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You know things have become very strange in the financial world when U.S. Federal Reserve Board chairman Ben Bernanke is forced to borrow from the playbook of Arthur Burns, the Fed boss who presided over one of most dismal stretches for the U.S. economy in recent memory.
By stepping in to support the commercial paper market, a key source of funds for some of the continent's biggest companies, Mr. Bernanke is stealing a move from Mr. Burns, who became a lender of last resort to Corporate America back in the 1970s.
Mr. Burns led the Fed during the era of bell bottoms, a time of weak economic growth and high inflation. In one of his earliest acts, he also laid out the blueprint for a rescue of the commercial paper market, an unheralded but crucial linchpin of commercial finance.
Penn Central, a U.S. railway, defaulted on more than $80-million (U.S.) of commercial paper in 1970, leaving investors who had bought the unsecured, short-term loans out in the cold.
Immediately, tremors rocked the market for the corporate IOUs, bringing much of the short-term lending to corporations in the United States to a halt and raising concerns that the entire economy could seize up.
Under Mr. Burns, the Fed crafted a plan to lend money to banks that were willing to make loans to companies that had maturing commercial paper, as well as flood the market with cash.
If that wasn't enough, the Fed announced that, as a last resort, it would lend directly to companies that lost access to the CP market. Together, the measures restored confidence in commercial paper, a market that has since grown into the largest segment of the short-term lending game.
Now, the CP market is under siege yet again, because of a big bankruptcy that left investors burned, this time of Lehman Brothers Holdings Inc. Investors have cut their holdings by more than $200-billion in the past two weeks, meaning that a third of the market has disappeared in the United States. The Fed is concerned that companies won't be able to raise the short-term cash they need to meet payroll and pay their suppliers. Mr. Bernanke's plan, with its echoes of the Burns response, is aimed at restarting that lending.
Commercial paper “is the really the grease that keeps the engine going,” said Steve Foerster, a professor at the Richard Ivey School of Business at University of Western Ontario. “It really is the bloodline of corporations. It all comes down to liquidity; either you have it and you can meet your day-to-day needs, or you don't.”
The biggest users of commercial paper are financial companies, but many firms from all sectors go to the CP market to raise short-term cash. The other option is a bank credit line, but that's generally been more expensive and, in recent days, banks have begun to cancel those lines. That means some companies are in danger of being shut out. For companies that are otherwise in good shape, a loss of access to short-term financing can cause failure.
Take a manufacturer of lawn mowers: Sales peak in spring, so that's when the money comes into the till. But the biggest bills are in the winter months as the company pays workers and suppliers to build mowers. In good times for a well-regarded company, the commercial paper market offers a direct pipeline to investors who will lend the company money at better rates than a bank line of credit. Investors front the money to make the lawn mowers, and the company pays the investors back when the lawn mowers are sold.
Generally, the purchasers of commercial paper are money market funds, but in addition to their lack of confidence that companies will repay the paper, many funds are facing massive withdrawals.
“Until investors can better predict their cash flows and be certain they're going to have that money for 30, 60 or 90 days, they're going to continue to support the market but be more cautious,” said one senior money market trader.
The Fed's move should enable companies with solid balance sheets that qualify for the new program to buy CP, to keep access to funds, and be able to pay workers and suppliers. It should also help the Fed keep interest rates lower by driving down market rates for short-term corporate loans, which have jumped as supply has been restricted.
“It's going to make it easier to administer a rate of 2 per cent,” said one senior money market trader. “It's nice to say the fed funds rate is 2 per cent but if everybody else is funding at dramatically higher rates, then there's more to do.”
