Why commercial paper is the next problem...

The credit crisis. Episode Eight.  While your bank may be okey-dokey, since the board and management have never been excited about exotic investments, we often forget how commercial paper infiltrates our lives.

Commercial paper essentially can be compared as an alternative to lines of credit with a bank. Once a business becomes large enough, and maintains a high enough credit rating, then using commercial paper is always cheaper than using a bank line of credit. Nevertheless, many companies still maintain bank lines of credit to act as a "backup" to the commercial paper. In this situation, banks often charge fees for the amount of the line of the credit that does not have a balance. While these fees may seem like pure profit for banks, if the company ever actually needs to use the line of credit it would likely be in serious trouble and have difficulty repaying its liabilities.

Currently, more than 1,700 companies in the United States issue commercial paper. Financial companies comprise the largest group of commercial paper issuers, accounting for nearly 75 percent of the commercial paper outstanding at mid-year 1990. Financial-company paper is issued by firms in commercial, savings and mortgage banking; sales, personal and mortgage financing; factoring; finance leasing and other business lending; insurance underwriting; and other investment activities. The remaining commercial paper outstanding at mid-year 1990 -- over 25 percent -- was issued by nonfinancial firms such as manufacturers, public utilities, industrial concerns and service industries. [More]

For example, banks may be shifting to honor their backup position for the failing commercial credit market.  And it is indeed struggling.

 When the credit crisis started to unfold last summer, the key area of weakness within commercial paper was mortgage-related asset backed instruments tied to the already declining U.S housing market. But now, the sag in issuance by financial firms is a sign that the whole commercial paper part is succumbing to broad lending markets stress and endangers the the whole economy, analysts said.

"These declines in some ways carry more weight than those of a year ago, when the market was purging issuers with mortgage-related exposures," wrote Crescenzi. "This time the purge is broad and is impacting issuers with far more predictable cash flows--regular run-of-the-mill companies in need of working capital," he wrote.

As the global credit crisis deepens, banks' distrust of lending to each other has worsened in interbank markets, with many hoarding cash for fear that some short-term loans might not get repaid. A similar dynamic is roiling the commercial paper market, analysts say.

Money market funds have diverted hefty amounts out of commercial paper and other non-government instruments into the ultra-safe haven of Treasury bills, after a money market mutual fund broke the buck, or fell below $1 per share value last week, triggering investor fears about the safety of short-term paper from banks, insurers and companies.

"The declines reflect the seizing up of the credit market and withdrawals of monies from money market funds, which held $700 billion of commercial paper at the end of the second quarter," wrote Tony Crescenzi, chief bond market strategist, Miller, Tabak & Co. in New York in an email note. [More]

The freezing of commercial credit stops business in its tracks and could trigger order cancellations and layoffs.  In fact, for businesses already struggling a month ago, loss of commercial paper affords a gold-plated opportunity to downsize and shift the blame elsewhere.

“The credit at risk extends well beyond mortgages. It includes automobile loans, college loans, credit cards, small-business loans. Businesses need credit to grow, and without that they will stagnate, which could cause layoffs or business closures. Thus, while global capital markets and short-term funding seems a world away from Arizona, no one is insulated from the impact. The tightening of credit in the wider market is just the beginning,” said Tanya Wheeless, CEO if the Arizona Bankers Association. [More]

We should know by today what the bailout rescue plan will look like, and by this evening whether it is pacifying investors overseas. The big risk here is a package emerges and nobody cares.