A good portion of the subprime market was financed through the structuring of CDO which were in turn financed through the commercial paper market. This represents the classic borrowing short and lending long story under a steep yield curve environment. There is a parallel with the S&L crisis of the 1980’s. When the curve flattened and rates rose, the profitability of CDOs were adversely affected.
More importantly, if there is a closing of the commercial paper window, these CDOs have one of two choices, sell assets to delever or find other financing. The selling of assets to delever is not possible because the pricing of assets has fallen. Alternatively, if the financing cannot be gained because money funds will avoid this type of commercial paper, we are left with a credit crunch. The sale of assets will still have to occur at even more distressed levels. There are no good alternatives to this story. Losses will have to be incurred. The issue is who will take the losses. The managers may be out of business but their capital losses are limited.
Now the problem is focused on the commercial paper that is on the books of the money funds which cannot break the buck. This paper has to be rolled. Banks may have provided credit lines as back-stops but these are usually limited in time. The funding problem may be pushed out into the future, like 30-60 days but the game is coming to a conclusion. The Fed may help with taking collateral and lending at the discount window, but this may not help some of the money funds. The contagion is that nothing associated with ABS CP will be safe even if it has good collateral. Funds are moving to safe havens and this problem is bigger than a stock market correction.
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