What Is Commercial Paper And Why Is The Federal Reserve Suddenly Buying It?

The Federal Reserve today announced the creation of something called the Commercial Paper Funding Facility (CPFF), that will buy commercial paper directly from issuers. So, you’re asking yourself, what is commercial paper? Why do I care that the Federal Reserve is buying it?

To put it simply, the commercial paper market works like a credit card for big companies. Some days they have money, and some days they do not. So if they need money Tuesday, but will have money Friday, they’ll go to the commercial paper market and borrow some money. Then on Friday they will pay back the money, plus interest. It’s usually all very calm and safe — but when large well-respected companies started failing and the people who had lent them money on the commercial paper market (money market mutual funds, for example) actually lost money on these “safe” investments — the pool of lenders dried up.

Now the Federal Reserve is stepping in to “inject liquidity” into this market.

Here’s how the Federal Reserve explains:

The commercial paper market has been under considerable strain in recent weeks as money market mutual funds and other investors, themselves often facing liquidity pressures, have become increasingly reluctant to purchase commercial paper, especially at longer-dated maturities. As a result, the volume of outstanding commercial paper has shrunk, interest rates on longer-term commercial paper have increased significantly, and an increasingly high percentage of outstanding paper must now be refinanced each day. A large share of outstanding commercial paper is issued or sponsored by financial intermediaries, and their difficulties placing commercial paper have made it more difficult for those intermediaries to play their vital role in meeting the credit needs of businesses and households.

The fact that the Federal Reserve has resorted to this move, which is of questionable legality and requires the use of a SPV (Special Purpose Vehicle), which is a separate legal entity that does the buying and selling on the Fed’s behalf, is well, scary — and could be a “broader” undertaking than the $700 billion bailout.

Under its plan, the central bank would buy unsecured commercial paper, essentially short-term i.o.u.’s issued by banks, businesses and municipalities.

The market for that kind of debt has all but shut down in the last week, with many major corporations unable to borrow for longer than a day at a time, as banks become more fearful of giving out cash. The volume of such debt totaled about $1.6 trillion as of Oct. 1, down 11 percent from three weeks earlier.

These credit fears persisted over the weekend despite the $700 billion bailout package that Congress approved last week.

The cost of borrowing from banks and corporations remained high on Monday, increased in part by a series of high-profile bank bailouts in Europe, where governments scrambled to save several major lenders from collapse.

The United States government appears to be pressing ahead with other radical efforts to shore up the financial system, even wading into corners of the markets where it has rarely interfered.

One thing seems clear, the “credit crunch” is not going away and it is spreading beyond the mortgage issue.

Press Release [FED]
Fed Announces Plan to Buy Short-Term Debt [NYT]
(AP Photo/Miguel Villagran)

Comments

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  1. mariospants says:

    Liquid commercial paper.

  2. zigziggityzoo says:

    I keep wondering how long until we’re the USSA…

  3. Brontide says:

    Don’t blink, you may miss trillions of new dollars being born. While there is substantial credit destruction from hedge funds unwinding, this will cause additional inflation.

    The fed is loaning money to companies without regard to credit worthiness because you, the taxpayer, will pay for any losses. This is a bad idea and will only continue to perpetuate a broken system by proping up the hollow shells of banks in an attempt to deny the fact that they are bankrupt.

    • Erwos says:

      @snowmoon: Um, no. A tight credit market, falling asset/commodity prices, lower wage growth, and massive demand for bonds are indicative that we are in a _deflationary_ episode at the moment, and will be for a while. Could the Fed overshoot in the long run? Sure. But that’s just not going down today or tomorrow, and the folks with money to play the game seem to agree with that sentiment.

      It’s probably a credit to the Fed’s previous management that no one comprehends what deflation can do and promptly says inflation anytime they see an economic problem – but there’s no excuse for constant inflation scare-mongering, especially when deflation is so much worse.

      • Brontide says:

        [www.lewrockwell.com]

        @Erwos: While it is true that this may not cause inflation *today* the rise in the debt ceiling and outright printing of money should give anyone shivers.

        You can’t just continue to monetize at this rate and not cause monetary inflation.

