What is the Commercial Paper Market?

If you're like most people, you kind of but don't really understand how it is that our economy got to be in such bad shape. You've heard politician sling strong words at one another, but many of the terms, to average Americans, still sound like Greek. In this article, we'll take a look at one of these terms - the commercial paper market - and try to understand how it has played a major role in slowing down the economy.

Commercial paper is roughly a short-term loan for big businesses

In Wikipedia, you can read this dense definition of commercial paper: "In the global money market, Commercial paper is an unsecured promissory note with a fixed maturity of one to 270 days. Commercial Paper is a money-market security issued (sold) by large banks and corporations to get money to meet short term debt obligations (for example, payroll), and is only backed by an issuing bank or corporation's promise to pay the face amount on the maturity date specified on the note."

Uh... huh?

Let's break it down a little further.

An "unsecured promissory note" means that commercial paper is a giant IOU. In essence, Company Z might call Bank A and say, "I'll give you $1,100,000 tomorrow if you give me $1,000,000 today." There are lots of reasons why Company Z might do this - anyone who has ever worked in business understands that business is largely a matter of balancing cash flow. Company Z might need to buy some equipment or make payroll, but won't have the cash on-hand to do so for another week. So they use commercial paper as a way of borrowing that cash for the short-term.

And sometimes, a company needing extra cash today might have cash to spare tomorrow, so that same company might switch roles and make these short-term loans to other companies.

The "unsecured" part of the definition means that there's no collateral that backs this loan, so if it's not paid back... well, it's just not paid back. This becomes an important part of the story later on.

Money-market funds are the main source of cash for commercial paper

While companies borrow and lend from one another, the main source of the cash in commercial paper are money-market funds. In other words, the money you put into your money-market fund doesn't just sit there - it is loaned out in order to make an interest, and one of the main ways it is loaned is as commercial paper.

Something really, really important happened on September 16, 2008: one of the biggest pools of money-market funds there is, the Reserve Fund, did something called "breaking the buck." That means that their investors' money market dollars were actually shrinking instead of growing. This is a little like depositing $100 into your savings account, coming back a month later, and discovering that now there is only $99. If you like, you can read their press release here. Overall, it sounds like it's written in Greek. But if you speak Wall Street Greek, this reads a little like an Apocalyptic warning.

"Breaking the buck" was simply not supposed to happen in the twenty-first century - at least, not to something as stable as money-market funds.

And that's why the commercial paper market started to freeze up.

Nobody trusts anybody, and so nobody wants to loan

With money-market funds "breaking the buck" because of financial heavyweights like Lehman Bros., Merrill Lynch, Fannie Mae, and Freddie Mac dropping like flies, and European banks doing the same, the lenders of commercial paper did something that's really quite logical: they stopped trusting companies to be able to re-pay their short-term debts. So, they either stopped loaning commercial paper altogether, or they raised interest rates so high that it made it nearly impossible for many companies to get commercial paper. As a result, the commercial paper market volume has fallen by over $100 billion. That's a lot of money that's NOT going into the economy.

And remember what commercial paper is often used for... making payroll, buying much-needed supplies, etc. The Fed's Chairman, Ben Bernanke, said on Monday, October 20, 2008, that this kind of intercompany lending has become "essentially unvavailable" (Source: Reuters.com)

But there is good news...

Many people worry that we are facing a second Great Depression, but the truth is that we will probably not see this level of Depression, despite how bad the economy has gotten. Why? Although it might look to some like the villain being called the hero, the government - in particular the industrialized world's central banks - are stepping in to help this time, and these structures didn't exist in 1929. So when the economy started to fail seventy-nine years ago, there was no big bailout plan, no Bernanke to advise congress, no summit meetings of the world's central banks. In short, there was very little government help for the markets at the beginning of the Great Depression.

Regarding commercial paper in particular, the Treasury, Bernanke says, "implemented a temporary guarantee program for balances held in money market mutual funds, helping to stem the outflows from these funds."

In other words, remember what happened to the bank in It's a Wonderful Life? When people panic about their savings, they naturally want to withdraw it before they lose it all. By issuing the temporary guarantee program, Bernanke and the others are hoping to stop bank runs, stabilize the money-market funds, and replace panic with trust in the commercial paper market.

Will it work?

I guess we'll all have to wait to find out.