- The Fed announced the creation of a new commercial paper lending facility on Tuesday.
- Commercial paper is a short-term, unsecured or asset-backed loan to a corporation.
- Commercial paper is considered a relatively low-risk investment, but of late investors are fleeing all but the safest securities.
- Although short-term (of the one day variety) commercial paper interest rates eased somewhat Thursday, it remains unclear whether that improvement will prove sustainable or more market trouble is on the way.
*** Before we begin the today's core topic, if you are feeling like just selling out of the stock market entirely in response to another huge down day, we urge you to read the following New York Times article that provides a very rational view of how best to evaluate such a decision. http://www.nytimes.com/2008/10/09/business/yourmoney/09money.html ***
As Monday's global panic led to Wednesday's orchestrated global interest rate cuts, various other domestic policies were also implemented. In particular, the Federal Reserve announced a further expansion of their lending facilities, this time targeting commercial paper markets, an important conduit linking large firms to short-term funding.
If there's one thing we financial types have in spades, it's impenetrable lingo. So what is commercial paper and why is it important?
Commercial paper is a short-term, unsecured or asset-backed loan to a corporation. The loans are paid off quickly, anywhere from a day to a couple of months. Unlike more familiar securities like corporate bonds, commercial paper doesn't need to be registered with the Securities and Exchange Commission (SEC) and can often be sold without backing collateral (commonly referred to as unsecured). Due to its convenient structure, many firms use commercial paper to support day-to-day operations like paying workers or rent.
The commercial paper market consists primarily of big, creditworthy companies. And because a big firm's couple-month prospects are fairly easy to predict, commercial paper is considered a relatively low-risk investment. Many average investors own commercial paper via money market funds without ever realizing it. However, in times of financial uncertainty when perceived short-term risk is higher, interest rates rise and it becomes harder for firms to get quick funding. If uncertainty becomes panic, the whole market can break.
Of late, as financial markets' perceived opacity has increased, investors have fled all but the safest investments (US Government Treasuries for instance), shunning even the traditionally safe commercial paper markets. According to the Wall Street Journal, the now $1.5 trillion market shrank by $56 billion in the week ending Wednesday—capping a cumulative decline of $264 billion in the last four weeks.
Worried about the strain collapsing commercial paper markets could have on underwriting financial intermediaries or the broader economy, the Fed announced Tuesday it would open a new lending facility to prop commercial paper. (At the beginning of the year the Fed dealt only with commercial banks, but that power has since extended to investment banks and now directly to non-financial firms.) Although short-term interest rates (of the one day variety) eased somewhat Thursday, investors remained skittish, indicating they still preferred very short-term paper to longer-term loans of a month or more.
Though we believe some Fed and Treasury actions have been questionable throughout the crisis, this step could be quite important. However, it remains unclear whether Thursday's slight improvement will prove sustainable or more market trouble is on the way.