        There is also the problem that the companies that most need this new facility are the ones that are most risky. As has been pointed out for weeks CP trading in non-financials has been quite brisk. It’s those risky companies that are taking a beating since they refuse to step up and accept the higher interest offers that are out there.

        Those companies too risky to be in the CP market are doomed and should declare bankruptcy so that the productive parts can be sold off and the capital markets can concentrate on productive companies.

        • Erwos says:

          @snowmoon: Two things:
          1. The article you quoted is from 2001-2002. The tech bubble crash doesn’t even compare to this.
          2. Yes, you can monetize like this because a _ton_ of money has left the system. The money supply is basically a pool – if there’s a giant hole in the bottom draining it out, you could pour way more water into it without it overflowing.

          I’m not actually saying I think this is the best plan ever by the Fed – I think it sucks. But, what’s the administration going to do, really? Sit on their hands and look impotent? The only thing these bail-out measures are accomplishing is political ass-covering, nothing more, and ALL AT YOUR EXPENSE! :)

          • orlo says:

            @Erwos: I’m no economist, but where is this hole draining money out of the system? All money that the banks have lost has shown up in someone’s bank account. The LHC is not online!

            • Erwos says:

              @orlo: I am an economist, so lucky you.

              All the money that the banks have lost have _certainly_ not shown up in bank accounts. When the housing market crashed, a lot of home value simply disappeared. People then began to default on their loans, making the value of the loans disappear. The mortgage-backed securities based on these loans then lost their value. And when those mortgage-backed securities lost their value, the folks guaranteeing them took a bath.

              To hear you tell it, there’s several trillion dollars in bank accounts as a result of home prices falling. I don’t think so.

  4. lodleader says:

    not very much longer sadly…

  5. SkokieGuy says:

    I’ll gladly pay you Tuesday for a hamburger today.

    • captainpicard says:

      @SkokieGuy:

      Today is tuesday!??!!?! Joke fail.

    • Orv says:

      @SkokieGuy: That’s actually the way a lot of the corporate world works. If you’re a company buying stuff from another company, you don’t usually pay up front. You get “net 30″ terms, meaning the bill for what you buy today is due in 30 days. That’s part of the reason access to credit is so essential for companies — they often need to cover expenses today on transactions that they won’t be paid for until a month later.

  6. agnamus says:

    Pull out of market, put money in gold.

  7. davere says:

    So a payday loan.

  8. Snarkysnake says:

    This is much bigger news than it is being given credit for in the big media (possibly because they don’t know what commercial paper is). This will do more to keep the wheels turning than most anything the Fed has done so far. By definition,if a company is big enough to issue commercial paper, it is probably credit worthy and the treasury should be OK with buying it as an emergency measure.I agree with Snowmoon,however, that the Fed should not buy banks commercial paper because they haven’t come clean on what other skeletons are hiding in their closet. But without this short term liquidity, a LOT of big companies that have NOTHING to do with speculative finance would have to start sending workers home SOON. Then the cycle really becomes vicious. So , I am glad to see this …

    • HRHKingFridayXX says:

      @Snarkysnake: EXACTLY. A crash in commercial paper would have the most direct consequences for many of us. Just imagine companies like Starbucks or McDonalds suddenly unable to pay their employees. A lot of companies with tight margins operate (briefly) in the red while buying up food and fuel.

  9. ninabi says:

    In my small world of daily living, it seems odd to still be receiving credit card offers in the mail.

    Kind of like living by the ocean and getting a flyer advertising swimwear and beach towels when forecasters are warning about the Cat 5 hurricane about to hit the coast.

    • MameDennis says:

      @ninabi:
      Especially when the credit card offers were mailed by banks that have ceased to exist by the time you pull the envelopes out of your mailbox…

  10. OmniZero says:

    I learned of commercial paper while listening to NPR.

    Go public radio! It taught me something.

  11. moore850 says:

    So basically the government just decided to cover a whole bunch of IOU’s to businesses, where no one else wants to cover them? Sounds like a safe bet.

  12. jodark says:

    I wonder if Dunder Mifflin can get in on this paper market you speak. With electronic ordering and decreasing costs of national chains they need something to keep them competitive.

