commercial paper


U.S. non-financial companies held a record $931 billion of checking and savings deposits as of March 31, according to the Federal Reserve flow-of-funds reports. Deposits more than doubled from June 2009, when the latest recession ended, as the economy grew 6.3 percent.

Its a bit of the Recency effect — Cash is rising as companies guard against the risk of another slump, with management looking back towards the 2008-09 crash.

Checking accounts held 40 percent of non-financial companies’ deposits at the end of the first quarter, and the other 60 percent was in savings. Deposit figures at the end of the second quarter will be included in the Fed’s next flow-of- funds report, due Sept. 20.

Rather speaks for itself. This is the other less visible component of inflation. While this effect remains, inflation of the money supply will not effect prices in the most pernicious manner. Should things change the potential for a greater distortion in prices is present in the liquidity created.

The commercial paper market is a critical market for businesses, and thus potentially the employment picture. If corporations could not roll over short-term debt for wages, inventories, and other working capital requirements against Receivables, the whole system grinds to a very nasty halt, and unemployment soars.

Sales of longer-term commercial paper soared 10-fold after the Federal Reserve began buying the corporate IOUs, a sign that the central bank’s efforts toward unlocking the market may be working.

Companies yesterday sold 1,511 issues totaling a record $67.1 billion of the debt due in more than 80 days, compared with a daily average of 340 issues valued at $6.7 billion last week, according to Fed data. The central bank probably absorbed about $60 billion of the total, said Adolfo Laurenti, a senior economist at Mesirow Financial Inc.

Here is the previous volumes in the CP market

And the newer data now that the Federal Reserve has stepped into the market, performing the function that Banks once did. This has been one of the more serious consequences of the Banks imploding and hoarding capital, they had starved the market of capital.

The interest rate cut will cheapen the cost of this capital to corporations, offsetting to an “unknown” degree problems [losses] that they have suffered since the credit debacle blew up in the banks faces.

From the Economist.

ANY good tradesman will tell you the importance of the bits of a house that you cannot see. Never mind the new kitchen: what about the rafters, the wiring and the pipes? So it is with financial markets. The stockmarkets are the most visible: as they soar or swoon, the headline-writers get to work. The money markets, however, are the plumbing of the system. Normally, they function efficiently and unseen, allowing investment institutions, companies and banks to lend and borrow trillions of dollars for up to a year at a time. They are only noticed when they go wrong. And, like plumbing, when they do get blocked, they make an almighty stink.

At the moment, these markets are well and truly bunged up. In the words of Michael Hartnett, a strategist at Merrill Lynch, “the global interbank market is effectively closed.” The equivalent of a run on banks has been taking place, without the queues of depositors seen outside Northern Rock, a British mortgage bank, last year. This stealthy run has been led by institutional investors and by banks themselves.

Many banks have had to be rescued by rivals or the state. This week the Irish government felt compelled to guarantee the deposits and some other liabilities of the country’s six largest banks. Surviving banks have become ultra-cautious—“just taking things one day at a time,” says Matt King, a strategist at Citigroup.

The effect has been most dramatic in the overnight rate for borrowing dollars. Bank borrowing costs reached 6.88% on September 30th, more than three times the level of official American rates, while some were willing to pay a remarkable 11% to borrow dollars from the European Central Bank (ECB). Banks have become so risk-averse that they deposited a record €44 billion ($62 billion) with the ECB on September 30th even though they could have earned more than two extra percentage points by lending to other banks. It was the last day of the quarter and, for balance-sheet reasons, banks were particularly keen to have cash on hand. (Overnight rates fell back on October 1st, but one-month rates rose further, indicating that the crisis had not eased.)

In the absence of private-sector lenders to banks, central banks have become vital suppliers in the money markets. With the help of the ECB, the Bank of England and the Bank of Japan, the Federal Reserve agreed to lend a further $620 billion on September 29th (see article). That package, though of similar size to the Bush administration’s $700 billion bail-out plan, did not need congressional approval or attract public opposition.

