[using crisis in the medical rather than the Marxist sense :o) This is still the best article I've found on this side of it. And it's not merely a parochial interest -- as the article goes on to say, most of the European finance involved is in dollars, and when European banks ran out, they came to banks in New York, who weren't willing to lend to Europe for longer than overnight, if at all. I wonder if that could possibly be part of why the Fed's new discount window policy has introduced 30-day duration for loans rather than overnight: offering such loans as a basis for getting the commercial paper market flowing freely again.]
August 13 2007 Financial Times
Age-old risk is the big new threat to stability By Gillian Tett, Paul J. Davies and Norma Cohen
Policymakers and investors have been obsessed in recent years about the potential for a hedge fund collapse to spread financial panic. But it seems one of the biggest threats to stability is coming from the age-old risk of short-term borrowing to fund investments in illiquid long-term products.
In a corner of the market few people knew existed, regulators are scrambling to understand what is happening in structured investment vehicles (SIVs), a breed of often huge, mainly bank-run, programmes designed to profit from the difference between short-term borrowing rates and longer-term returns from structured product investments.
These have proliferated in recent years and control assets worth hundreds of billions of dollars. Depending on whether they are fully rated by credit rating agencies and on how strictly they have to conform to certain rules, they are known as SIVs, SIV-lites, or conduits.
They are typically quite opaque, invest in complex securities and often do not need to be displayed on a bank's balance sheet.
It seems they have played a key role in last week's liquidity crunch.
"We are in the middle of a mini-crisis in the commercial paper market, at least half of which is related to the SIV conduits," says Robert McAdie, global head of credit strategy at Barclays.
These programmes typically invest in credit market instruments, such as US subprime mortgage-backed bonds and collateralised debt obligations. These assets tend to be the highly rated, supposedly safe versions of such debt, but in the recent fear-driven turmoil have shown just how illiquid and hard to value they can be.
The profit for those who run such programmes comes from the fact that the assets pay fairly high yields, while the conduits and SIVs fund their purchases with short-term borrowings in which interest and principal payments are backed by financial assets that are deemed to have stable cash flow. Collectively this so-called "asset-backed commercial paper" -- or ABCP -- lasts for anything between a few days and a few months before needing to be refunded.
The problem could be thrown into relief when billions of dollars of ABCP mature today and on Wednesday, with great uncertainty as to whether this can be refinanced. [Note: this was Wednesday the 15th, which passed with just the normal amount of tumult for these our times.]
Everything in this market depends on investors in the ABCP market maintaining their faith in the programmes and the assets they hold. With the current rush for the exits in many structured credit markets, this faith has been evaporating wholesale. No investors are sure exactly what assets SIVs and conduits are holding, or how damaged those holdings might be.
While many non-SIV funds -- such as those run by BNP, Axa and others that have hit trouble recently -- were able to stop investors pulling their cash out, SIVs and conduits who see their funding expire on a regular basis have no such luxury.
In the case of a blip in the market, SIVs and conduits are supported by liquidity facilities from highly rated, mainstream banks. This means banks must step in to provide finance if the SIV cannot raise commercial paper in the normal way, unless the SIVs' assets suffer significant ratings downgrades. Typically, the credit line provided by the sponsoring bank and a group of others in a syndicate must cover 100 per cent of outstanding commercial paper.
These funding lines have rarely been drawn in recent years, because liquidity has been abundant in the ABCP market as almost everywhere else in the financial world. As recently as mid-June, the European commercial paper market was seeing records levels of issuance.
However, what sparked last week's turmoil -- and the dramatic intervention by central banks -- was a pernicious chain of events. As it became apparent this summer that the US subprime problems were worsening and infecting a broader range of structured products, some investors in the ABCP market started to worry about whether SIVs were also sitting on losses.
The rush to sell structured products by hedge funds facing redemptions and other investors meant those market values that could be ascertained were being marked down heavily. As a result, by mid-July some investors decided to stop buying ABCP paper from SIVs suspected of subprime exposure.
The German bank IKB was an early victim. Like many local peers, it had a conduit -- called Rhineland Funding -- which had ex-panded rapidly and had almost E20bn ($27.3bn, £13.5bn) worth of outstanding commercial paper in the markets in July. In mid-July, ABCP investors refused to roll over some of these notes.
Rhineland asked IKB to provide a credit line, as the rules of SIVs require. But it appears the German bank did not have enough cash to meet this request and was unable to liquidate enough assets to plug the gap. This threatened to trigger IKB's collapse, until KFW, the state-owned German bank, stepped in and offeredan E8bn credit facility.
German officials hoped this action would stop growing panic in the sector. But it may have had the reverse effect: investors started to shun almost all commercial paper issued by SIVs.
"This is an environment where there has been a big loss in confidence and nobody is distinguishing between apples and oranges," notes Mr McAdie.
By early August, the problems in the ABCP market had become so serious that some European banks were preparing for additional calls on credit lines to SIVs. But the banks are also grappling with a backlog of unsold leveraged loans, which is placing additional pressure on their balance sheets.
So early this month some European banks -- and a few US institutions as well -- quietly started trying to raise new credit lines themselves. That, however, triggered additional alarm, as rumours spread about the potential losses at SIVs -- on top of problems in other corners of the financial world.
Consequently, by the middle of last week, some banks started shutting credit lines to a sweeping list of institutions. "Commercial paper is now being funded on an overnight basis. The banks will not roll paper for three months," says Dominic Konstam, head of interest rate strategy for Credit Suisse.
And while it seems that European financial institutions were particular victims of this credit squeeze, the problems -- perhaps ironically -- were extreme in US markets, since SIVs typically raise a large proportion of their finance in dollars. One banker admitted last week: "The attitude is 'Don't show me anything east of a [New York] 212 area code'. If you lend to [those banks] it could be a career-ending experience."
Policymakers hope that some of this panic will dissipate this week following the massive emergency injections of liquidity by the ECB and US Federal Reserve. And indeed, by the end of last week, borrowing rates were stabilising. There were signs vulture funds were circling, ready to pick up ABCP paper at bargain prices.
"What some people are hoping is that the bottom fishers will appear and help the market self-correct," says one big ABCP issuer.
But nobody close to this sector expects to see a quick solution soon. Commercial paper interest rates have not yet fallen, irrespective of central banks' actions.
In New York on Friday, they closed at their highest level for six years. There is deep uncertainty about what the central banks will do next -- making ABCP players even more reluctant to start issuing and trading again. "Nobody is going to handle commercial paper if they think the Fed could be about to cut rates or do something else completely unexpected overnight," says one.
However, the third, most pernicious problem is that it is becoming clear central banks cannot resolve the biggest problem -- a lack of clarity about valuations in structured credit markets and the almost complete loss of confidence that is infecting even the biggest and most diversified of conduit-type programmes.
Additional reporting by Michael Mackenzie, Richard Milne and Stacy Marie Ishmael