Credit problems are too big for the feds to fix

Also, a reader of my daily column who works in quantitative finance wrote to me that "the next chapter of the credit story could be a collapse or outside losses in well-known and respected quantitative hedge funds." Though this hasn't gotten onto anyone's radar screen yet, it could be another hole about to spring in the dike.

On the back of a bank that barfed in Düsseldorf

Turning to losses abroad -- caused by investments here -- when the German bank IKB imploded two weeks ago, it was revealed that they had about $17 billion in subprime exposure and had lost $3 billion. IKB held these structured-credit assets in a conduit, which is a version of a special-purpose entity that banks use to own structured credit. More importantly, conduits are funded in the commercial-paper market. So, in addition to credit risk, it sounds to me like they are borrowing short and lending long, which is always dangerous when your assets are illiquid.

• Video: Did the Fed make the right move?

Soon, most conduits will be updating their net asset values and rolling their commercial paper. In addition to those two potential data points, it's important to understand that in all likelihood, IKB won't be the last entity in trouble. As my "lord of the dark matter" friend notes, most of these European banks all pursued similar strategies. And I would say that if European banks were involved, U.S. banks probably were, too.

Conduit unbecoming

Meanwhile, a friend in the commercial-paper market (who wishes to remain anonymous) noted: "Yes, spreads have certainly widened on (A-1/P-1, top tier) ABCP (asset-backed commercial paper) conduits from about L - 5 (Libor minus 5) to now about L + 0 to + 3-ish. I think this is generally part of the fear of structured credit you're seeing in the market.

With some of these ABCP conduits, a certain opaque nature exists surrounding the nonstandard methods of reporting or the standard definitions of certain asset types. So, one's not always sure exactly what type of collateral exists inside the conduit.

"ABCP has grown very dramatically in the past 15 years or so, and no investor has ever lost money. Hopefully, cool heads will prevail, as most money-market funds hold 50% to 75% ABCP, and banks or financial institutions are obligated to support nondefaulted -- and in some cases even defaulted -- assets in the conduits. So, implications for the financial system are large."

Money-market dark matter?

The moral of the story? As we get further down the road, I think we'll discover that some money-market funds owned commercial paper issued by a conduit whose assets may not be up to snuff. So folks with a lot of assets in money-market funds might want to double-check that they know what's in them.

Bottom line: The upcoming weeks should be pregnant with indications of more trouble throughout the whole financial-engineering world. More than a few outfits may discover that the triple-A pieces of paper they thought were worth 100 cents on the dollar are worth only, say, something in the 70s. That will make for a lot of heartache.

At the time of publication, Bill Fleckenstein did not own or control shares of the equities mentioned in this column.

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