The credit markets are not going to see a recovery, despite the cumulative 75 basis point cut in US interest rates: the possibility of improvement is being quashed on several fronts. A leader in today’s FT likens the continued pain inflicted on the credit markets to an aching tooth. The choices available are:
1) Action — going to the dentist — promises immediate pain
2) Delay — waiting for an abscess — promises deferred agony
Institutions knee deep in the credit markets are choosing to take the latter option, biting down and making the squeeze more painful than necessary, as a result further aggravating the factors that will keep the credit markets constricted, says the FT.
First, subprime mortgage collateral, and far more important, the outlook for a wide range of US loan collateral, has deteriorated further. That has hurt the value and trading liquidity of instruments backed by such loans. From mid-September there was a sharp second leg down in indices tracking subprime mortgage bonds; the amount of asset-backed commercial paper continues to decline; and interbank lending rates remain unusually high.
Second, it has become clear that the statistical assumptions used to value some structured bonds such as collateralised debt obligations were wrong. That has not only created the risk of fire sales as those bonds go into default but means it will be hard to restore confidence to the CDO market in either the short or medium-term. CDOs appear to be quite fundamentally broken.
And thirdly, says the FT, the banks have effectively shot themselves in the foot. Banks’ disclosure on the affected holdings has been slapdash; in part because they themselves can’t fully identify the extent of their own exposure. However, by announcing massive losses and then having to revisit and up the numbers, it is unsurprising that they have effectively crushed any remaining faith in the strength of their balance sheets.
In order to resolve this everyone involved, commercial banks, insurers and asset managers, not just investment banks, need to be explicit about their exposure and deal with it in real terms.
Rather than just a dollar writedown, they should offer a breakdown of their holdings, so analysts can forecast their ultimate losses.
To help restore confidence in structured finance, the rating agencies should open their methodologies to public scrutiny and debate.
And failing that, it may be time to call in the regulators, says the FT:
If none of this happens then regulators — co-ordinating themselves across borders, if necessary — may have to start pushing. It is time to pull some teeth.
Politicians, it seems, are already thinking that way.