The US commercial-paper market remains seized up, while the US stock market has rebounded to near-old highs — leading CLSA’s Christopher Wood, in the current issue of his client newsletter Greed & Fear, to conclude that “most equity investors have no understanding of what is going on in the credit space”.

That is why, says Wood, “the equity market only freaks out when presented with the reality of ‘surprising’ bad news, for it is hard for investors to discount something they do not understand”.

The banks are under pressure on various fronts, as the FT notes on Monday, among them, LBO financing commitments and higher interest charges. Wood focuses on how the large (and seemingly growing) spread between Libor and the US 3-month T-bill rate is ratcheting up pressure on banks’ funding, as they are forced to refinance asset-backed commercial paper, for which they have provided liquidity guarantees.

“The banks also have to refinance their own commercial paper (of which the US financial service sectors has issued a lot), as well as those off-balance sheet structured investment vehicles, which investors have lately been reading about,” he adds.

This continuing pressure on banks’ funding means that “the cost of credit is being repriced throughout the system,” Wood notes.

This will take time to work through to consumers and corporations. But it is clearly happening. The process is deflationary since it amounts to forced deleveraging – most extremely for credit hedge funds borrowing short and lending long on 20 to 30 times leverage.

It is for such people, says Wood, that “Libor at 5.7 per cent is a major problem since the long-term securities they own may well be yielding less”.

All of the above, he notes, “raises the issue of what the authorities can do about it”.

The Fed and the ECB have bought time with their extensive funding of recent weeks. But this will not solve the problem, if it is an issue of insolvency, rather than illiquidity, says Wood.

Not surprisingly, Wood’s view is that the problems in the money markets reflect an insolvency issue.

Moreover, this problem remains devilishly difficult to address from a practical standpoint, not only because the losses are so widely spread, but also because the instruments held are so complex. No one, for example, really knows how many synthetic CDOs there are out there, let alone how leveraged they are. It is also quite clear that neither the Fed nor the ECB had any idea whatsoever that the subprime crisis would have the effect of freezing the commercial paper market. They are, therefore, making policy on the run.

If the commercial paper market remains a point of tension, the big focus in the past week has shifted to potential US government efforts to bail out financially challenged US homeowners, notes Wood. “So far, there has been more noise on this issue than real action, despite George W. Bush’s plan to help low-income borrowers with good credits.”

Wood reiterates an earlier point, that real US government action in response to the escalating housing mess will only come in 2008, a US presidential election year, “by when the housing market should be really bad on Main Street”. Meanwhile, all the evidence is that news on housing will continue to deteriorate for the rest of this calendar year, he adds.

The issue for both major US political parties is a practical one of how to bail out borrowers without bailing out the lenders, notes Wood. “This practical problem is going to delay concrete bailouts for the time being, until the situation on the ground gets much worse”.

Greed & Fear’s view is that investors should assume that the Fed will cut rates at the next FOMC meeting on September 18. That said, it is also clear that Ben Bernanke is reluctant to ease rates, until the data signals slower growth. The Fed chairman will not be happy to see the renewed strength of oil and gold.

For investors long Asian and emerging-market equities (who, it should be noted, are among Wood’s core readers), “it makes sense to continue to hedge their risk, given what is going on in US and in the world of credit”, he concludes.

“In this respect investors should look again at shorting credit spreads. The other way to hedge long Asian exposure is to remain short or underweight those financial stocks that have been geared to securitisation and consumer financing in the western world.”

This entry was posted by Gwen Robinson on Monday, September 10th, 2007 at 9:17 and is filed under Capital markets. Edit this entry.