Unless you’re an economist, a Wall Street wonk or Fed Chair Ben Bernanke, the recent rebound in the commercial paper market is just about as exciting as watching snails race.
Commercial paper is not as sexy or headline grabbing as the stock market, the housing boom and bust or unemployment, but its collapse was ground zero in the financial crisis.
Commercial Paper, or CP, is an unsecured promissory note with a fixed maturity of 1 to 270 days. It’s a money-market security sold by large banks and corporations to get money to meet short-term debt obligations like payroll. Since it is not backed by collateral (like a mortgage or car loan), only firms with excellent credit ratings from a recognized rating agency are able to sell their CP at a reasonable price.
Anyone who has ever put his idle cash into the money market knows that while the returns may be stingy, your money is safe. You won’t get rich if you put your funds in a money market, but you know that your money always will be there when you need it.
The chief goal of money market funds is to maintain a stable net asset value or NAV. Their primary aim is to never lose money for their investors. While money market investors know that their returns will be sparse, their expectation is that the value of their asset never will drop below the original amount invested. This unthinkable scenario where your dollar no longer is worth a dollar is referred to as “breaking the buck.”
The Day of Doom
On Sept. 16, 2008, after Lehman Brothers Holdings, Inc. filed for bankruptcy, the unimaginable happened. That day the shares of Reserve Primary Fund, the nation’s oldest money market fund, returned only 97 cents after the firm was forced to write off the debt of the collapsed Wall Street bank.
It was the first time in the nearly 40-year history of retail money market funds, that the buck had been broken. Community Bankers U.S. Government Fund had broken the buck in 1994, returning only 96 cents. Community Bankers, however, was an institutional fund. Consequently, few individual investors even noticed when it broke the buck.
In sharp contrast when Reserve Fund broke the buck, the ensuing anxiety nearly caused a fatal run on the money market funds as investors/depositors rushed to redeem their holdings. Money market funds across the country were forced to liquidate assets or impose limits on the withdrawals.
Two days later, in a further attempt to restore calm and avert a widespread panic, the U.S. Dept. of the Treasury stepped into the fray. It set up an unprecedented ad hoc insurance program akin to the FDIC’s depositor guarantee to bring stability back to money market funds. Under this hastily conceived guarantee program, Treasury assured investors that it would fill the gap if any covered fund broke the buck.
The True Causes
Although Treasury’s emergency measures prevented an unchecked run on the “shadow banking” system, the result was a liquidity crisis of the sort not seen since the Great Depression. Without the ability to roll over their short-term debt or to issue additional marketable paper, hundreds of financial institutions and major corporations were thrown into chaos.
Make no mistake, the failure, and subsequent bankruptcies of corporate behemoths like GM and Chrysler had more to do with their inability to secure short-term financing in the commercial paper money market than with the clunkers they put on the showroom floor. Without access to short-term financing, these companies were like Caddies without a carburetor, stuck in neutral and going nowhere fast.
According to data recently released by the Federal Reserve, CP activity is up 47 percent on the year. Leading the way in the revival of this once moribund market are companies like internet giant Google and German drug maker Merck. With borrowing costs at a historic low, these companies have begun to re-energize the $1.1 trillion U.S. market. Not since 2002 have nonfinancial companies like Google and Merck been as active in this market.
Along with Google and Merck, foreign banks also are back as borrowers in the short-term U.S. commercial paper market. Starting in May, several European banks had been shut out of this market as investors feared that ‘these banks solvency was threatened by their disproportionate holdings of bonds from Greece, Spain and other struggling European countries.
Nearly three years after the market froze, triggering the worst financial crisis since the 1930s, analysts believe that the surge in CP may signal that corporate executives are feeling more optimistic that the U.S. will avoid slipping back into recession. From their perspective, this renewed appetite for short-term corporate debt combined with a willingness of the money market funds to meet that need, means that the U.S. economy actually may be on the road to a real recovery.
If this trend holds, the U.S. employment logjam soon could be broken, leading to new hires. Now, if the President and Congress could do for small businesses what the money markets are doing for corporate America by providing access to short-term capital, Main Street may soon be able to follow the trends being established on Wall Street.
John Cohn is a senior partner in the Globe West Financial Group based in West Los Angeles. He may be contacted at www.globewestfinancial.com
