The Asset-Backed Commercial Paper Crisis: Just Another Credit Boom Gone Bad

by: Michael Shedlock

In one of the best articles I have read in month if not much longer, Minyanville's Mr. Practical was asking What Future Does the Credit Crunch Bring?

As the general public is fed old financial news day in and day out by TV, news of what happened already, let’s look at some forward-looking current facts.

The most important data release yesterday was the weekly Federal Reserve commercial paper outstanding number. Asset-backed commercial paper fell a further 3.1% for the week to $966.7 bln. Overall commercial paper outstanding fell by $54.1 bln. Total commercial paper outstanding has fallen 13.4% in one month. During the 2001 downturn, commercial paper peaked in November 2000 and slid through to December 2003. Over that three-year period it declined by only 22%.

15-day commercial paper is yielding 6.3%, 90 basis points higher than a month ago. Treasuries are 200 basis points below these levels.

Credit in the system is contracting fast. As a result, signs of weakness in the economy will appear fast.

Libor rates remain at extremely elevated levels, also suggesting that the credit crunch in debt markets is as bad as it has been despite more liquidity injections from the ECB. Something is very wrong in the financial system. Does that not have vast implications to an economy that is built on the financial industry with over 30% of all S&P 500 earnings based on financial companies?


Harley-Davidson (NYSE:HOG), the biggest U.S. motorcycle maker, scaled back its forecast for deliveries amid a "difficult time" in the U.S.

Harley-Davidson expects to ship 86,000 to 88,000 motorcycles of its main brand in the third quarter instead of a previous forecast of 91,000 to 95,000 units, the Milwaukee, Wisconsin-based company said today in a PR Newswire statement. The company expects a "modest'' decline in 2007 revenue and earnings per share to fall to between $3.69 and $3.77 from last year's $3.93 per share, Harley-Davidson said. Full-year deliveries will total 328,000 to 332,000 motorcycles. Shipments are coming down 7%; EPS being cut by 10%.

Harley-Davidson is a nearly perfect example of a business benefiting from the credit boom on the way up and suffering on the way down. The telling thing is the speed with which they are being affected: this credit contraction which began in the beginning of August is already affecting the big end consumer market (Harley-Davidson bikes are definitely discretionary items for the middle and high end consumer, statistically speaking).

... HSBC Chief Executive Michael Geoghegan said it is hard to say whether the worst of the global credit crunch is over yet, the Hong Kong Economic Times reported Friday.

Geoghegan added that the credit problem was a matter of market confidence and might not be resolved by slashing interest rates.

This is what they who own all that debt (this bank is really at risk) would have you believe. It is only a matter of confidence.

Well, confidence is born of value. If you know you can swing a golf club, you are confident.

When you have too much debt, how can you be confident?

And the London Times reports that Barclay's (NYSE:BCS) could be on the hook for another of its ABCP SIVs (special investment vehicle) - Barclays is offering to underwrite the $1 bln rescue of another highly geared fund that got into trouble because of the liquidity squeeze. Mainsail II, a $4.5 bln (£2.2 bln) structured investment vehicle designed by Barclays Capital and managed by the hedge fund group Solent Capital, had been forced to start selling assets as it struggled to roll over finance in the commercial paper market. The plan is to pay out CP investors at par without the Barclays line.

For those of you not up on SIVs, they are just off-balance pockets of debt that banks have created to borrow short term and lend longer term. They do it off-balance so as not to require much capital, thus throwing off huge margins at huge risk. That risk is now coming due.

If we assume that the last five years of economic growth is almost all credit-induced, and now that credit is contracting, we must conclude that future economic growth is clearly in danger. The problem with recession is that the enormous debt that exists must be serviced still. If it can’t be serviced, it must be destroyed through default. That is deflation.

Chart of the Week

The Chart of the week is a chart of asset-backed commercial paper courtesy of Minyanville's Bennet Sedacca.

In the chart below, note the drastic drop in asset backed commercial paper. In a mere four weeks, nearly 20% of the entire market has evaporated. Yes, evaporated. This is otherwise known as debt deflation or credit destruction. It is why I continue to be cautious about credit risk and financial markets in general.

Of note, there is a lot of issuance starting to surface in the longer term fixed rate corporate bond arena. I expect this to continue and feel that spreads will continue to widen and put pressure on profit margins.

