Low-risk debt moved into a high-risk neighborhood Tuesday, taking major averages along for the descent. Financial institutions and money market funds that are exposed to so-called low risk, short-term debt that's collateralized by mortgage-backed securities may be in jeopardy. So far, the problems with short-term debt, called asset-backed commercial paper, are reportedly limited to Sentinel Management Group, an Illinois-based money management firm, and Coventree, a Canadian company that organizes commercial paper sales for companies seeking the short-term financing. But the potential for contagion has increased amid fears that short-term financing obstacles could lead to further drying up of liquidity across the board. "This really turns it up a notch in terms of systemic risk," says Christian Stracke, analyst at CreditSights, an independent fixed-income research firm. In reaction, the Dow Jones Industrial Average fell 208 points, or 1.6% to close at 13,028.92 while the S&P 500 fell 1.8% to close at 1426.56 and the Nasdaq Composite declined 1.7% to close at 2499.12. (Risk of additional declines Wednesday accelerated after the close as Applied Materials ( AMAT) issued cautious comments about its fiscal fourth quarter.) The CBOE Volatility index, or VIX, which is an indicator of fear, ended near its highs for the day, up 4.7% at 27.83. The Amex Securities Broker Dealer Index slid 3.1% amid more losses for big brokers, including Lehman Brothers ( LEH)and Goldman Sachs ( GS). The stock and credit markets have been extremely volatile since the subprime mortgage market sparked a correction in riskier debt assets. Mystery surrounding the valuation of derivatives called collateralized debt obligations has also led to liquidity drying up, a scenario so real that it recently required extra liquidity injections from central banks around the world.
Fueling Tuesday's chaos and fears of economic fallout, mortgage lending has come to a virtual halt, even for originators of jumbo loans, or large loans to borrowers with high credit ratings. Thornburg Mortgage ( TMA) shares were down 46% Tuesday, when the New York Stock Exchange halted trading pending news. Thornburg had declined because the company announced Tuesday that it was temporarily suspending locking in rates on any mortgages. After the closing bell, the company said it would delay payment of its quarterly dividend and said its book value per share fell to $14.28 as of Monday vs. $19.39 at the end of June, Reuters reports. But more importantly, the company said it faced a "sudden and unprecedented decline" in prices for its higher-rated securities -- those with AAA ratings. Thornburg said it was not having problems meeting its commercial paper obligations. But it is exactly those higher-rated mortgage-backed securities that can be used as collateral in the asset-backed commercial paper market that took center stage Tuesday. "The potential of broadening of systemic risk as a result of liquidity providers' conditional exposure to the
asset-backed commercial paper market now looms as the most pressing issue facing financial markets," writes Jeffrey Rosenberg, chief fixed-income strategist at Bank of America. Asset-backed commercial paper is debt with a maturity of typically 90 to 180 days issued by a bank or financial institution, which uses the borrowings for normal business operations like lending. The institution offers up receivables like mortgage payments, or collateralized debt obligation dividends, or actual physical assets as collateral.
Because the debt is so short term, typical investors in this type of debt are low-risk, conservative mutual funds like money market funds. Money market funds are perceived as safe bets by investors, as they are filled with highly rated and liquid bonds, including Treasury bonds, municipal bonds and agency bonds. On Tuesday, reports emerged that Sentinel asked regulators for permission to stop investors from withdrawing money. The firm said in a letter that it could not meet redemption requests without "selling securities at deep discounts to their fair value and therefore causing unnecessary losses to our clients," according to a Bloomberg report. Sentinel is reportedly invested in short-term commercial paper, currencies, Treasury bonds and investment-grade corporate bonds. "I can perceive of few greater fears than the general public having money once thought completely safe from the vicissitudes of the markets suddenly seeming to be at risk," writes Tony Crescenzi, chief fixed-income strategist at Miller Tabak, who adds such fears may be overblown. "While confidence in what has long been seen as riskless might erode, it is unlikely that confidence will erode materially enough to cause large amounts of redemptions
in money market funds," he writes. Standard & Poor's also reported Tuesday that of the 450 money market funds it rates, "less than a half dozen of these rated funds have exposure to the asset-backed CP programs that experienced maturity extensions last week." S&P has not taken any ratings actions on any of the money market funds that it rates, but is "continually monitoring the credit market."
The asset-backed commercial paper market is about $1.2 trillion in size, according to Moody's Investors Service. The entire commercial paper market is about $2.4 trillion. But many in the markets warn that the risk of exposure to this type of debt has ballooned as the assets backing the debt, including mortgage-backed securities and derivatives like CDOs, have declined. If issuers of this type of debt run into resistance when they attempt to refinance, or "roll," the debt for another 90 to 180 days, they will surely have to offer higher yields. If they run into a wall, they will likely have to turn to the banks and bond insurers who act as backup financiers -- as Coventree reportedly did. Large banks and bond insurers have agreements to be the last-resort financiers for these types of borrowing programs. But funding commercial paper is a role the banks never imagined they'd have to play because this debt was considered so safe, says Stracke. Any such demands on banks would eat into their working capital, which is already increasingly allocated to patch up credit crunch holes like loan commitments to leveraged buyouts. If this all happened, and it is a big if, admittedly, the market could see more banks hoarding cash, unwilling to lend to each other, and driving up overnight lending rates. This would lead to more liquidity injections from global central banks.
In the best-case scenario, these problems never get to the banks, and investors buy the securities at higher yields, and the machine keeps rolling. In the meantime, fears of a repeat of 2002 may persist amid the prevailing uncertainty. In 2002 after WorldCom and Enron's bankruptcies, corporations couldn't finance their short-term needs in the commercial paper market. That drove companies to the banks for last-resort credit lines and risk in the banking system multiplied, with stock proxies suffering in kind.