Why Credit Markets Might Get Some Healing

David Russell, who helps produce "Closing Bell," shared his thoughts on why there's a light at the end of the tunnel for credit markets. Here's his post:

"Banks find themselves with more securities than they’d like," Citigroup CEO Vikram Pandit told Charlie Rose in an interview this week. Now they want to sell them, and "that’s deleveraging," said Pandit.

This was perhaps the most concise thing anyone has said about the financial crisis. Pandit’s company is the largest manufacturer of bonds in the world. He knows the problem didn’t start with falling home prices, or too many houses, but too much debt. Too many bonds are floating around in the global capital markets. This caused the problems on bank balance sheets and between counterparties. After spending the last seven years cranking out $3 trillion of securities linked mainly to home mortgages, Wall Street is now drowning in its own product.

Each phase of the credit crunch has ultimately resulted from this glut of debt. In August 2007, money-market investors got nervous about asset-backed commercial paper and proceeded to unload $372 billion over the next five months, according to the Fed. This ABCP was issued by structured investment vehicles (SIVs), which used the money to buy longer term bonds backed by home mortgages. When these investors refused to roll over the ABCP, the SIVs were forced to sell similar amounts of mortgage bonds. The next thing we knew, prices fell, spreads widened and banks faced writedowns.

Fast forward to September 2008. The CP market was in trouble again as investors worried about Lehman Brothers withdrew more than $400 billion from general money-market accounts, according to AMG Data Services. The fund managers were forced to sell large amounts of short-term bonds to meet the redemptions, pushing yields higher. Many were priced versus Libor, so Libor rose as well, along with the dreaded TED spread.

Again this month, Treasury Secretary Hank Paulson caused a sell-off in commercial mortgage backed securities (CMBS) when he said he wouldn’t buy any "troubled assets" under the TARP. Some investors who had been hoping to sell CMBS to the government immediately put them up for sale. Soon AAA securities traded for 50 cents on the dollar and yielded more than 20%. Shares of life insurers like Metlife and Hartford Financial, big CMBS owners, plunged.

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Each of these disruptions resulted from market forces that put large amounts of bonds up for sale at a time no one wanted them. Until recently, policymakers focused almost entirely on banks, even though their balance sheets were really just ships being tossed about in a much larger storm at sea.

Fortunately, Paulson and Bernanke are shifting focus to the bond market itself. They will provide buy $600 billion of mortgage-backed securities issued by Fannie Mae and Freddie Mac , and provide another $200 billion to aid in the purchase of bonds linked to credit-card payments and auto loans. This caused the largest drop in mortgage rates on record, and suggests we might finally be starting to address the disease rather than just the symptoms.

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