  13. wgrune says:

    This American Life did a story on this last week. They talk about Commercial Paper and how nervous industry insiders got when it locked up a couple weeks ago. It’s worth a listen:

    [www.thisamericanlife.org]

  14. Ouze says:

    i love how they refer to it as “paper” and not “millions of dollars that will inevitably come out of taxpayer dollars”

    • humphrmi says:

      @Ouze: The alternative is much worse. Imagine Wal-Mart sending home all 1.1 million of it’s employees without pay for three days because they couldn’t get a three-day loan in the corporate paper market. Now imagine that wal-mart is just one of the largest employers, and there are many more who rely on corporate paper to do things like payroll. Just for comparison purposes, last week everyone thought the world was ending because payroll employment declined 159,000 in one month (September.)

      • bwcbwc says:

        @humphrmi: Not to mention that “inevitably” is way too strong. If we sink into a “normal” recession, the government will still get all that money back except from the notes it happens to hold at the time individual companies actually go belly-up. If we sink into a real depression, the government will lose taxpayer dollars, but then most people won’t be paying (income) taxes anyway because they’ll be out of a job.

  15. Fist-o™ says:

    Does this paper come on a cardboard roll with 1,000 sheets?

  16. ddg says:

    is this a commercial version of payday loans? seriously… cuz thats what it sounds like.
    guess it depends on the amount of interest…

    • Snarkysnake says:

      @ddg:

      “is this a commercial version of payday loans?”

      No. Payday loans are generally given to people with poor or no credit (if they had good credit,they could get a much better interest rate). Commercial paper is so safe (for the most part) that it is suitable for Money Market Funds . Large, stable companies use it for day to day expenses when they temporarily have more going out for supplies,materials ,payroll and such ,than they have coming in from sales and profits.Generally,the market is self limiting : If a company has too much short term debt floating around out there,the market will demand a higher interest rate that makes it more attractive for the company to issue longer term debt. You probably already own (indirectly ,anyway) commercial paper if you have a money market fund. This and soon- to- mature treasury debt are what makes up the “money market” that keeps the wheels greased.

  17. katbur2 says:

    Did I read correctly that this is possibly not legal? What the hell is going on here? How about they figure out the laws before they make these kinds of plans with my money!

  18. RobUsdin says:

    Hmm… Has someone been listening to This American Life for story ideas? This was featured on this week’s show and the wording – especially that of “Some days they have money, and some days they do not” is exactly like their story, as are other parts of this post.

    –*Rob

    • equazcion says:

      @RobUsdin: Most of the time Gawker sites are a digest of stories found elsewhere. I’m not terribly bothered by that.

    • Trai_Dep says:

      @RobUsdin: Isn’t it an awesome episode?
      It’s done by the same crew – Alex Blumberg & NPR’s Adam Davidson – as the one that made the fantastic episode, A Giant Pool of Money.
      People, if you haven’t seen this week’s TAL ep, Another Frightening Show About the Economy, you’re missing something fantastic.
      Funnily, I thought, “What droll hyperbole” when I saw the title. A couple segments in, and I realized it was a perfectly apt title for the show after all.
      Highly recommended, folks!

  19. AgentTuttle says:

    Buy gold coins and forget about this loan, borrow, scam, print more game. When it all comes crashing down, you will have real value in your hands that’s good all over the world.

    • youbastid says:

      @AgentTuttle: Have you done this? Where does one go about buying gold coins? Inquiring minds.

      • JustThatGuy3 says:

        @AgentTuttle:

        Gold is highly volatile – it’s anything but safe. Look at it this way: what would you have today if you had bought gold and a Dow Jones index fund at varying times:

        Since December 1978:
        Dow up: 1100%
        Gold up: 280%

        Since Nov 1979:
        Dow Up: 1070%
        Gold Up: 18%

        Since Dec 1998:
        Dow Up: 20%
        Gold Up: 195%

        As you can see, gold moves around a LOT.

        Also, if it all comes “crashing down,” your gold coins (assuming that gold’s worth anything – since it has no intrinsic value, coin of the realm might well be antibiotics, food, or ammunition) will only be “in your hands” if you have the firepower to keep them there.

    • joellevand says:

      @AgentTuttle: The only thing that’s ever universally accepted is the ability to barter and trade goods and services, so buy hammers and nails, not gold.

