The action by the Federal Reserve to not only lower the Discount Rate but also to encourage commercial banks to borrow from the Federal Reserve eased pressure on a crucial part of the financial markets—short term lending to corporations. Encouraging borrowing from the Federal Reserve is an unprecedented step and reflects the fragility of the international monetary system.
What was so Special About the Federal Reserve Action on Friday?
While the lowering of the discount rate has received much attention, the subtle but important change in policy by the Federal Reserve to encourage commercial banks to borrow from the federal reserve system has not gotten attention. Until this change in policy on Friday, historically the Federal Reserve viewed borrowing from it as a “privilege and not a right.”
Stated differently, the Federal Reserve made the uncharacteristic statement that “borrowing from the federal reserve” showed strength not weakness in the borrower. I believe one must not take at face value that being a borrower from the federal reserve is a sign of strength. That is, until Friday, commercial banks hesitated to borrow from the Federal Reserve, because it was a sign of their inability to obtain funds in the open market. Moreover, the Federal Reserve lending rate was 100 basis points higher than the federal funds rate; thus, a commercial bank who resorted to borrowing from the federal reserve paid a “penalty rate.
What is the commercial paper market?
The commercial paper market is a $2.2 trillion dollar market composed solely of short-term obligations that have less than 270 days maturity. Historically, commercial paper obligations are high quality borrowings where the borrower can obtain funds without posting collateral; hence, the loans are unsecured. By definition, to obtain unsecured borrowing the debtor historically must enjoy an excellent credit rating.
Why was the crisis in commercial paper market so disruptive to the economic system?
Unfortunately, prior to Friday, the commercial paper market was experiencing a terrible logjam. That is, borrowers were unable to roll over their maturing short-term debt, forcing them to either default or obtain secured financing from the commercial banks. In effect, losing this financial pipeline meant that corporations were confronted with a financial crisis. As a friend of mine said, “if a person cannot get oxygen for 120 seconds, he dies.” If a corporation cannot repay its debts, it “financially dies;” that is, the corporation files for bankruptcy.
Who buys commercial paper?
Investors in money market funds, the treasury departments of corporations, and other financial institutions find commercial paper a convenient place to park their cash. That is, the lender can specify exactly the number of days that he wishes to invest. Alternatively stated, a lender who does not have 100% confidence of repayment on a timely basis can easily be terrified.
Why do problems in the commercial paper market have much wider ramifications?
This panic over repayment can cause ripples throughout the short-term markets initially. Moreover, the ripples can become a tidal wave of financial distress as the logjam in the commercial paper market widens to the entire debt market and then the stock market. Let me provide an example of how the problem mushrooms.
A borrower of commercial paper assumes that it can rollover its debt. However, when the corporation loses access to the commercial paper market, it must scramble to get other sources of cash or it will default. Frequently, borrowers of commercial paper have back-up lines to commercial banks. Thus, when credit is no longer available in the public markets, then the borrower obtains financing from the commercial bank. However, since the commercial bank must in turn borrow to support their corporate clients; the commercial banks must have access to the Federal Funds market. However, once a commercial bank appears to be excessively borrowing in the Federal Funds market, other commercial banks will put either limits or even deny borrowing privileges to a “problem” bank. Historically, commercial banks that were in trouble only in the last resort borrowed from the Federal Reserve System. Thus, a problem that began with a corporate borrower has now spread to the commercial banking system.
Why did commercial bank paper borrowers suddenly lose their reputation and thus their ability to have access to the commercial paper market?
Over the last few years, about 53% of the borrowers of commercial paper were backed by pools of assets like home mortgages, credit card receivables and car loans. Many of the home mortgage borrowers had lent in the sub prime market. When the rating agencies downgraded their ratings on those borrowers who had significant exposure to the sub prime market or had significant exposure to low quality corporate loans, investor appetite dried up.
Why was the credit system so vulnerable?
Citigroup and JP Morgan Chase, for example, has guaranteed more than $90 billion of liquidity to back-up commercial paper borrowings. This number represents about 5 or 6 percent of their total assets. State Street, a custody bank, guaranteed about $29 billion or 23 percent of its total assets.
Interestingly enough, European banks might have percentage wise an even greater exposure to “risky” credits than American institutions. The exposure to “risky” loans explains partially why foreign central banks have lent about 65% of the $500 billion dollars that have been poured into commercial banks in recent weeks. Stated differently, until Friday, the Federal Reserve System had only lent about $150 billion dollars to American commercial banks. While this is a large number, it is significantly less that what foreign central banks have lent.
What is the big picture?
The big picture is that the financial system is dangerously exposed to highly leveraged borrowers whose credit worthiness was not properly understood. That is, only in recent weeks, did the rating agencies aggressively downgrade high-octane financially engineered asset pools! If the rating agencies did not properly assess the borrowers, it is even more likely that the investors who relied on the rating agencies due diligence did not understand the “risks” of their investments.
Originally published in the Sarasota Herald-Tribune
