As investors fled the money and commercial paper markets, they dove into short-term treasuries. Yields on three-month treasury bills plunged a breathtaking 200 basis points during the first three weeks of August from 4.95% to 2.90%. Investors did not bother to discriminate between commercial paper issuers or money market funds. Those that had nothing to do with subprime were punished along with the guilty parties as investors sold first and asked questions later in their flight to quality.

In some ways, it is hard to blame the investors. After all, the rating agencies had failed them. Trust in the rating system failed when investors started taking losses on investment grade bonds backed by subprime mortgages. Not surprisingly, investors balked at other forms of debt rated by the agencies. Many no longer trust the agencies and do not have the expertise or staff to analyze the underlying assets themselves.

Into this mess stepped the Federal Reserve. After a couple of weeks of hoping the markets would stabilize themselves, the Fed lowered the discount rate by 0.5% on Aug. 17. Just as important, the Fed indicated that it would shift at least a portion of its focus from inflation to the health and stability of the capital markets. In a purely symbolic move, the Fed encouraged the four largest banks in the country to step up to the window to borrow $500 million each even though none of these banks needed the liquidity. The Fed (and presumably the banks) wanted to show investors that liquidity still existed in the banking system. Bank of America capped off last week by investing $2 billion in Countrywide Financial Corp., effectively ending rumors that the nation's largest residential mortgage lender would fail.

The stock market immediately rallied in response to the rate cut and continued its recovery into last week. Yields on three-month T-bills began to rise while a lone CMBS pool priced during the week with significantly tighter spreads. Super senior AAA bonds tightened 13 bps to Swaps + .53% while BBB- came in 75 bps to Swaps + 4.53%. All in all, the week of Aug. 20 was relatively quiet if still somewhat fragile. One suspects that many investors and issuers headed to their traditional August vacations resulting in light trading. But given the turmoil of the previous three weeks, any respite, however ephemeral, was welcome.

Unfortunately, instability returned Aug. 27 as the stock market sold off all of the week before's gains and T-bill yields fell as investors sought safe harbor. As much as many of us hoped last week indicated a trend toward stability, none of us really believed it. Investors stuck their toes in the water last week, but yesterday's market shows it does not take much to send them flying back up the beach. And don't forget about potential hedge fund failures. Many hedge funds leveraged their investments to buy securities that have since plummeted in value. I would be surprised if we do not have more hedge funds fail or suspend redemptions in the next couple of months. Such failures could send more shock waves through the capital markets.

September should provide us with some clarity as to when stability will return to the markets. Many issuers delayed taking CMBS or CDO transactions to the market when the turmoil hit in late July. Approximately $30 billion of commercial mortgages underwritten to the old, more aggressive underwriting standards still have to clear the market. Since issuers have to mark this paper to market, they have little incentive to sit on these securities. Furthermore, many issuers hold significant amounts of unsold bonds from CMBS and CDO pools issued earlier in the spring and summer. The question is whether there is enough demand amongst investors to clear this flood of supply coming to market.

If investor appetite returns in September, the market should stabilize, albeit at higher yields. But if investors continue to sit on the sidelines, we could have several more months of instability. Many buyers think CMBS looks cheap but hesitate to buy for fear that spreads will widen further. They are seeking any sign that the markets have stabilized. The question remains, when will it be safe to go back in the water?

Scott Bottles is principal at George Smith Partners. The views expressed in this article are the author's own.