Asset-backed commercial paper - Liquidity crisis spreads

August 22, 2007

Investors and banks are now becoming wary of purchasing all asset-backed commercial paper (ABCP's), spreading the banking liquidity crisis beyond just subprime mortgages.

Over the past week,

• Investors fled to short-term Treasury bills, causing yields to make their biggest two-day fall since October 1987.
• Money market funds have surged to a record $2.7 trillion.
• Yields on asset-backed commercial paper soared to over 6%, the highest since January 2001.
• The UK's largest mortgage lenders, HBOS, had to repurchase $35 billion in ABCP's that it couldn't sell.
• Canada's six biggest banks agreed they would continue to purchase each other's ABCP's, a $113 billion market.

(Source: FT.com, Short-term debt costs soar as money market surges, 8/20/07; Bloomberg, HBOS to provide financing for commercial paper unit, 8/21/07; Canadian banks work together on commercial paper, 8/21/07)

What the asset-backed commercial paper crisis means:

Fear about defaults in the subprime mortgage market has spread to any subprime loans, including auto loans, consumer credit, and corporate debt. All of these loans have been repackaged and resold into collateralized debt obligations (CDO's). These CDO's obscure the credit rating of any individual borrower. Therefore, the potential for large-scale default is unknown, although the overall CDO market is estimated at $2.75 trillion. (See Global risks shifting to you, 3/28/07)

Why were these CDO's purchased? The irrational exuberance that drives any bull market. The excess liquidity of the past few years caused investors to accept the extra risk, knowing they could resell the CDO's on the open market. Now the opposing emotion, fear, has gripped these same markets and investors. Although many analysts have said that the worst is over, we may find next week that the crisis has spread to yet another financial market.

Action Steps:
The correction in the global stock markets and credit markets may seriously escalate into something worse before it gets better. Hopefully, you have already moved any money you need in the short-term to a money market account, as I suggested in June. Now, check those money market funds to make sure they do not contain a large portfolio of asset-backed commercial paper.

The best way to withstand market volatility is with a well-diversified portfolio. Find out how to protect yourself with my home study course, “Retirement Planning 101.” This course will guide you through building a diversified portfolio using the same steps I took to retire at age 50.

Related articles

Central banks add global liquidity, 8/15/07

Bear Stearns hedge fund collapse, 8/8/07

U.S. subprime mortgage mess spreads to Europe, 8/1/07

Global markets drop again, 8/1/07

Trade surpluses driving asset bubbles, 6/27/07

Global markets decline, 3/7/07

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