate; the actual rate is higher than that. Banks are trying to hold on to their cash.

It will be interesting to see how this shakes out. Lehman Brothers, the leader in selling bonds backed by risky mortgages (subprime loans), is laying off 4.2% of its workforce, or about 1,200 people… not good news.