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11.06.08

Another Crazy Debt Addiction

After my last post, I will delve into something a lot more temporal and straight forward. The US Federal Reserve recently released information that it has now purchased $243 billion worth of commercial paper from various companies. This number has increased almost $100 billion in one week. Although I understand some of the reasoning behind cushioning the harshness of the sudden aversion to commercial paper, it substantially grates against my senses at how commercial paper has been utilized by banks and large corportions. First a primer on commercial paper, the description below is pulled directly from wikipedia.

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. Since it is not backed by collateral, only firms with excellent credit ratings from a recognized rating agency will be able to sell their commercial paper at a reasonable price. Commercial paper is usually sold at a discount from face value, and carries shorter repayment dates than bonds. The longer the maturity on a note, the higher the interest rate the issuing institution must pay. Interest rates fluctuate with market conditions, but are typically lower than banks’ rates.

As defined by American law, commercial paper is a financial instrument that matures before nine months (270 days), and is only used to fund operating expenses or current assets (e.g., inventories and receivables) and not used for financing fixed assets, such as land, buildings, or machinery. By meeting these qualifications it may be issued without U.S. federal government regulation, that is, it need not be registered with the U.S. Securities and Exchange Commission. Commercial paper is a type of negotiable instrument, where the legal rights and obligations of involved parties are governed by Articles Three and Four of the Uniform Commercial Code, a set of non-federal business laws adopted by each of the 50 U.S. States.

At the end of 2007, more than 1,700 companies in the United States issue commercial paper. As of 2008 October 31, the U.S. Federal Reserve reported seasonally adjusted figures for the end of 2007: there was $1.7807 trillion (short-scale, or 1,780,700,000,000) in total outstanding commercial paper; $801.3 billion was “asset backed” and $979.4 billion was not; $162.7 billion of the total was issued by non-financial corporations, and $816.7 billion was issued by financial corporations.

Here’s the skinny. Corporations and financial institutions perceived to be stable and highly solvent are able to receive substantial loans at extremely discounted rates via issuing commercial paper and rolling it over continually. Recently, many institutions which heavily utilize commercial paper have suddenly been revealed as something less than highly solvent. (e.g. AAA rated GE needed cash bad enough to borrow from Warren Buffett at a 10% rate plus incentives.) This has naturally led to a substantial reduction in the amount of cash available to them via commercial paper. Suddenly they are forced to play the game like the rest of us and either finance their activities from their own pockets or post collateral for a loan from a financial institution. (FYI - Financial institutions aren’t looking so stable either and don’t really want to lend to less than highly solvent corporations no matter how big.) It seems to me that receiving cash to fund your operations at interest of 3% or less falls under the category of “too good to be true.” The more prudent among us understand that if something sounds too good to be true it probably is. Alas, this maxim has been forgotten along with much of our senses during the period of our “goldilocks” economy. So for the good of the economy, the US Federal Reserve feels it must step in and help these major, highly solvent (supposedly) institutions come down from their commercial paper high gradually. This is nothing more than a not so cleverly disguised, massive, additional bailout of financial institutions and major corporations. These actions must ultimately be funded by newly issued T bills from the US Treasury. (But what’s another $100 billion a week. That’s just $5.2 trillion added to the national debt per year!) I’m still waiting for my 3% loan from the US Federal Reserve. Perhaps it will come with the next stimulus package.

Author: joe | Permalink | No Comments | Daily Entries

John 14:6

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Another Crazy Debt Addiction

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