But central banks can only do so much. In particular, they tend to lend for short periods and then only against collateral with a high credit rating. That still leaves banks with the problem of financing their more troubled assets, an issue the Bush administration’s plan was designed to solve.

The money markets’ difficulties began in July 2007, when two Bear Stearns hedge funds revealed the damage done to their portfolios by subprime mortgages. Since August of that year, central banks have been intervening to keep them functioning, with a series of schemes like America’s Term Auction Facility. But the collapse of Lehman Brothers, followed by the long series of rescues in Europe and America, seems to have brought the money markets close to breakdown. Even immediate passage of the Bush plan would not solve all their problems straight away, because it would take time to put the plan into place.

Why do these markets matter? First, the rates on loans paid by many consumers (adjustable-rate mortgages, for example) and companies are set with reference to the money markets. Higher rates for banks mean higher rates for everyone. Second, if the markets are blocked for more than a week some companies may find it hard to get any finance at any price. That could mean more bankruptcies and job losses. Third, more banks could go bust if the blockage continues, making investors even more risk-averse. The downward spiral would take another turn.

“We are at the juncture where more widespread and permanent support is required to restore confidence in the banking sector,” say analysts at the Royal Bank of Scotland (RBS). “Without it, the banks will be aggressively trying to contract their books and will be unable to provide credit to retail and corporate clients.”

So it is safe to say that, until the money markets behave more normally, the financial crisis will not be over. And until the financial crisis is over, the global economy may not recover.

Liquid dynamite
First, the problem. It is widely assumed that central banks set the level of interest rates in their domestic markets. But the rate they announce is the one at which they will lend to the banking system. When banks borrow from anyone else (including other banks), they pay more. Every day, this rate is calculated through a poll of participating banks and published as Libor (London interbank offered rate) or Euribor (Euro interbank offered rate).

Normally, these are only a fraction of a percentage point above the official interest rates. But that has changed dramatically in recent weeks (see chart 1). Take the cost of borrowing dollars. On October 1st banks had to pay 4.15% for three-month money, more than two percentage points above the fed funds target rate. In theory, three-month rates could be that high because markets are expecting a sharp rise in official rates. But that is hardly likely, given the depth of the crisis.

Instead, the width of the margin reflects investors’ worries about the banks, not least because so many have faltered so quickly. Three months is now a long time to trust in the health of a bank. In addition, banks are anxious to conserve their own cash, in case depositors make large withdrawals or their money gets tied up in the collapse of another bank, as with Lehman.

One way this risk aversion shows up is in the “Ted spread” (see chart 2), the gap between three-month dollar Libor and the Treasury-bill rate. After being as low as 20 basis points (a fifth of a percentage point) in early 2007, the spread is now 3.3 percentage points. In other words, the relative cost of raising money for banks has risen 16-fold in the past 18 months.

Indeed, some banks argue that Libor and Euribor understate the full extent of the increase in banks’ borrowing costs. According to John Grout of the (British) Association of Corporate Treasurers (ACT), banks have started to talk to companies about invoking the “market disruption” clause in loan contracts. This would allow them to replace the two benchmarks with the “real” cost of their funds, which they say would be higher. (Companies usually pay Libor or Euribor plus a margin that depends on the riskiness of their finances.) One company, Hon Hai of Taiwan, an electronics manufacturer, says its banks have already invoked the clause.

This affects only debt facilities that have already been set up. Mr Grout says that when companies are negotiating new loans with banks, they are being asked to accept rates based on Libor plus a quarter of a percentage point. Unsurprisingly, the ACT is unimpressed with this tactic, since Libor is calculated from data supplied by the banks themselves.

Companies do not have to borrow from banks; they can raise money from the markets by selling commercial paper, a type of short-term debt. For much of this year, that was an attractive option. The preference of investors for debt issued by non-financial companies made commercial paper a source of cheap finance.

