As outstanding commercial paper experienced its greatest monthly drop ever in August, market participants are hoping the Federal Reserve will breathe new life into the short-term debt market that allows corporate America to finance its operations on the cheap.
The Federal Open Market Committee meets on Sept. 18 to set the target for the fed funds rate that banks charge each other for overnight lending. Fed funds futures, a gauge of market expectations, are showing odds greater than 50% that the U.S. central bank will lower the 5.25% funds rate by 50 basis points.
The commercial paper market remains under pressure, said John Lonski, managing director of the economics group at Moodys Investors Service in New York. One possible development that could improve sentiment would be a rate cut at the FOMC meeting to a 4.75% fed funds rate. A 25-basis point cut, oddly enough, could make matters worse for commercial paper because it would be such a disappointment.
The last thing the commercial paper market which shrank by a record $259.6 billion to $1.92 trillion in August needs is more disappointment. Despite financial market turmoil and signs of an economic slowdown, Fed officials have not signaled that help is on the way.
A real financial crunch
Commercial papers 11.9% August drop reflective of the deep distrust for any credit-related collateral used to borrow was nearly twice the previous largest decline of 6.2%. That occurred in September 1970, when Penn Central Transportation Co., the debt-burdened railroad giant, roiled financial markets by filing for bankruptcy.
The easy money days are a thing of the past, said Mr. Lonski, who sees no quick fix to commercial papers trials.
The new climate of risk aversion has made it difficult, or even impossible, for corporations to find takers for the new commercial paper they must issue to roll over maturing short-term debt a grand total of $1.9 trillion maturing over the next nine months. As a result, these companies will have to turn to banks and other financial intermediates for their financing needs, at higher rates.
The drop in the level of outstanding commercial paper illustrates the fact that risk-averse investors have no appetite for the new debt that issuers attempt to float when the older ones mature.
Mr. Lonski noted that the commercial paper market seized up during the Penn Central collapse to the point that it threatened the overall economy. In quick response, the fed funds rate sank from August 1970s 6.1% to November 1970s 5.6%.
Mr. Lonski said corporations are already feeling the pinch, as evidenced by the Duke University/
CFO Magazine Business Outlook monthly survey released on Sept. 11. The survey said chief financial officers are very concerned about credit markets, with 26.9% already feeling a negative impact from the credit markets turmoil through either higher borrowing rates or lower credit availability.
CFOs felt the corporate borrowing situation was so dire that a 50-point cut in the funds rate would either not help their ability to borrow or would help only marginally.
Higher corporate borrowing costs are bound to restrict economic activity and weigh on future profits, which may well limit the potential for much strength in the U.S. stock market in the months ahead.
Creditworthy entities are able to refinance commercial paper in the market but can only do so at punitive terms; that is, at higher rates and/or at shorter maturity, London-based Citigroup currency analyst Michael Hart wrote in a Sept. 12 research note to clients.
As borrowers find it tougher to raise short-term capital, banks that help in the process are conversely suffering from a dearth of business in what was a booming $2-trillion-plus market earlier this summer.
Anecdotal evidence suggests that much of the reduction in outstanding commercial paper has taken place at the expense of sponsoring banks, squeezing their balance sheets in an unforeseen way, Mr. Hart said. Strains in money markets are thus likely to stay for some time.
Commercial paper is rarely the topic of much debate among market regulators. But Erik Sirri, director of the Securities and Exchange Commissions Division of Market Regulations, told the House Financial Services Committee on Sept. 5 that this was cause for concern, particularly in the asset-backed segment.
Money (market) funds frequently invest in asset-backed commercial paper, including instruments that provide financing for portfolios of mortgages, Mr. Sirri said. The staff has contacted fund representatives and pricing agents to determine the effect on funds in terms of pricing their portfolio holdings and maintaining sufficient liquidity to meet redemptions.
The asset-backed segment of the commercial paper market has suffered the most because of fears over its exposure to the subprime mortgage market. During the four weeks ended Sept. 5 the day Mr. Sirri addressed lawmakers it had dropped 18% or $216.2 billion to $966.7 billion. This is less than half of its level a month earlier, when it soared to a record high of $2.225 trillion.
That market is dead. Its a market that has been tried and tested and that has failed, said Robert Brusca, chief economist at the independent economic research firm FAO Economics in New York. Because of investors lost confidence in asset-backed securities, Mr. Brusca does not expect a Fed rate cut of any magnitude to save that segment.
Yet, any help the Fed could provide on the interest rate-front would be good news.
Anthony Crescenzi, chief bond market strategist at Miller Tabak + Co. LLC in New York, said: If the Fed cuts the funds rate, it must boost the amount of reserves in the financial system. That liquidity will push people out on the risk spectrum and money will find its way slowly but surely out on the risk spectrum. This would cause a migration of money back into riskier assets.