Reader FairEconomist left a short comment on an earlier post which we hoisted along with some other material, on why the bailout bill could make the illiquidity in money markets worse. He left a longer comment j that sets forth the issues, as he sees them, in more detail.
I hope readers do not mind my failure to add my own observations, but I found this discussion to stand on its own (and I think my value added is greater in cranking out some other posts!). Further comments very much appreciated.
For new readers’ benefit, commerical paper is short-term unsecured paper, up to 270 days, but most is 30 to 90 days (there is also asset backed CP, but that’s not the subject of discussion here). Large companies and banks use it actively to manage short term cash needs. It is good practice to have commercial paper backed up with a standby line of credit at a bank. Thus, if for some reason a company cannot roll maturing CP (ie., sell new commercial paper to replace maturing paper), they will use their bank back-up line. Those lines, when used, require a lot of equity relative to other bank products, and of course, also require banks to hand out cash when they worried about extending credit. So even when companies can solve their short-term funding needs by turning to their bank instead, it puts a further strain on already stressed banks.
From reader FairEconomist:
I’ve been thinking mostly about the durations issue, mostly because it’s really obvious something is going badly wrong in the commercial paper market. If you look at the volume report http://www.federalreserve.gov/releases/CP/volumestats.htm overall paper is actually *up* but the longer durations (20+ days) are way down. For example: the overall market average for the week of Oct 3 is 183,610, up from 2008 average of 148,710. But 20-40 day paper is only 6,778, *way* down from the yearly average of 15,864.
So the market has lost about 2/3s of its ability to convert liquidity to 30-day loans. 90-day is probably similar although there are technical issues with analyzing the chart because 90-day would expire during the end of year crunch so there probably isn’t much demand. Next week we’ll be able to look at 90-days again.
One of the most critical functions of the banking system is converting short-term deposits into longer-term loans for businesses. Much of the working capital market, for decades has come via money market funds (MM). Joe public or Joe CFO deposits money into a MM. That MM loans it to a bank (usually by buying paper, and usually at a medium duration) and then that bank loans it out to business for inventory, payroll or whatever. The MM has converted Joe’s demand deposit into a fixed-duration loan.
The problem we’re having is that people are fleeing commercial MM for treasury MM. Those are buying treasuries and thus converting the money to the desirable medium duration BUT that money is loaned to the Fed, and the Fed doesn’t make working capital loans. So the deposited money that had been made into working capital has been diverted into the Fed and lost to working capital.
The Fed is kind of trying to address this by loaning out money via various auction/discount windows. BUT, those loans have been overwhelmingly overnight – a particularly nasty demand deposit because it goes back so fast. For a bank to convert that to a 90-day loan it’s got to win 90 auctions in a row – a very risky deal with a crunch on. So the Fed undoes the duration conversion, and then some, converting the liquidity into a form that the banks can’t make into useful-duration loans.
Right now we have both commercial and treasury MMs. Deposits have shifted from commercial MMs to treasury MMs, and consequently we have less working capital (a commercial MM product) and better credit for the Fed (a treasury MM product). But, treasury MM rates are now very low and the gap between treasury and commercial fairly high, which creates an incentive for depositors to put money into commercial funds, producing some working capital.
When Paulson dumps out his 700 billion in treasuries it’s going to be at the short end. That will drive up rates for short-term treasuries. This will obviously draw even *more* deposits into the treasury MMs. That means even less in the commercial MMs and thus less working credit, the eventual commercial MM product. Hence Paulson’s billions remove working capital by competing for the deposits that could get used to make working capital loans. That 700 billion is going to go to fairly long-term mortgage securities. So Paulson’s billions divert credit from working capital to long-term mortgages – from where it’s most needed to where it’s most wasted.
Even if the giveaway adequately props up the banks, which I doubt, they still can’t make working capital loans, because the raw material they used (commercial MM deposits) will be desperately short.
I think it’s very telling that in two days of hearings and two weeks of discussion we have yet to see *any* detailed mechanism for how Paulson’s plan will increase the supply of, say, inventory loans. It’s not that every economist in the world is an idiot, it’s just not going to help. I think people have fallen into the fallacy that if it costs a lot it must be valuable. Paulson’s plan falls into the category of very expensive way to hurt ourselves.