  20. labowski says:

    I never knew about commercial paper before reading this article, but I get it. I’m a recent college grad, and when times got rough and money got tight (like no top ramen or beer money tight) I’d go to my mom ask if I could borrow some money and promise to pay it back. This worked great until I missed a few payments and ma cut the line. But that’s how it works, my Dad didn’t run to the rescue. I understand large corporations need a “lending tree” just as individuals need it. But if the market has restricted these short term loans it seems that the market would be correcting itself… Maybe the companies that are taking this commercial paper are in no fiscal position to do so, and a band aid is no way to treat a hemorrhage.

    Also, I totally agree with AgentTuttle the problems with our financial crisis can be boiled down to the absence of a commodity based system.

    • Trai_Dep says:

      @labowski: Using your analogy to the current situation, you’ve taken loans of a couple days for 1/1,000th of your paycheck from your mom. And you’ve always paid her back and bought her flowers or chocolate to thank her for letting you fill your tank so you can drive to work so you can continue earning an income.
      Your mom’s sister’s sister’s grandson, however, took his money and blew it on a videogame and didn’t pay her back. Twenty years ago.
      Your mom, finding this out, tells you, “Tough cookies, kid. Learn to live within your means.”
      No one’s suggesting that your distant relative’s squandering shouldn’t impact his ability to get a short-term loan. But it should only nominally affect you.
      I think that’s closer to what this situation is: the commercial paper market is laughably staid, conservative and safe. It’s a sign of how messed up everything is – and how important it is – that everyone’s ears pricked up and that the gov’t moved so quickly to grease the wheels.

      Commodity systems would work. If you’re happy living in a medieval type economy. But unless you’re noble-born, I’m betting that’d be a big, fat, “no”.

    • JustThatGuy3 says:

      @labowski:

      CP really isn’t like that. It’s mainly used to handle true day-to-day expense fluctuations that are, proportionately, a tiny share of overall revenue. The alternative is to have a _huge_ amount of cash on hand, earning very little interest, which is usually a huge waste of money.

  21. redandjonny says:
  22. EmmettAquila says:

    Excellent definition of commercial paper. For as long as this entire financial debacle has been underway, consumers, the people who are most affected by this entire situation, have no idea what’s going on because those associated with the financial industry talk in a language consumers can’t understand.

    Thanks for dumbing it down. For more simplistic financial news check out ‘blog.hsh.com.

    Thanks for a great post,
    Tim

  23. tinyrobot says:

    If you want the best, no-nonsense explanation of all of this, then you have to spare an hour of earphone time and download/listen to the This American Life/NPR News coproduction explaining all of this mess in plain language. They have their original episode, The Giant Pool of Money, which explains the subprime crisis in language so plain my 8th graders understood it perfectly, but the whole mess to come (and it should prove messy…) is explained equally brilliantly in this week’s episode: Another Frightening Show about the Economy, which you can (and should) download for free (it’s a podcast) now.

    I know the public is outraged, but we all need to listen to this, so we can direct our outcries at the right places.

    And pay special attention to “stock injections” – this could be the hook taxpayers need to get control of this whole debacle.

    • Trai_Dep says:

      @tinyrobot: Didn’t you love the part of the second show where they described how, despite the Wall Street firms’ lobbyists’ efforts, provisions were snuck into both the Senate and House bills to backdoor in the option for the Treasury Secretary to set up capital/equity swaps with the $700B if he decides it’s the best way?

      One of the few times that I’m happy to see sneaky legislative slight-of-hand. Take that, swarm of K Street lobbyists!

  24. fisherstudios says:

    Gold is almost entirely worthless. It is only worth what it is worth because we arbitrarily assign it a worth.

    It’s funny what happens when an economy collapses – the cost of even the most basic necessities such as food goes up. Eventually there is panic and starvation and no one will be willing to trade their loaf of bread for your useless lump of rock known as gold.

    So my advice for anyone wishing to weather this economic collapse is to invest into things that have easily visible value – food, oil, etc rather than things that don’t ex. diamonds, gold, platinum.

  25. Cortina says:

    Hah, I am actually reading this in my Commercial Paper class! One of my friends raised his hand and asked the professor if she thought it was ironic that we are learning about commercial paper at a time when all the providers of commercial paper have gone tits up, and she laughed and then made him brief a case. Ah, law school.