Asset Backed Paper Remains Illiquid

by Rob Kirby, Kirby Analytics. August 27, 2007

Despite the best efforts of Central Banks around the world - responding to CDO/Sub-prime worries with unprecedented amounts of liquidity injections – the Asset Backed Paper market has remained illiquid.

European ABS market sees continued illiquidity
Mon Aug 20, 2007 6:20am ET
By Richard Barley
LONDON, Aug 20 (Reuters) - Liquidity in the European asset-backed securities market remains low despite moves by central banks to lubricate the financial system, with even the largest bonds with the highest credit ratings suffering..

So what exactly is asset backed paper?

Asset Backed Paper is created through a process known as securitization:

Securitization is a financing process in which a corporate entity moves assets, to an ostensibly bankruptcy-remote / low risk vehicle, to obtain lower interest rates from potential lenders. This is obtained because the assets cannot be seized in a bankruptcy proceeding, the risk is less for lenders and they are willing to offer a lower rate. The technique comes under the umbrella of structured finance as it applies to assets that typically are illiquid contracts (i.e. assets that cannot easily be sold). It has evolved from tentative beginnings in the late 1970s to a vital funding source with an estimated total aggregate outstanding of $8.06 trillion (as of the end of 2005, by the Bond Market Association) and new issuance of $3.07 trillion in 2005 in the U.S. markets alone.

The process of bundling [securitizing] mortgages into "tranches"- to obtain lower interest rates for consumers - and selling them off to investors is EXACTLY the process from which the current sub-prime mortgage situation was borne.

Through this "securitization process," credits of questionable quality or backing were bundled so as to create a derivative paper instrument with a TRIPLE A [AAA] rating.

What may not be readily apparent to casual onlookers, there's an implicit assumption in the definition citied above; namely, that the "assets" in question are solvent and performing.

So what's gone wrong?

These derivatives, which ratings agencies were perhaps too quick to award AAA ratings, are now being "reassessed" and in at least some cases, written off.

This has made market participants reluctant to purchase other highly rated asset backed paper out of fear that it may be down-graded similarly.

Why mortgaged-backed paper?

The mortgages that were offered to marginal consumers, would-be home buyers with poor credit ratings or insufficient incomes, dubbed ARMs [Adjustable Rate Mortgages] with "teaser rates" were made with the assumption that these same consumers would qualify [or have the means to pay] for the same mortgage when rates actually "reset."

In the interim, credit conditions have fundamentally changed; as a result of falling real estate values lenders have reassessed risk.

The results should have been predictable. Firstly, with "teaser rates" now resetting at market rates, those who marginally qualified for home ownership based on current income, no longer can afford their mortgages at the higher rates. Secondly, with credit standards having tightened, many of these same folks no longer qualify for a mortgage AT ANY RATE.

The Fed's response to date has been to provide "liquidity" largely through the REPO mechanism, where this "unwanted" derivative paper is purchased on a "temporary" continuing roll-over-basis from banks and financial institutions with inventory of such as their latest Temporary Open Market Operations illustrate:

Deal Date: Monday, August 27, 2007
Delivery Date: Monday, August 27, 2007
Maturity Date: Thursday, September 06, 2007
Type of Operation¹: Repo
Settlement: Same Day
Term of Operation²: 10 Days
Operation Close Time: 09:40 AM

Results	Amount ($B)		Rate (%)
Collateral Type	Submitted	Accepted	Stop-Out³	Weighted Average⁴	High	Low
Treasury	13.450	0.131	5.05	5.050	5.05	4.55
Agency	14.350	3.160	5.17	5.170	5.17	4.95
Mortgage-Backed	22.350	6.209	5.25	5.253	5.26	5.00
Total	50.150	9.500

The Fed's Open Market Operations have lately been almost exclusively REPOS of both Agency and Mortgaged-Backed paper.

The temporary "funding" being provided to the holders of this debt IN NO WAY resolves the underlying problem which is one of solvency, not liquidity.

Unfortunately, increased liquidity and/or lower interest rates will not improve an insolvent counterparty's creditworthiness.

What the unprecedented "liquidity add" amounts to is the "MUSIC" in a game of musical chairs.

If as and when the MUSIC stops, it’s a pretty safe bet that chairs are going to be harder to find than hen's teeth - because there are none.

Today's Market

Overseas equity markets began the week on a positive note with Japan's Nikkei Index gaining 52 points to 16,301. North American markets didn't fare as well with the DOW losing 56.7 to 13,322.10, the NASDAQ off 15.44 to 2,561.25 and the S & P losing 12.55 to 1,466.80. NYMEX crude oil futures gained .96 to end the day at 72.05 per barrel.

On foreign exchange markets the U.S. Dollar Index gained .09 to 89.70.

Interest rates were roughly 5 basis points easier across the curve with the benchmark 5-year bond ending the day at 4.35% while the 10-year bond finished the day at 4.58%.

Precious metals ended the day lower across the board with COMEX gold futures losing .80 to 68.10 per ounce while COMEX silver futures lost .22 to 11.81 per ounce. The XAU Index was hit for 2.28 to 137.15 while the HUI gave up 6.17 to 318.82.

On tap for tomorrow, at 10:00 a.m. Aug Consumer Confidence data is due - expected 104.0 vs. prior 112.6. Then at 2:00 p.m. - the minutes from the Aug. 7 FOMC meeting are due to be released.

Wishing you all a pleasant summer evening!

Rob Kirby

Contact Information

Rob Kirby | Proprietor, Kirby Analytics Newsletter - Proprietary Macroeconomic Research
Toronto, Ontario, Canada | Observations | FSU Editorials | E-mail