Credit Crisis Update: An Inside Look at the Commercial Paper Debacle

By Shah Gilani
Contributing Editor
Money Morning

The commercial paper market is the thoroughfare where Wall Street merges into Main Street. Corporations, finance companies and banks rely on Main Street investors for the cash they deposit into money-market funds and other short-term investment vehicles. Ultimately, that cash buys the commercial paper that’s issued to help fund everything from corporate payrolls to a manufacturing company’s production inventory.

The deepening credit crisis – with its inevitable contagion spreading like a nuclear winter across the globe – is forcing the U.S. Federal Reserve and central banks worldwide to go to extraordinary measures in their attempts to thaw out the credit freeze and save banks.

While the Fed’s rush to rescue the commercial paper market has been promoted by some as a Main Street rescue, make no mistake, the intensity of the U.S. central bank’s heat is directed toward frozen banks. The number of bank failures would inevitably spike without the Fed buying commercial paper directly from desperate institutions. What is also inevitable is that it is only a matter of time before this desperate maneuver will expire – and with it, many of the banks this maneuver is protecting. The problem is the funding model that our banks have come to rely on.

Let’s look at some examples to see what I mean. Each of these will be highly simplified, to make the point easier to understand.

Banks make money when they make loans (at least that’s how it’s supposed to work). But in order to make a loan, a bank has to have money to lend. If a depositor at a commercial bank – we’ll call it “Bank A” – deposits $1 million, then that bank has $1 million to lend. If Bank A makes a loan of $1 million to a borrower who wants to borrow the money for 15 years, and the bank charges the borrower 7% interest, then the bank makes 7% a year, or $70,000, for 15 years.

Because the deposited money came into the bank for free – in other words, there was no “cost” associated with that money coming into the bank – Bank A keeps the entire profit margin of 7%. And that’s just one loan. Multiply that by tens of thousands of loans, and you get an idea of how big the bank’s business really is. It’s nice work if you can get it.

Since the bank took in $1 million and lent out $1 million, it’s out of money to lend.

To grow its business, Bank A offers a one-year certificate of deposit (CD), with an interest rate of 4%. An investor with $1 million buys the CD. The bank now has another $1 million to lend. It makes another 15-year loan and charges 7%. The bank borrowed money from the CD investor and agreed to pay him 4%; it then lent out the $1 million to a borrower and charged him 7%. The bank’s cost-of-money (how much the bank had to pay to get the money that it then lent out) was 4%, and the borrower is paying 7%, so the bank’s profit margin is 3% (7% minus 4% = a profit margin of 3%). In this example, the bank makes 3% a year, or $30,000. There’s less of a profit margin in this funding scenario. Nonetheless, it’s still nice work.

Too bad the bank is out of money again. To grow the business further, the bank decides to borrow more money so it can make even more loans. Additionally, in order to increase its profit margin, it has to borrow money more cheaply. Banks borrow money by issuing commercial paper, or “CP.” Commercial paper is the term used for very-short-term debt obligations issued for durations ranging from one day to 270 days (although, more generally, the CP is issued for periods of 30 days, 60 days, or 90 days) by banks, finance companies, corporations and other mostly recognizable borrowers. Commercial paper sold to investors may be backed by assets. But more often it’s backed simply by the borrower’s balance sheet, or good faith (creditworthiness).

Since our bank is trying to keep its cost of money very low, it borrows money for a short time (in this example we’ll say it borrows for 90 days) by issuing commercial paper, which an investor buys. If the bank sells $1 million of CP, and pays the investor/buyer of its CP only 2% (after all, it’s only borrowing the money for 90 days) and lends the money out for 15 years at 7%, that’s a profit margin of 5%, or $50,000 a year. Nice work, right?

Houston, we have a problem.”  If you can identify the problem that’s brewing in the above examples, give yourself a “AAA” investment-grade rating – or, better yet, a gold star, since that’s probably more bankable. If you aren’t able to spot the massive problem, don’t worry – the consolation is that you can always get a job as a banker.

In each example, "Bank A" lent out $1 million for 15 years. But in none of the examples did the bank secure the money it got from the depositor, the CD buyer or the commercial paper investor, for the same 15 years. What if the depositor withdraws their money? What if the CD buyer doesn’t “roll over” this CD into another in one year when it matures? What if no one wants to buy the bank’s commercial paper … at any price or interest rate?

Banks used to try and run a “matched book,” meaning they matched the maturity of the money they took in with the maturity of the loans they made. However, in an effort to increase their profit margins, banks try and borrow very short term and pay as little interest as they have to and try and lend out the money for as long as they can. It’s called “borrowing short and lending long.” It is an interest-rate bet by the banks. It works if rates are steady or falling.

But if short-term rates start to rise, margins get crimped. If banks end up having to pay more to borrow short than they are collecting on their long loans (this results from an inverted yield curve) they have a BIG problem. But that’s only a small problem compared to what’s actually happening now.

If the certificate-of-deposit buyer doesn’t buy any more CDs from the bank because he or she doesn’t trust that the bank is safe, the bank can’t count on that source of funds. That’s not good. If the bank can’t borrow in the commercial paper market, it can’t count on that source of funds. That’s terrible.  But if depositors don’t trust that the bank is safe and they withdraw their money, and if enough of them do it so that it’s called a “run on the bank” … well, that’s game over.

