This week the Federal Reserve announced the creation of the Commercial Paper Funding Facility. The facility allows the Fed to purchase 3-month commercial paper directly from issuers. Why is it doing this, and how much will this cost taxpayers?
Let me start with some background. The commercial paper (CP) market is an important source of quick funds for high-grade firms in the corporate and financial sectors. If a company like GE needs to raise $100 million quickly, it could do so in the CP market. GE is unlikely to issue long-term debt or stock to raise the $100 million—- such funding takes time to source. While the CP market is used to raise money quickly, it is also used as an ongoing source of funds. As of June of this year, GE had $63 billion in commercial paper outstanding. This was one-third of GE’s short-term borrowings and over 10% of its total borrowings
Institutionally the CP market works for two reasons: First, CP issuers rarely default. The firms are almost all high-grade and the debt is typically around 30 days. Second, money market funds, who are the main buyers of CP, control large pools of moneys for which they are always seeking short-term investments. So, one can think of CP as the marketplace where firms in need of short-term cash strike deals with money funds who have the cash. In this regard, money-market funds are like banks: they offer “deposits” and use the funds to make “loans”. The CP market is around $2 trillion in size, which gives a sense of its economic importance.
As part of the financial turmoil over the past year, money funds have become increasingly reluctant to buy CP. Figure 1 shows the drop in CP issuance since August 2007. $500 billion has vanished from this market, which means that firms have $500 billion less credit. This is a serious cost of the credit crunch. Firms must either replace the $500 billion—- difficult these days—- or spend less.
Figure 2 is also interesting. It shows that, over the last few weeks, the remaining CP issuance has dramatically shifted to under 9 days. The money market funds want to keep their investments liquid and reducing maturities to overnight or one week accomplishes this objective. However, maturity shortening comes at a cost to companies because they are asked to return to the CP market repeatedly, thereby facing the risk that if money funds further decrease their CP holdings, the firms will be unable to finance themselves and will then have to cut back on expenditures. Faced with the prospect of a future crunch, firms are likely to start cutting back now. This is a further cost of the credit crunch.
In my last blog entry, I suggested that there is a substantial premium that the government can earn by buying illiquid assets and paying for them by issuing Treasury securities.
The Commercial Paper Funding Facility is a good example of putting this into practice. 3 month CP rates for top tier non-financials is 2.22% and for financials it is 3.66%. History is only a partial guide, but there has never been a default on CP among this tier of firms. So, CP rates currently reflect the illiquidity and risk aversion of money market funds. 3 month Treasury bills are currently yielding 0.63%. This rate is so low because investors place a huge premium on the liquidity and safety of Treasuries.
If the government issues 3 month Treasury bills and purchases financial CP, it stands to earn around 3% per annum. Since we surmise that a good part of this premium is compensation for illiquidity, and the US government does not have to worry about liquidity as would a money market fund or any other private investor, much of the 3% will be earned as a pure liquidity premium. This is a good deal for taxpayers.
For firms, the Fed’s decision to buy CP removes a major funding strain and reduces the extent of the credit crunch. So the corporate and financial sectors also benefit from this move.
I would add one more general point on government interventions, of which we are seeing more these days. US government debt has a special safe-haven status during times of turmoil. We have seen this repeatedly in past episodes such as around 9/11 or during the 1998 LTCM crisis. Investors want liquid US government securities in a crisis. This is the one bright spot in the current crisis: The government is well positioned to act to normalize capital markets and thus allay the fears that we would face another Great Depression.