Credit Markets / Level 3 Rising / Fed Widening Collateral

A: In the post-Bear Stearns era of a saving grace federal reserve, the risk of a systemic crisis shutting down the financial system was all but removed. So, all those shorts in equities and credit markets had to unwind their bets and buy/bid to cover the very positions that were designed to profit on doomsday; the doomsday that Ben Bernanke will not allow to happen. When I look at the stock market & credit market indexes in the past 5 weeks, I see major short covering rallies and bids. Corporate spreads have narrowed, TED spread has fallen, ABX indices have rebounded, CMBX spreads have narrowed, Investment Grade spreads narrowed, and it seemed as if the credit market distress has eased significantly. Is it truly the end amidst all this new liquidity? If it were, LIBOR would have come in much more, Level 3 assets would be shrinking, capital raising would end, and the fed would not need to continue with TAF's and widening acceptable collateral!

The good news is that there are certainly signs of easing credit market distress as a result of everything the fed has done. The bad news is that we are NOT out of the woods yet, from those I talk to the credit markets still remain quite challenging, and the fed is continuing auctions and widening acceptable collateral to now include credit card receivables and student loan securities. The credit problem is clearly spreading.

If it weren't, Fannie Mae would not have just announced a $2.2Bln loss, cut their dividend, warn of 'severe weakness', and plan to raise an additional $6Bln in new capital by diluting shareholders further! Either you wake up, or you have your head in the sand. While the worst may be behind us, we are by no way, shape, or form in for a new boom!

Let me start with the positives and show you the credit market indices that have eased:

ABX AAA Index - Easing (up) Since mid-March (via Markit)

Corporate Spreads Narrow (Wachovia HY Corporate Bond vs iShares LEH 7-10YR Treasury Bond Fund via Bloomberg)

TED Spread Falling (via Bloomberg)

The 3 charts above show the following signs of easing distress in credit markets since the Bear Stearns bottom:

a) rising ABX AAA Index
b) narrowing corporate bond spreads
c) falling TED spread

What has not participated in easing significantly is the money markets and LIBOR. Banks are still reluctant to lend to one another at normal spreads, signaling the need for capital to remain on the books. In fact, banks need to raise MORE capital as balance sheets continue to update hard to value assets! This is why many brokerages and banks have decided to shift assets into their Level 3 hideout's on their balance sheets.

Look at what Merrill Lynch said this morning, according to CNN Money's "Merrill Lynch Level 3 assets increase through March":

Merrill Lynch & Co. disclosed Tuesday that highest-risk assets on its books rose 69 percent during the quarter ending March 28.

Merrill Lynch had $69.86 billion in so-called "Level 3" assets as of March 28, according to a filing with the Securities and Exchange Commission. Level 3 assets totaled $41.45 billion on Dec. 28. At the lowest end, Level 3 assets are those whose valuation is essentially a best guess by the investor, because there is virtually no active trading market for the product to use as a pricing guide.

Level 3 assets accounted for 15.5 percent of total assets as of March 28 at Merrill Lynch, compared with 9.2 percent as of Dec. 28. Level 3 assets as of March 28 included $9.3 billion of collateralized debt obligations, of which $9 billion were tied to subprime mortgages _ loans given to customers with poor credit history.

Another $20.6 billion of level 3 assets at Merrill Lynch are tied to derivatives of collateralized debt obligations. Within that $20.6 billion, $16.7 billion is related to subprime mortgages. About $18 billion are tied to credit derivatives from corporate and other non-mortgage debt.

Things that make you go hmmmmmmm!

No, things are not rosy just yet. Anyone notice how the fed snuck in another $25Bln in its auction to banks on Friday? And what about the little announcement that the fed will now take on credit card receivables and collateralized auto loans, and student loans! Geez Louise! What in the world is the fed doing here and who is still debating that this is contained to subprime?

According to Daily Reckoning's "US Fed Now Accepts Credit Card Debt as Collateral":

First the Fed increased by US$25 billion the amount of money it will auction to banks (commercial and investment) through its Term Auction Facility (TAF). Here banker people, borrow more. Please.

Second, the Fed expanded the list of collateral it will accept for asset-swapping through its Term Securities Lending (Facility). Remember, that's the one that lets banks and prime brokers swap mortgage-backed securities for Treasury bonds for up to 28-days.

The Fed is now expanding that list of asset-backed securities to include collateralized car loans, credit card receivables, and student loans. It's doing so because the lack of demand for bonds backed by those assets has had a real political impact in an election year. What it really means is that that the Fed has lowered interest rates as far as it can to deal with the bank lending crisis. It still hasn't encouraged banks to loan to each other, or investors to buy bonds backed by various kinds of consumer liabilities.

When will it end? We have a major moral hazard problem brewing here and you can count on one thing: wall street will invent a new product to generate revenue from dodgy debts that utilize the gray areas of future regulation that will be imposed! The reason why? Because they will always get bailed out by our fed!

Must be great to be an American wall street executive!

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