In order to quell fears that depositors are at risk, the U.S. Treasury Department rescue plan allows for an increase in Federal Deposit Insurance Corp. (FDIC) insurance from $100,000 to $250,000. That gives depositors a reason not to rush for the doors. While it’s too bad the FDIC doesn’t have the money to cover all the depositors, at least it can ask the Treasury to print money to backstop its liabilities.

With depositors temporarily at ease, the immediate problem is the commercial paper market. It’s dead. Neither banks, nor corporations, nor any other commercial paper issuers are able to raise significant amounts of money in the CP marketplace. Almost all of the commercial paper being sold is only one-day paper. Because of systemic fear, one day’s risk is all most buyers are willing to stomach. However, all CP issuers have long-term obligations, or liabilities that they need to continue to fund – in short bursts – by borrowing in the commercial-paper market. But there are no buyers, because buyers don’t want to lend to anyone on just their creditworthiness, and they don’t want to lend to anyone who is willing to back their CP with assets. Why? Because no one knows what those assets might be worth tomorrow.

As far as the banks are concerned, it’s even worse than you think. Not only did banks lend long to borrowers, banks borrowed short-term CP money to buy collateralized residential and commercial
mortgage-backed securities for their own inventories or balance sheets. Banks paid for these toxic assets by issuing commercial paper: They thought it was a great borrow-short/lend-long spread play. But when these short-term loans come due, they can’t “roll” them over. Where are they going to get the money to pay back the investors who bought their commercial paper when it comes due – in one day, 30 days, 60, days, or however long they borrowed for? If no one will buy any more paper, that’s a big problem.

In fact, that’s a game-ending problem.

Enter the Fed, investor of last resort.

Between commercial-paper borrowings and floating-rate notes (which are similarly short-term borrowings, but for typically up to two years) for just financial institutions – not including industrial corporations and others – it is estimated that more than $1 trillion will have to be paid off by the end of 2009. Now you know why the Fed has to backstop the commercial paper market. All these desperate short-term borrowers trying to fund long-term assets (loans and securities) will have to find other funding sources; all of which will be devastatingly more expensive than what they paid in the CP market.

As we’ve repeatedly pointed out, this credit crisis is exposing every weakness.

As I write this, it has come across the wire that the Fed is signaling that it may lower the benchmark Federal Funds rate. I’m very sorry to inform you that it will do no good. I’ll tell you why tomorrow. But, in the meantime, I’ll tell you that it has to do with a truth that most people don’t know: The Fed has no direct control over the Fed Funds rate. You didn’t know that, did you? The Fed can “lower” it, but the market can ignore the rate. What’s worse is that if the Fed actually is able to push down the Fed Funds rate, the cost will be enormous. Do I have your attention? I hope so, for this affects you directly.

There has to be an immediate action taken to stem the crisis. The Fed is trying: However, the central bank’s efforts are just not enough. Unfortunately, the Treasury plan signed into law by President George W. Bush is unlikely to work for myriad reasons [A special Money Morning report details just why this bailout plan will not work. The report is free of charge.] The administration and Congress need to jump-start the U.S. economy by immediately eliminating all pork-barrel spending, and by immediately cutting off all non-essential spending and redeploying capital to consumers and homeowners by addressing capital-gains and tax policies to provide initiatives and incentives to liquefy banks, borrowers, homeowners and consumers.

Backstopping U.S. confidence is just as important as backstopping the commercial paper market.

[Editor's Note: Contributing Editor R. Shah Gilani has toiled in the trading pits in Chicago, run trading desks in New York, operated as a broker/dealer and managed everything from hedge funds to currency accounts. In his just-completed three-part investigation of the U.S. credit crisis, Gilani was able to provide insider insights that no other financial writer or commentator could hope to match. He drew upon the experiences and network of contacts that he developed through the years to provide Money Morning readers with the "real story" of the credit crisis – and to propose an alternate plan of action. It's a perspective on the near-financial meltdown that more than 140,000 readers have already read – and an insight that you'll find nowhere else.

If you missed Gilani's investigative series, Part I appeared Sept. 18, Part II ran Sept. 22 and Part III was published Sept. 24. Gilani’s plan was published on Sept. 25 as an open letter to U.S. Treasury Secretary Henry M. “Hank” Paulson Jr. It actually contains contact information for readers who still wish to protest the government’s action with the bailout bill by passing their disenchantment along to their elected representatives in each state’s governor’s mansion, and in both the House and the Senate. Check out Gilani’s plan of action.

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About the Author

Shah Gilani boasts a financial pedigree unlike any other. He ran his first hedge fund in 1982 from his seat on the floor of the Chicago Board of Options Exchange. When options on the Standard & Poor's 100 began trading on March 11, 1983, Shah worked in "the pit" as a market maker.

The work he did laid the foundation for what would later become the VIX - to this day one of the most widely used indicators worldwide. After leaving Chicago to run the futures and options division of the British banking giant Lloyd's TSB, Shah moved up to Roosevelt & Cross Inc., an old-line New York boutique firm. There he originated and ran a packaged fixed-income trading desk, and established that company's "listed" and OTC trading desks.

Shah founded a second hedge fund in 1999, which he ran until 2003.

Shah's vast network of contacts includes the biggest players on Wall Street and in international finance. These contacts give him the real story - when others only get what the investment banks want them to see.

Today, as editor of Hyperdrive Portfolio, Shah presents his legion of subscribers with massive profit opportunities that result from paradigm shifts in the way we work, play, and live.

Shah is a frequent guest on CNBC, Forbes, and MarketWatch, and you can catch him every week on Fox Business's Varney & Co.

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