Now we see how the Fed’s toolkit is not well suited to the problem at hand, and its next-best moves are dubious indeed.
Acute conditions in the commercial paper market, a vital source of short-term funding for large corporations and banks, threaten to produce a sharp contraction in business activity. Commercial paper defaults have been rare (unlike structured credits, corporate ratings are less difficult for the rating agencies, and perhaps more important, it isn’t overwhelming for investors and analysts to make their own assessment). However, due to the knock-on effects of the Lehman bankruptcy, not only has the total of unsecured (non-asset-backed) commercial paper fallen, but maturities have also contracted. Issuers who could once easily place 30 to 90 day paper are now rolling it on a day-to-day basis.
Commercial paper issuance tends to be limited to relatively sound companies; excluding Lehman (which the officialdom belatedly realizes it should have salvaged) there have only been 7 defaults since Penn Central in 1970. Thus a guarantee would be a cheap way to backstop the market (some attention might need to be paid to how to deal with moral hazard, but a short-term backstop of three to six months would not lead to big changes in behavior)
But the Fed can’t issue a guarantee. Instead, it appears to be considering the balance sheet ballooning approach of buying commercial paper. And once the Fed steps in as a major player (major is required to have any impact), how does the Fed wean the market of its support?
Warm up the helicopters, and welcome to central planning. We said goodbye to the greenback some time ago.
And the stress in the US press is constantly of the impact to taxpayers. There is perilous little attention paid to the fact that taxes will most assuredly not be increased in an amount sufficient to cover these needs. We continue to rely on the support of our foreign creditors, and how long will they play ball?
From the New York Times:
Under a proposal being discussed with the Treasury Department, the Fed could buy vast amounts of the unsecured short-term debt that companies rely on to finance their day-to-day activities, according to officials familiar with the discussions. If this were to happen, the central bank would come closer than ever to lending directly to businesses…“There is a growing recognition that not only has the credit crunch refused to be contained, it continues to spread,” said Ed Yardeni, an investment strategist. “It’s gone truly global.”
Investors are worried about what the evaporation of credit will do to an already-weakened global economy.
In the United States, consumers appear to be significantly curbing spending; last month, employers cut more jobs than any month in five years. The $6 decline in oil prices, which settled at $87.81 a barrel, stemmed in part from fears that demand will slacken in the face of a deteriorating economy.
Yves here. While these are all Very Bad Things, the logic is flawed. These developments were in motion before the latest seize-up in the money markets. Yes, that will unquestionably make matters worse, but by discussing the Fed’s commercial paper idea and the accumulation of economic woes, it creates the unwitting impression that further Fed intervention might reverse the deteriorating fundamentals, when the best feasible short term result is to halt them (and that we deem unlikely given the magnitude of the credit overhang).
The Fed plan is intended to renew the flow of credit on which the economy depends. Under its plan, the central bank would buy unsecured commercial paper, essentially short-term i.o.u.’s issued by banks, businesses and municipalities.The market for that kind of debt has all but shut down in the last week, with many major corporations unable to borrow for longer than a day at a time, as banks become more fearful of giving out cash. The volume of such debt totaled about $1.6 trillion as of Oct. 1, down 11 percent from three weeks earlier.
These credit fears persisted over the weekend despite the $700 billion bailout package that Congress approved last week.
The cost of borrowing from banks and corporations remained high on Monday, increased in part by a series of high-profile bank bailouts in Europe, where governments scrambled to save several major lenders from collapse.
The United States government appears to be pressing ahead with other radical efforts to shore up the financial system, even wading into corners of the markets where it has rarely interfered.
Buying commercial paper could open the Fed to difficult conflicts of interest, because it would be juggling the goals of protecting its investment portfolio with its traditional goals of promoting stable prices and low unemployment.
“The Federal Reserve really would become the buyer of last resort, trying to jump-start the commercial paper market by taking on credit risk,” said Vincent Reinhart, a former top Fed official who worked under Alan Greenspan, a former Fed chairman, and Ben S. Bernanke, the chairman now.
The Federal Reserve has already stretched its resources to the limit by providing hundreds of billions of dollars in short-term loans to banks, Wall Street firms and money market funds….
To pay for its burgeoning responsibilities, the Fed has no choice but to keep printing more money. To prevent that flood of new money from reducing the central bank’s overnight interest rate to zero, the Fed also announced on Monday that it would start paying interest on the excess reserves that banks keep on deposit at the Fed.
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If you look at the latest Fed release, you’ll see the actual drop in non-financial non-asset-backed commercial paper is pretty small — less than a billion. It’s clear why nobody wants financial or asset-backed paper, but regular industrial paper seems to be doing okay.