The recent 50-basis-point drop in the U.S. Federal Reserve Board’s funds rate is aimed at increasing liquidity as well as stimulating the U.S. economy. This is much needed, given the increasing cracks in credit markets.

The Canadian asset-backed commercial-paper market is in disarray; and the Big Five banks have now joined together in an attempt to restructure it. As a result, some banks have bought ABCP paper from subsidiaries that had large investments in that market.

The U.S. ABCP market also continues to shrink, notes a recent report from Montreal-based National Bank Financial Ltd.It was down by US$238 billion, or 20%, in the five weeks to mid-September. That put outstanding ABCP at less than 50% of commercial paper outstanding for the first time since November 2005 — though still well above the 37.6% level of 2001.

The temporary suspensions of some of Paris-based bank BNP Paribas’s and New York brokerage house Bear Sterns Companies Inc.’s hedge funds underlines the risk in that sector, says another NBF report. The hedge fund sector fuelled its five-fold expansion since 2000 by investing in risky and sometimes illiquid instruments.

Non-current loans — those that are 90 days or more past due — surged 10.6% in the second quarter. That’s the largest quarterly increase since the fourth quarter of 1990, which was a year in which the economy was in recession. NBF points out that most of the delinquencies were still concentrated in residential mortgages, but notes that the largest deterioration in the quarter — a 39.5% increase in non-current loans — was in real estate construction and development. Non-current home equity lines of credit were up 16.6%.

The implications could be far-reaching, including further consolidation in the financial services industry. Acquisition opportunities are emerging in the deterioration of the ABCP market. Bank of Nova Scotia, for example, has taken over Dundee Bank of Canada and purchased 18% of DundeeWealth Inc. and now has the right of first refusal on future sales of a controlling interest in the company. At the same time, Home Capital Group Inc. has been buying up books of mortgages that had been securitized through ABCPs.

In the hedge fund sector, NBF says financial service companies are likely to face difficult choices. On the surface, banks and brokerages have offloaded the risk inherent in hedge funds through securitization, but that risk has not evaporated. NBF warns that banks and brokerages may face difficult choices: “Step back in to buy back risk, or stay on the sidelines and proceed with margin calls, with the risk of exacerbating market turmoil.”

The hedge fund sector was able to attract money and keep the bull market rolling as long as investors kept their optimism. But as Paribas said in a press release: “The complete evaporation of liquidity in certain market segments of the U.S. securitization market has made it impossible to value certain asses fairly, regardless of their quality or credit rating.”

Paribas developed a new pricing mechanism for obtaining market prices in certain sectors and resumed calculation of net asset values in its three suspended hedge funds on Aug. 23 — a little over two weeks after the Aug. 7 suspension.

One factor that could increase market turmoil would be a rise in high-yield corporate default rates and a further widening of the spreads on this debt. The U.S. subprime mortgage problems have already sent investors scrambling to buy protection. The spread between high-yield debt and 10-year U.S. treasury bills was 463 bps on Sept. 20 vs 266 bps in mid-June. (For more on T-bills, see page 49.)

NBF warns that corporate defaults may soon be on the rise, despite the rebound in the second quarter. Financial institutions accounted for 72% of the increase and that’s unlikely to continue given their vulnerability relating to the current stresses in credit markets. Outside of financials, corporate profits were up only 3%. IE