The Backwater's Backwater

For years, those of us that are fixed income professionals had to endure playing second banana (at best) to those in the equity market, no matter how more important or smarter we are (Ha!). We were always the backwater of the investment world. Within the backwater is its own backwater, commercial paper (many of you thought I was going to say retail). There is kind of a Revenge of the Nerds poetic justice in all of this turmoil. Imaging the mighty stock and bond markets being led around by the nose by the commercial paper market. Twenty years ago, this couldn't have happened. However, this isn't your father's CP market. Way back when, the CP market consisted of a bunch of A1/P1 rated companies like GE and GMAC (then part of a triple-A rated GM) issuing short-term IOU's primarily to manage cash flows. While that still accounts for the bulk of volume, there have been a slew of new types of instruments sold through CP market, many of them tied to assets that are illiquid and/or difficult to value. Theirin lies the problem. While it is relatively easy to determine what the chances are that GE is going to repay its CP in seven days, it gets much trickier when trying to value SIV #1 30-day CP when their assets consists of 100% I/O sub prime mortgages.

The market has to work out these valuation problems on its own. While the Fed can assist with extra liquidity to keep things moving, the chips have to fall where they may. Otherwise, this asset bubble doesn't deflate as the players have no fear of future losses. That lack of fear will occur in some other future asset bubble, probably in a market that hasn't been invented yet. Eventually, value will return to the short end and investors will tire of putting their money in 1mo. bills at three percent.

The Fed has a fine line to walk. Who knows what Bernanke says tomorrow? The Fed will probably ease next month, but they need to "ease" the public into the easing. They need to look as if they are active and not reactive to the current situation. Their face-saving out might be to say that as the economy is anticipated to slow down, future inflation will remain subdued, allowing for an ease. The Fed needs to show that it is in charge of monetary policy. The final point to remember is that the Fed has to be thinking whether a Fed Funds cut helps CP at all (which is why they cut the discount rate). If investors aren't going to buy asset backed CP at +250-350bp to bills, what's another 25-50-bps going to do? It will help the top quality financial institutions issue CP at lower rates, making money center banks more profitable, assuming they lend to anyone. Have a good weekend!