Money Market Stress May Not Tell Full Story

Despite persistently sticky short-term borrowing markets, signs of some stability in broader financial markets suggest the economy may be able to weather the storm brought on by troubles in the subprime mortgage market.

Short-term debt markets continue to show signs of stress, with investors, nervous about the quality of credit, willing to lend money only for the shortest period of time and backed by the safest possible collateral. Wednesday, in a sign of continued stress, the three-month London interbank offered rate, or Libor - the benchmark for floating-rate debt, including corporate debt - rose again, to multi-year highs as banks remain reluctant to lend to each other. Activity in the commercial paper market - the crux of the credit market crunch - remains far from normal. But in a sign that investors haven't entirely buried their animal spirits, stock markets, while wobbly, haven't been as hard hit even as short-term borrowing costs have risen sharply, making it more expensive for companies to do business and putting a brake on the recent buyout boom. Stocks were lower Wednesday after several pieces of softer economic data, but they did end August on a strong note, suggesting a degree of investor optimism that the broader economy will pull through after a period of credit tightening and with the help of at least one rate cut. The prevailing view among stock investors - and those outside financial markets - is that "it's the rascals on Wall Street - they're at it again - but that doesn't affect my portfolio," said Michael Kastner, managing director at private investment firm SterlingStamos in New York.

Flight-to-Quality Effect

While the problems in short-term funding markets tie back to the dramatic weakening in the U.S. housing market - which has been clearly weighing on economic growth - they also reflect the massive repricing of risk currently underway. Until this year, yield-hungry investors chased all types of debt products in their hunt for returns, pushing risk premiums to historically cheap levels. Bankers developed structured finance products that gave investors a couple of additional basis points of returns, often coupled with high credit ratings. With volatility low, banks and hedge funds set up structured investment vehicles that borrowed short-term funds to invest in longer-term paper with higher returns. "The money market stresses and strains have to do with financing vehicles investors are concerned about," said Mary Miller, director of fixed income at T. Rowe Price in Baltimore. Investor concerns are focused mainly on credit risks and structured products and to a lesser degree on the economy - which after all, has been holding up pretty well. "So far, we're not seeing real trouble in the real economy," with the stress concentrated in the financial services sector, she said. As a result, investors are shunning asset-backed commercial paper in particular, since it is secured with assets such as home loans, and piling into the ultra-safe Treasury bills in a classic flight-to-quality move. While it may be hard to get a price for a piece of a collateralized debt obligation backed by U.S. mortgage bonds, there is still a lot of liquidity around for investments that aren't tainted by association with housing. "There's still plenty of money out there looking for a home," said Gary Pollack, managing director at Deutsche Bank Private Wealth Management. Stock market investors are taking "some solace from still decent economic growth," Pollack said, and many are more willing to accept heightened volatility while they wait for the financial market turbulence to pass. It's not just in stocks, investment-grade corporate debt issuance was strong in August as investors looked for a high-quality place to park funds. In contrast, asset-backed commercial paper market investors are taking a "glass half empty view of the world," Pollack said. These investors are simply not used to risk and have become more skittish. Large institutional investors are looking to eliminate the risk on their balance sheets, he said.

Economy Holding Up

One bright spot in the current financial market turmoil: the economy outside housing has been holding up pretty well, entering the third quarter with considerable momentum, thanks partly to strong growth abroad. Second-quarter growth stood at a 4.0% rate, the strongest pace of growth since the first quarter of 2006. While consumer sentiment readings have fallen, auto sales last month held up better than expected. Manufacturing overall continued to expand, though at a slower pace. The Federal Reserve's Beige Book - a survey of regional economic conditions - also painted a fairly benign picture of the economy besides housing. "Equity investors aren't transporting concerns in credit to corporate earnings yet," said SterlingStamos' Kastner. "And a lot of equity strategists are looking for the stock market to shake off what we've seen and move to higher levels." That's not to downplay the current market stresses and their potential impact on the economy, particularly as recent economic data have yet to reflect the period during which credit concerns have driven markets. And some of the more timelier reports, such as weekly jobless claims, have been showing signs of weakness. But investors in both stocks and bonds are betting that the Federal Reserve will act in time to stave off a sharp economic downturn, with short-term interest rate futures pricing in a series of rate cuts. However, that won't necessarily solve the woes plaguing the short-term debt markets, as one bond fund manager points out - no matter how far the fed funds rate falls from its current 5.25% perch, it won't fix shaky mortgage collateral.