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Stunned Investors Swarming Out of Market
Asset Backed Alert, Harrison Scott Publications Inc. (September 19, 2008)

Already-swollen spreads on structured-finance products ballooned even further this week, as the worst financial crisis in a generation grew even deeper.

Trading of asset- and mortgage-backed securities became petrified as investors withdrew from the market en masse, forcing sellers to pump up offered yields as they competed for the attention of the few buyers bold enough to remain active. Asset-backed commercial paper offered no safe haven, as funding costs in that sector shot through the roof due to fears that the credit market still hasn't seen its darkest period.

"Everything is wider, and it's wider offered without a bid," said David Castillo, who heads trading of fixed-income products at broker-dealer Further Lane Securities in San Francisco. "We're in the middle of history."

The catalysts in the structured-finance shakeup were the same as those roiling the broader financial market this week: the bankruptcy of Lehman Brothers, the forced acquisition of Merrill Lynch and a government bailout of AIG. The stunning developments came just a week after the government's seizure of Fannie Mae and Freddie Mac. The firestorm showed no signs if letting up late in the week either, as Morgan Stanley weighed options for additional backing and questions persisted about the fates of Goldman Sachs and Washington Mutual.

A report by CNBC on Thursday that Treasury Secretary Henry Paulson is working on a plan to set up an entity that would buy troubled debt from financial institutions could counteract some of the effects. But there was no word of an immediate market reaction.

While most investors were too shell-shocked to keep buying asset-backed bonds this week, those still in the game were demanding spreads of 250 bp over swaps on top-rated 3-year bonds backed by auto loans - up from an already-inflated 210 bp over swaps last week and 170 bp over swaps in late July.

In July 2007, at the brink of the credit market's collapse, those same issues were changing hands around 7 bp over swaps. The widening that occurred in the past two months, meanwhile, translates into a par-value decline of about 2.5 cents on the dollar. "That's a huge move in 60 days," one commercial-bank analyst said.

Credit-card bonds with 2- to 3-year lives were trading at spreads 20-30 bp wider than last week's levels of about 110 bp over Libor, translating into a decline in value of half a cent to one cent on the dollar. Prior to the credit crunch, such bonds' par values rarely budged more than a quarter-cent per month, one trader said. Values are still a moving target though, as trading volume remains unusually light. Another trader said the following formula could be applied to the values of most types of asset-backed bonds this week: 1-year securities were trading about 50 bp wider than a week ago, which works out to a dollar-value decline of about half a cent; 3-year issues widened by 50-60 bp, or down about 2 cents; and 5-year bonds were trading 75 bp wider, down 3 or more cents.

Even then, many of the values are only theoretical, representing what panicked sellers were offering to an investor audience that proved largely uninterested during what will likely prove a landmark week for the market. "People are still sitting around, waiting for the smoke to clear," a trader said

Activity was even slower on the new-issue scene, as prospective issuers opted to remain under the radar. Word is that several new deals, including an offering from subprime-auto lender Prestige Financial, have been called off this month due to persistent nervousness about widening spreads and vanishing liquidity (see article on Page 6). Spreads on asset-backed commercial paper also spiked this week, largely in response to news that holdings of troubled Lehman debt had caused Reserve Management's Reserve Primary Fund, a money-market fund, to "break the buck," or fall below $1 per share. One-day yields on conduit paper jumped to 8% - or higher, in some cases - in the days that followed. That's more than double where they were before, signaling an outright refusal by many investors to take part in short-term trades.

Yields on 1-month asset-backed commercial paper soared as well, to 3.2% from 2.6% last week. "Investors are worried about people throwing money out of their funds," said the head of conduit originations at one investment bank, referring to the prospect of massive withdrawals and asset liquidations at money-market vehicles that hold conduit paper. Reserve Primary Fund wrote down its Lehman holdings, which had been valued at $785 million, to zero. Now it is expected to liquidate or unwind most of its remaining assets, 57% of which consists of asset-backed commercial paper, according to research from J.P. Morgan. Amid a wave of withdrawals, the fund's assets had already fallen to $23 billion by mid-week from $63 billion in late August.

Beyond the Reserve Fund situation, wider credit-crunch pressures facing banks were also weighing on conduit-paper values. "Nobody wants to hold it, because there's a lack of confidence in the financial firms that issue it," said another bank analyst.

At the same time, credit-default swaps linked to asset- and mortgage-backed bonds plunged in value this week, due largely to uncertainties about AIG, a major seller of credit protection through those contracts. "The reason why they're falling is because one of the biggest intermediaries on the planet just went away," one trader said. Credit default swaps referencing triple-A-rated home-loan securities issued in the second half of 2005 were trading at 88.2 cents on the dollar Tuesday, down from 89.7 cents on Friday, according to J.P. Morgan research.

The U.S. government bailed out AIG on Wednesday, providing $85 billion of financing in exchange for 80% ownership of the insurer. The move came just a day after Lehman agreed to be bought by Barclays, following Lehman's Chapter 11 bankruptcy filing on Sunday - the same day Merrill struck a deal to sell itself to Bank of America for the fire-sale price of $50 billion. v



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