But in recent weeks even this has become more difficult. The volume of commercial paper outstanding fell by $61 billion to $1.7 trillion in the week ending September 24th. And investors are unwilling to lend for long: AT&T, a big American telecoms company, said on September 30th that the previous week it had been unable to sell any commercial paper with a maturity longer than overnight. The volume of asset-backed commercial paper maturing in four days or less ballooned from $32 billion a day to $104 billion during September (see chart 3), while the amount maturing in 21 to 40 days fell by 63%.

Where there is doubt about a company’s finances, it inevitably has to pay a higher rate. Worries about GE, one of America’s most prestigious companies, pushed up the premium on its credit-default swaps and made raising short-term debt dearer. According to the Wall Street Journal, the rate on its commercial paper had gone up by two-fifths of a percentage point. That might not sound much, but GE has $90 billion of paper outstanding, so it faced an extra interest bill of $360m a year. On October 1st the company announced a $12 billion public share offering and a $3 billion injection from Warren Buffett, a leading investor.

Why has commercial paper lost its shine? The explanation seems to lie back in the authorities’ willingness to allow Lehman to collapse. That move, designed to warn the markets that the authorities took moral hazard seriously, has had some unintended consequences.

Fund of surprises
The most severe was the loss imposed on the Reserve Primary fund, a money-market fund. Such funds invest in short-term debt and offer investors higher rates than on bank deposits. But they also aim to repay their customers at par. Because it had bought Lehman debt, the Reserve Primary fund was forced to “break the buck” (that is, to repay less than 100 cents on the dollar), only the second such instance in the industry’s history. This caused a crisis of confidence in money-market funds. “Prime” funds, which offer slightly above-average rates in return for higher risk, have lost about $400 billion out of $1.3 trillion in the past few weeks, as investors have switched to funds based on government debt. In turn that has made other funds more cautious and led them to steer clear of bank loans and commercial paper.

Buried among the many recent American regulatory initiatives was a scheme to insure money-market funds against failure. That scheme may have halted a stampede by retail investors out of the industry, but it has not restored the level of confidence of two months ago and new deposits do not qualify.

At the same time as they are struggling to raise money from outsiders, banks may face more claims on their capital. In the good times they promised to provide back-up loans to companies—which they thought would never be asked for. On some estimates, the value of these promises is $6 trillion. But with the commercial-paper market tightening and the economy deteriorating, more companies will be asking banks to keep their word.

Indeed, companies already seem concerned that banks will be unable to maintain promised loan facilities. So they are using those credit lines earlier than expected, in case they vanish. A prime example is Duke Energy, an American utility, which recently drew down $1 billion from a credit agreement. Chris Taggert of CreditSights, a research group, foresees a “funding blitzkrieg” by high-yield borrowers tapping their banks for cash if the mayhem does not abate.

“There’s a vicious-spiral element to the inability of companies to roll commercial paper,” says Ajay Rajadhyaksha, a fixed-income strategist at Barclays Capital. “Those that have back-up lines of credit with banks are increasingly drawing on them. This is hurting the banks, and making money-market funds even queasier about buying bank debt, and so on.”

CreditSights notes that it has become more common for companies to call on these loans amid “fears that bank lenders may not be able to honour commitments in the future.” Several of these companies, including General Motors, have cited the uncertain state of capital markets when asking for their money. Goodyear Tire & Rubber said it was drawing down its loans because some of its cash was locked up in, of all places, the Reserve Primary money-market fund.

Whatever the reason, the possibility of more calls from their corporate clients is another factor behind the banks’ desire to hold cash. That will mean any company without a back-up facility may struggle to raise new loans.

Luckily, most companies are not as exposed as they were when the dotcom bubble burst. Nevertheless, plenty of carmakers and retailers have mountains of debt or a strong need for cash. Then there are companies that underwent leveraged buy-outs. The private-equity groups that bought them may have been counting on refinancing their debts soon.

