For the first time since the Great Depression….
October 8, 2008 – 12:23 am….the Federal Reserve will lend directly to corporations. Announced today, the Fed’s latest plan to help unclog the credit markets is to provide financing directly to borrowers in the commercial paper market. According to the Journal:
The central bank, with the backing of the U.S. Treasury, said it would make loans directly to companies in this market. The move potentially puts taxpayers on the hook for new losses. Many commercial-paper loans are not secured by collateral. Though the Fed took a variety of steps to minimize its exposure, including asking borrowers to pay upfront fees, the government could suffer losses if corporate defaults rise and those steps prove insufficient.
A significant chunk of American business may soon be operating courtesy of the American taxpayer. This is a step closer to nationalizing, not only the financial sector, but much of the “real” economy.
Commercial paper is ultra-short term financing that large companies like General Electric, Bank of America and AT&T use to fund their day-to-day operations. This puts them in a rather vulnerable position if they are unable to roll-over their short-term debts.
Take for instance, General Electric. GE recently had $90 billion of commercial paper outstanding. That’s $90 billion of debt that either has to be rolled over or repaid every few days or weeks…
During normal economic times, triple-A credits like GE have no trouble rolling over commercial paper. But panic is sweeping the financial system, causing investors to flee even the “safest” debt issues. As I wrote last week, money-market mutual funds are seeing record redemptions. That cash is typically rolled over in commercial paper. Now it’s running to Treasury mutual funds or FDIC-insured savings accounts:
Prime funds have seen $500 billion in outflows since last month, while government money funds have grown by $380 billion, according to research firm iMoneyNet Inc. It is the largest flight to government funds in any four-week measure in history, according to AMG Data Services.
The wave of redemption requests from investors has forced prime money funds to sell billions of dollars in commercial paper they’ve invested in to raise cash.
Since the supply of cash is running short, the price of commercial paper is going up:
General Electric commercial paper maturing in December, which in normal times would yield 2% to 3%, was yielding above 5% on Tuesday, according to traders. GE’s finance arm, GE Capital, is one of the biggest issuers of commercial paper.
An interest rate is a price. It’s the price one pays to borrow money. But even with commercial paper prices skyrocketing, lenders still aren’t supplying enough to the market forcing issuers to roll-over their debt more frequently. Again according to the Journal article, 80% of commercial paper now carries a 1-4 day duration, as opposed to 40-50% during normal times. That means most commercial paper borrowers are at the mercy of creditors two-three times each week.
It’s conceivable that these companies—again: blue-chip, industrial, AAA-credits—could miss payroll if they lose access to this short-term funding. Banks are particularly dependent on commercial paper. Bank of America has $146 billion of short-term debt outstanding. I can’t claim to be an expert on the mechanics of bank failures, but I suspect the credit crisis will enter a whole new dimension if a company like B of A suddenly loses access to short-term funding.
That’s why the Fed took the absolutely unprecedented move of offering loans directly to corporations by offering to purchase commercial paper. This puts taxpayers at significant risk of loss.
Once upon a time two years ago, I believe a Fed loan required collateral in the form of U.S. Treasury securities. Then the Fed started accepting Mortgage-Backed Securities. And recently equities. But while mortgage-backed securities are certainly riskier than Treasuries, at least they are backed by something. A house. (Theoretically anyway)
Not necessarily so with commercial paper. As noted in the first quote at the top, most commercial paper is not secured by any collateral whatsoever.
That’s your money at risk folks.
……
Interesting that the Fed took such a dramatic step today and the market still dropped 500 points. Will it fall even as Hank Paulson starts buying up assets with his $700 billion allowance? I suspect so. The market seems to be saying we’re too far gone to be saved.
Posted in Economy, Fed, Interest Rates, bailout, credit crunch, government spending, taxpayer issues |
3 Responses to “For the first time since the Great Depression….”
I think I read that the gov’t coverage of money market funds will only last 3 months and will only apply to funds invested before a certain date - I think the middle of Sept.
That would mean if someone rushed to move from one MM fund to another, they might be thinking they were moving to safety but would not be covered by this three month guarantee.
Another thing - why couldn’t a group of unquestionably strong companies agree to work with each other on short term MM type trades? Say, GE, Caterpillar, Wal-Mart etc. This would allow some kind of trust to be established that could slowly expand from there. Their risk in doing this would be offset by the lower rates they could agree to by bypassing the panicked MM.
By CB on Oct 8, 2008
Good suggestion CB, I entirely support your proposition. These large corps you speak of know each other well, can easily assess counterparty risk of loaning to each other and have transparent balance sheets (well almost - but certainly better than the banksters we find in the money markets today).
They should think about making their own exclusive club, issue club paper and compete with the FED! Who knows, maybe the PONZI Fractional Reserve Banksters scheme will morph into a really free market.
Opps, I forgot, the Banksters are also the Corps….Ummmm perhaps Bill or Warren could help?
Good luck USA - it was a great party!
By Peter the Rock on Oct 8, 2008
Marriner S. Eccles, was the Chairman of the Federal Reserve from 1934 1948
In his 1951 memoir Beckoning Frontiers, Eccles detailed what he believed caused the Great Depression.
Our current situation is eerily similar.
Eccles wrote:
“As mass production has to be accompanied by mass consumption, mass consumption, in turn, implies a distribution of wealth — not of existing wealth, but of wealth as it is currently produced — to provide men with buying power equal to the amount of goods and services offered by the nations economic machinery.
Instead of achieving that kind of distribution, a giant suction pump had by 1929-30 drawn into a few hands an increasing portion of currently produced wealth. This served them as capital accumulations. But by taking purchasing power out of the hands of mass consumers, the savers denied to themselves the kind of effective demand for their products that would justify a reinvestment of their capital accumulations in new plants. In consequence, as in a poker game where the chips were concentrated in fewer and fewer hands, the other fellows could stay in the game only by borrowing. When their credit ran out, the game stopped.
By John Petty on Oct 19, 2008