Thursday, August 30, 2007

Commercial Paper Market Still in Distress

Bloomberg tells us that the commercial paper market is shrinking rapidly.

Thisis a more serious issue than might appear. Commercial paper is animportant, if not the most important, source of short-term funding forsizable corporations, mainly because it's cheap and flexible. They canreading adjust the amount outstanding to reflect changes in their needfor cash.

When CP matures, and an issuer cannot "roll" it, as inreplace it with new CP, he has two choices. If he has the option, hecan draw down standby lines of credit with his friendly bank. If he hasno, or insufficient, backup lines, he has to get the cash somehow.

Bothoption 1 and option 2 have costs. Option 1 means he is usinghigher-cost funding and has limited the company's alternatives fordealing with emergencies. But more important, the demand for cash atbanks means it crowds out other bank lending, such as to smallbusinesses.

Option 2 means the company goes into crisis mode,delaying payments to vendors, trying to accelerate payment fromcustomers, possibly even deferring payroll if that is at all an option.

Now on a small scale, these moves would create a fewcasualties. But on a large scale, as is happening now, both will put adamper on the real economy. They suggest that the 4% GDP growth release for the second quarter may have perilous little relevance now.

From Bloomberg:

TheU.S. commercial paper market shrank for a third week, extending thebiggest slump in at least seven years, as investors balked at buyingshort-term debt backed by mortgage assets.

Asset-backedcommercial paper, which accounted for half the market, tumbled $59.4billion to $998 billion in the week ended yesterday, the lowest sinceDecember, according to the Federal Reserve. Total short-term debtmaturing in 270 days or less fell $62.8 billion to a seasonallyadjusted $1.98 trillion.

Commercial paper outstanding has fallen$244.1 billion, or 11 percent, in the past three weeks, suggesting theFed's Aug. 17 reduction in the discount rate has yet to entice buyersback into the market. More than 20 companies and funds including CheyneFinance and Thornburg Mortgage Co. failed to sell new paper asinvestors fled to safer investments.

``I don't think the Fedunderstands how critical the situation is,'' said Neal Neilinger,co-founder of NSM Capital Management in Greenwich, Connecticut, in aninterview today. ``The market is going to overshoot itself and not lendmoney to people who deserve it.''...

The 11 percent decline over three weeks is the biggest since 2000, according to data compiled by Bloomberg....

Commercialpaper is bought by money market funds and mutual funds that invest inshort-term debt securities. In asset-backed commercial paper, the cashis used to buy mortgages, bonds, credit card and trade receivables, aswell as car loans. Some of the programs are backed by subprime loans.Subprime loans are issued to borrowers with poor credit or high debt.

About26 percent of asset-backed commercial paper outstanding as of July wasused to fund purchases of mortgage- related securities, according toStandard & Poor's. The yield on the highest rated asset-backedpaper due in a month reached a six-year high today of 6.18 percent....

TheFed lowered the interest rate it charges to lend to banks to encouragebuyers of commercial paper after the market seized up for Thornburg,Countrywide Financial Corp. and other mortgage lenders.

The Fed``failed to bring money markets back to normal,'' John Lonski, chiefeconomist at Moody's Investors Service in New York, said in aninterview. ``Credit markets are obviously in need of a rate cut.''

Ina sign that buyers are still favoring safer assets, an $18 billionauction yesterday for two-year U.S. government debt drew the mostdemand since 1992.

The sale drew $3.97 for every $1 sold, themost since at least 1992, according to Bloomberg data. For the past 12sales, the bid-to-cover ratio has averaged $2.77.....

TheFederal Reserve Bank of New York said last week that it is accepting``investment quality'' asset-backed commercial paper as collateral forloans. The central bank cut the discount rate, or the interest rate itcharges banks, by 0.5 percentage point on Aug. 17 to increase demandfor securities.

Futures as of yesterday show traders see a 46percent chance the Federal Reserve will cut its target rate forovernight lending between banks to 4.75 percent at its Sept. 18 meeting.

``Weneed to get the banks to start lending again,'' Plaut said. ``Once wesee that, we'll start to see the positive impact on the financialmarkets.''