A lack of access to capital is sure to make companies cautious. “Your ability to plan for investment is obviously affected,” says Randall Stephenson, chairman and chief executive of AT&T. In addition, higher finance costs will eat into profit growth, a fact that seems yet to be recognised in buoyant forecasts for 2009. “The equity market is going through the slow process of realisation that a large proportion of earnings growth over the last 25 years was due to the falling cost of money,” says Kit Juckes, an economist at RBS.

Polonius’s revenge
Consumers have been going on a greater debt binge than companies and the impact on them may be more immediate. In particular, they may face higher mortgage and credit-card rates. Some may be denied new credit altogether.

The last survey of senior loan officers by the Federal Reserve was back in July. Even then 65% of banks were tightening their lending standards on credit cards, up from 30% in April. Consumers had not felt the effects by then: credit-card lending rose by 4.75% in the year to July, although other types of credit barely grew at all.

Mortgage costs have also been rising for those with variable-rate loans. On September 30th, American adjustable-rate mortgage rates were 6.13%, according to Bloomberg, compared with 5.92% at the end of August and less than 5.5% in the spring. In Britain three leading lenders raised rates by half a percentage point in the week to September 26th. And Moneyfacts, an information group, says the number of buy-to-let mortgages (used by private landlords) has fallen 85% over the last year.

These effects might teach voters that punishing the banks for their follies is sometimes cutting off their noses to spite their faces. “At some point Main Street will realise it lies on the same road as Wall Street,” says Mr Juckes.

It is not too difficult to imagine bank failures leading to job losses, further falls in house prices, bad consumer debts and further bank losses. “We may already be at the point where corporate fear and conservatism are baked in: even if things start to improve for the banks, companies have seen how bad things can get, and that can prove lasting,” says Torsten Slok, an economist at Deutsche Bank. “So there is a risk they’ll continue to hoard cash and mistrust banks for quite some time.” That is the kind of spiral which the Bush administration’s plan was designed to avoid.

Relying solely on ad hoc rescues of individual banks would only make investors more nervous about the banks that remain. The financial plumbing would stay bunged up. Unless something is done to unblock it soon, there will not just be a nasty stink in the markets. There will also be an unholy mess in the wider economy.

Managers of money market funds are deeply divided as to whether the coast is clear to venture back into asset-backed commercial paper – a move that may be necessary to help end the global credit squeeze and unglue frozen mortgage markets.

Money market funds were heavy buyers of ABCP and paper issued by banks’ off-balance sheet conduits and structured investment vehicles, helping fund the excesses in credit markets prior to last summer’s blow-up.

But the funds, which hold some $4,000bn (£2,028bn, €2,590bn) of assets, have shied away from these markets since then as they have ratcheted down risk. And their absence from the market is increasingly being seen as the reason why inter-bank lending rates have remained well above overnight rates despite massive intervention by central banks on both sides of the Atlantic.

Eventually, they will. Money never sits idle for extended periods. Obviously confidence is low, and this will certainly drive the flow to the highest quality credits. But, as time passes, assuming no disasters, gradually money will again start flowing to the lower credits, and so the cycle turns once again the full circle.

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From Financial Week;

The credit crunch is taking a toll on corporate liquidity, as the soaring cost of debt—for both commercial paper and private placements—pinches the balance sheets of all but the most highly rated non-financial companies.

Cash and short-term investments of non-financial companies dropped by $250 billion in the second half of 2007, the first decline in the nine years that consultancy Treasury Strategies has been tracking the data.

Corporate liquidity had risen steadily, from $3.9 trillion in 1999 to $5.5 trillion in June 2007. But at the end of last year, it had fallen to $5.25 trillion, a 5% drop.

