The Federal Reserve’s announcement Tuesday that it would buy as much as $200 billion in commercial paper was a remarkable but poorly understood action in a week of extraordinary events.
Like other Fed and Treasury actions in recent weeks, it has an air of increasing desperation. The fact that world stock markets continued to fall apace after the announcement and that lending between commercial banks remained nearly paralyzed showed it was no magic bullet. Like other improvised financial rescue initiatives, it probably is better to try it than not. But don’t expect any miracles.
The average citizen has some general understanding of what it means to loan money to an insurance company like AIG or even to give the buyer of Bear Stearns good U.S. Treasury bonds in exchange for risky private securities. But what the heck does it mean to buy up “commercial paper”? And why is the Fed doing it?
Commercial paper is a specific type of an IOU or promissory note. It is like a corporate bond, except that it documents borrowing by a company for a short term, while most bonds involve long-term borrowing. So “selling commercial paper” means borrowing money and “buying commercial paper,” as the Fed is about to do, means lending money.
When you hear the Fed is going to buy $200 billion in commercial paper, it means our central bank is going to lend $200 billion to private companies that make a practice of borrowing in this way.
(For more about short-term borrowing, see the Richmond Fed’s classic reference, Instruments of the Money Market.)
Historically, a company that needed to borrow short-term had to get a loan from a bank. But decades ago, large, financially secure corporations discovered they could cut out the middleman and borrow directly from traditional institutional investors like insurance companies, endowment funds and pension plans, at slightly lower interest rates than if they went to a bank.
A large national retailer might use commercial paper to finance inventory for the Christmas season. A farm machinery manufacturer that made most of its sales in the spring and fall could use commercial paper to finance unsold inventory. Car manufacturers could do the same.
These borrowings did not involve any collateral. As long as the term of the borrowing did not exceed 270 days, the elaborate rigmarole of legal disclosures needed for a corporate bond issue was not required. Most borrowing was for much shorter periods, often 30 or 60 days. Commercial-paper buyers depended on knowing the general financial health of a corporation at the time it sold the paper and assumed it couldn’t go completely to pot in the very short term before the loan would be repaid.
For years, only the largest corporations could sell commercial paper. Most of it was for manufacturers, retailers or other nonfinancial businesses.
There were occasional defaults. When the Penn Central railroad went bust in the 1970s, its commercial paper suddenly was near worthless. (Goldman Sachs, which handled the railroad’s business, had assured its customers the paper was good while simultaneously dumping its own. The resulting criminal and civil legal actions went on for years.)
Nonetheless, the commercial-paper market continued to grow, and in recent decades many more companies were able to borrow via this method, even financial firms like investment banks. At any given time, there is more than $1.5 trillion in outstanding commercial paper. Because it is short term, tens or hundreds of millions of dollars worth needs to be sold each week.
Banks are not eager to lend to businesses. If banks cannot sell commercial paper either, they will be starved for cash. Firms that were financing long-term investments with short-term commercial paper borrowing will go belly up, further propagating ongoing panic. (Interestingly, it was a near freeze-up of commercial paper markets back in August 2007 that touched off the first massive intervention by the Fed and European central banks.)
Thus, the Fed’s decision to buy up commercial paper represents acting as a “lender of last resort.” Just as when it buys up government bonds in its daily open-market operations that control the money supply, the Fed can create new money just for this purpose. Unlike the Treasury, it does not need an appropriation from Congress.
Is this new initiative a good policy? It is about as good as any of the other rescue measures the Fed has tried. In desperate times, it may better to have tried and lost than never to have tried at all.
Will it work? I’m pessimistic. By the time a financial crisis gets to this stage, all rescue attempts often fail, and the crisis plays out by itself. That usually means a brutal recession. And that probably is in the cards right now.
© 2008 Edward Lotterman
Chanarambie Consulting, Inc.