Subprime Mess: More Fallout and One Potential Cure

In case you were wondering, the global credit markets aren't out of the woods yet. The London interbank offering rate, or Libor, is a widely used benchmark rate on everything from "adjustable rate mortgages in the US to giant floating-rate bank loans taken out by global corporations." How important is Libor?

Financial contracts with values of about $150 trillion are indexed to the Libor, according to a paper published in May last year by Donald MacKenzie, a sociology professor at the University of Edinburgh.

Yes that is $150 trillion with a T. So naturally an increase in the 3 month US Dollar Libor from its relatively narrow range earlier in the year does not bode well for the market. After spiking up in early August LIBOR appeared to be moderating, but has since reached a 7-year high at 5.72% after 10 straight days of gains. Economist Lou Crandall of ICAP in New York had this to say about the change:

"Higher Libor rates affect the whole economy by tightening the budgets of borrowers large and small. It hurts corporate profits and tightens household budgets, too."

This is hardly encouraging news for an economy seeking to find its footing and avert a recession. This becomes just another reason the Fed may have to loosen rates, though it is looking more and more like our problems will not be solved by a monetary solution.

At least a few people however are doing their best to find solutions instead of just pointing out problems. I stumbled across a post on WSJ's Deal Journal that had a rather interesting idea for how to restore liquidity to the debt markets. I'll let you decide for yourself if it is feasible:

Wall Street firms got into the pickle they are in now by doing deals that eliminated companies from the public scene. Now there is talk that to get out of the mess, they could create one.

As we discussed in this Ahead of the Tape column in The Wall Street Journal today, between now and the end of the year the firms must find somewhere to put more than $350 billion of loans and bonds, much of it from leveraged buyouts. With investors showing little appetite for the paper, there is a new theory circulating among bankers about the creation of a new company to house the debt that can’t find a home in the market.

Below is a bit more detail on how it all might work, according to a few bankers we spoke with, followed by some major caveats.

The banks would come together to create a new company we will refer to as LoanCo (though we can think of a lot of more colorful names, many of them with bathroom references). They would dump into the new company all the tranches of debt they are unable to sell to investors. These would include, say, a slice of covenant-lite loans from TXU and a pik-toggle bond issue from First Data.

Feel free to read on.