The findings are part of a survey of 135 corporate treasurers conducted by Treasury Strategies between July 1, 2007, and Jan. 1, 2008. Treasury Strategies then adjusted that data with findings from its annual survey of 600 corporate treasurers.

Anthony J. Carfang, a co-founder of Treasury Strategies, attributes much of the drop to a decline in commercial paper issuance. Many companies issue commercial paper not just to finance operations but to bolster the cash on their balance sheet. “As companies have tightened up, they’re shrinking balance sheets just a little bit by borrowing less,” Mr. Carfang said. “A lot of companies had been directly issuing commercial paper because it was easy to do, and keeping a little cash cushion as a result.”

But when the credit crunch began, it became expensive for all but the most highly rated companies to issue paper. As a result, he said, cash balances dropped.

For non-financial issuers of 30-day A2/P2 commercial paper, spreads jumped as high as 150 basis points in the second half of 2007, according to Federal Reserve data. Prior to that, spreads had hovered around 15 basis points for much of the last five years.

Commercial paper has become so expensive for some firms that they can’t issue it at all. Last week, commercial financier CIT Group reported it needed to tap $7.3 billion in unsecured credit lines because it was unable to raise money by selling commercial paper.

The jump in spreads caused a slowdown in issuance of commercial paper by non-financial firms. After increasing in the first half of 2007 by $14.2 billion, to $185.5 billion, the amount of commercial paper outstanding issued by non-financial firms fell by $10.3 billion, to $175.2 billion, during the following six months, according to Fed data.

One Treasury Strategies client, which Mr. Carfang declined to name, had $500 million in commercial paper outstanding prior to the credit crunch. That amount had to be cut to $200 million because the company found it difficult to issue amounts larger than that.

Commercial paper issuance by non-financial firms has bounced back since the end of last year, increasing by $7.8 billion, to $183 billion, through February. But spreads are still higher than normal, at around 80 basis points.

As a result of rising credit costs, said Treasury Strategies partner Dave Robertson, companies have been forced to use excess cash to pay down debt. And the cost increase isn’t limited to commercial paper, he added, noting that issuing debt via the private placement market has also become “significantly more expensive.”

The reason, Mr. Robertson explained, is the investment banks that aid companies with private placements don’t have the same access to the assets of a company—such as their cash balances—that a company’s primary commercial bank would. So, as fears of defaults grow, investment banks are forced to charge more to issue debt.

As part of the same study, Treasury Strategies found that approximately one-fifth of companies had invested in securities that had been affected by the credit crunch, also causing a hit to liquidity. In reporting their earnings for the fourth quarter, some companies have cited year-over-year declines in cash and short-term equivalents due to poor investment decisions made by management.

Teen retailer Hot Topic, for instance, earlier this month announced a 4% year-over-year decline in cash and cash equivalents and short-term investments, to $53 million, in part because it spent $7.2 million on its stock-buyback program. In addition, it reported that $21 million, or nearly half of its cash, was in auction-rate securities, of which the company had only been able to liquidate $8 million.

“We are looking at the long-term future of our business, and we want to be very prudent with our capital resources in terms of how we utilize them,” CFO Jim McGinty said in a conference call with analysts. “At this point in time, in the current environment, we feel like the preservation of cash should be our key concern.”

The beleaguered newspaper publisher Sun-Times Media Group, formerly known as Hollinger International, announced in its third-quarter earnings release that cash and short-term investments had declined to $132 million from $212 million at the end of the second quarter, in part because it held $48 million in Canadian commercial-paper investments that had become frozen when the asset-backed commercial paper market there seized up. By the end of the fourth quarter, cash had increased to $143 million, but that still reflected a 24% year-over-year decline.

Despite these incidents, Mr. Carfang notes that for the most part, balance sheets are in remarkably good shape, especially in a recessionary environment. “Corporate balance sheets are the strongest we’ve ever seen for non-financials heading into an environment such as this one,” he said. But while the higher costs won’t be fatal to most companies, “in some cases it hurts.”