Credit Problems vs. Market Confidence

As for the idea "credit problems are a matter of market confidence" ... a better way of stating it is: "credit problems arise from previous market overconfidence".

Certainly a major source of the problems we have seen to recently started with unwarranted overconfidence and belief in models suggesting that home prices always go up. See "Fitch Discloses Its Fatally Flawed Rating Model," for a discussion of one such massively flawed model.

Overconfidence in housing prices led to all sorts of foolish lending practices. Those debts can never be paid back.

Another source of overconfidence is called the Greenspan Put. Today, there still remains a misguided belief that the Fed can rescue the market from any problem. It can't for the simple reason the Fed cannot force consumers to borrow or banks to lend.

Look at the recent jobs numbers as depicted in "Moonbats Active Again in Massive Jobs Disaster." What lenders want to take on additional massive risk in the face of that? Some may, but they will likely be punished for it.

What borrowers want to take on extra debt now? Once again some might but they too are likely to regret it. And those taking on debt out of desperation (no other source of funds) will eventually default causing the lender to regret extending credit. Once the default rates gets high enough (and they will), the willingness to extend credit will further shrink.

Jobs are the key and the jobs picture is bleak.

I keep mentioning this but it is a very important concept to understand: the Fed can only encourage lending and borrowing, it simply cannot force either lending or borrowing, nor can the Fed physically drop money out of helicopters. Besides, the Fed would not drop money out of helicopters even if they could, for the simple reason it would destroy their own wealth.

The Fed's Limitations

Mr. Practical weighed in about the Fed's Limitations in reply to a reader question about the 12 Federal Reserve Banks: Minyan Mailbag: The Fed's Limitations

Ultimately, the Fed is not a bottomless pit there for the discretions of politicians eager to please constituents (bail them out). The Fed does have a monopoly on money, which provides a nice steady income to its shareholders as monopolies usually do. These shareholders know who butters their bread, but when push comes to shove, they won't feed their bread to the birds.

Bernanke cannot "drop dollars from helicoptors" to the "nth" degree because that would plummet the Fed's balance sheet into ruins. He is already stretching the rules to the breaking point (allowing less than pristine collateral to lend more credit to banks, allowing increased lending with that collateral from banks to their non-banking entities like brokerage, etc., etc.).

There is a limit and that limit is fast approaching.

-Mr. Practical

With that in mind, someone please tell me how interest on all this leverage can be paid, how enormous carry trades that need to be unwound can be unwound without causing a catastrophe somewhere, why there will not be a major debt insurance company blow sky high causing a cascade in defaults, and how $300-$500 trillion in derivatives and swaps floating around all of it marked to model as opposed to marked to market can all ever be paid paid out or collected on when asset prices start dropping on a sustained basis?

It can't be done. It only appears possible because credit had been expanding fast enough to allow interest on previous debt to be paid.

Once credit contracts and asset prices drop it becomes impossible to service debt. The greatest financial experiment in history has really been nothing but one giant ponzi scheme of willingness to extend credit all based on models that asset prices only go up and/or the Fed can solve every crisis by throwing more money at it.

Very few ever bother to figure out what the limitations of the Fed are. Most presented with the rationale are quick to discard it. And there is still rampant faith in the Fed, "misguided overconfidence" actually, that inflation is a one way street from the past, to the present, to the future.

But the same was said about housing wasn't it? Just two years ago, in fact. Right? Remember the saying that housing prices have never gone down nationally and they never will either? Even Greenspan believed that as late as May 2006, long after the housing bubble had burst. I will have more on "Wrong Way Greenspan" later this week.

But did confidence prevent housing prices from collapsing or did overconfidence in a flawed model cause a lending boom that virtually guaranteed a housing collapse?

The limitation in housing was the inability of borrowers to service mortgage loans once home prices stopped rising. For a while credit expansion related to housing continued as consumers treated their house as an ATM. That ATM has now gone in reverse. It is no longer dispensing cash. The housing ATM has now turned into a vacuum that is sucking up dollars faster than people can come up with them.

The shattering of the housing myth makes it one myth down and one to go. Likewise, the myth that inflation is a one way street from past, to present, to future will be shattered as well.

Credit booms do not end in inflation as most people believe, but instead credit booms are inflation that end in deflation. This credit boom is not any different.

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