Jump to content

Commercial Paper Market


Cevian
 Share

Recommended Posts

Unless you find yourself in a desperate situation, would you use short-term one day or one week financing to cover your most basic expenses?

 

I've been reading a lot about the reasons why the Fed decided to intervene and pump money into the Financial Markets and one of the reasons being cited over and over is that a lot of the Fortune 500 companies depend on short-term commercial paper in order to finance ongoing expenses such as payroll. When this market dried up during the crisis, the fear was that companies not being able to meet their short-term requirements would be out of business and this would send shock-waves throughout the world economy.

 

Now one thing I don't understand is why these large companies have put themselves in a situation where they are so dependent on this short-term nature of financing without having appropriate backups and safeguard available? Honestly, am I missing something?

Link to comment
Share on other sites

During the crisis, NPR Planet Money staff (at the time I think it was a show on This American Life) did a detailed one hour segment on the CP market, which was quite informative. I'm sure you can find it.

 

I think the more interesting question is what will happen with money market funds and the rates they provide.  My understanding is that to keep petty cash available on demand, investors could make a deposit in some form at a bank or put the money in a money market fund, which in turn invests in CP.  Over the last two decades, the money market yield has averaged roughly 1.5% higher.  One wasn't getting the FDIC insurance on the money market balances, until you needed it, and then in fact, the Fed guaranteed them. 

 

What is interesting today is that CP yields are very low at around one quarter of 1 percent, while demand deposits at banks (such as ING Direct) are offering 1%.  The historical relationship between the rates has inverted.  A number of businesses, such as Schwab's, are impacted by this.  What is going to happen?

Link to comment
Share on other sites

Unless you find yourself in a desperate situation, would you use short-term one day or one week financing to cover your most basic expenses?

 

I've been reading a lot about the reasons why the Fed decided to intervene and pump money into the Financial Markets and one of the reasons being cited over and over is that a lot of the Fortune 500 companies depend on short-term commercial paper in order to finance ongoing expenses such as payroll. When this market dried up during the crisis, the fear was that companies not being able to meet their short-term requirements would be out of business and this would send shock-waves throughout the world economy.

 

Now one thing I don't understand is why these large companies have put themselves in a situation where they are so dependent on this short-term nature of financing without having appropriate backups and safeguard available? Honestly, am I missing something?

 

I think it is because CP costs less than a line of credit with a bank. Basically, CP allows borrowers to borrow directly from lenders and cut out spead earned by the middleman (i.e. the banks). CPs also bypass the capital adequacy rules that banks would have to comply with when providing lines of credit.

Link to comment
Share on other sites

Unless you find yourself in a desperate situation, would you use short-term one day or one week financing to cover your most basic expenses?

 

I've been reading a lot about the reasons why the Fed decided to intervene and pump money into the Financial Markets and one of the reasons being cited over and over is that a lot of the Fortune 500 companies depend on short-term commercial paper in order to finance ongoing expenses such as payroll. When this market dried up during the crisis, the fear was that companies not being able to meet their short-term requirements would be out of business and this would send shock-waves throughout the world economy.

 

Now one thing I don't understand is why these large companies have put themselves in a situation where they are so dependent on this short-term nature of financing without having appropriate backups and safeguard available? Honestly, am I missing something?

 

Think of commercial paper like a low rate credit card that you have.  Say you have a credit card with a low rate.  You go out to eat, you buy some t-shirts from the Gap, you go to a movie, etc. and use your low rate card.  Why do you use it?  Because it's easier than carrying around a ton of cash.  In addition, you might not have the cash this second, but you are 99.99999% certain you will.  Maybe because your paycheck is coming in a couple of days.  You may have plenty of assets, but are you going to liquidate some stocks to go to the movies while waiting for the paycheck?  Of course not.  I'm not saying there shouldn't be some cash reserves, but magnify this by lots of expenses.  There's negative drag in holding too much cash.  There is nothing nefarious about CP - it's been in use for many many years and to my knowledge has been very very few defaults.

 

In terms of financials, that's a bit of a different story.  They got caught with their pants down in the financial crisis because they committed the cardinal sin - they essentially borrowed short and lent long.  That is, they financed themselves in many cases through CP (often through SIVs and CP securitization vehicles), but perhaps more through repos and the like.  This is what killed Bear.  They couldn't roll their repos at the end and simply ran out of liquid cash. 

 

But there is nothing wrong with a strong company using CP so long as it is used correctly.

Link to comment
Share on other sites

Create an account or sign in to comment

You need to be a member in order to leave a comment

Create an account

Sign up for a new account in our community. It's easy!

Register a new account

Sign in

Already have an account? Sign in here.

Sign In Now
 Share

×
×
  • Create New...