The commercial paper market, a little-known but vital part of the nation’s financial system, is still feeling the pressure from the meltdown in the subprime mortgage market – and could prompt the Federal Reserve to cut its key discount rate further.
Commercial paper is short-term debt that corporations use to keep their cash flow running smoothly. Investors buy commercial paper to get higher yields than then they would from ultrasafe Treasury securities.
But some commercial paper, particularly that backed in part by mortgages or issued by mortgage lenders, is finding fewer buyers because of credit-market jitters.
For example, investors yanked $9.3 billion from institutional money market mutual funds that invest in commercial paper on Thursday and Friday, says iMoneyNet, which tracks the funds. Institutional money funds that invest only in government securities saw inflows of $26.8 billion. Fewer buyers means that issuers have to offer higher yields to sell asset-backed commercial paper, which is more than half the commercial paper market. Yields on asset-backed commercial paper, some of which may be backed by mortgages, soared to 5.99 percent Friday, the highest rates in almost seven years, Bloomberg says.
In contrast, the yield on commercial paper issued directly by top-rated industrial companies was about 5.2 percent. This type of commercial paper is backed only by the issuer’s financial strength.
High yields on asset-backed paper signal deeper problems in the credit markets. Some smaller financial institutions may not be able to float enough commercial paper as they need – which could, in turn, force them to shut down.
That’s one reason the Fed cut the discount rate by half a percentage point, to 5.75 percent, on Friday.
Countrywide, the biggest mortgage lender by volume, had to tap an $11.5 billion credit line Thursday because of its problems getting short-term loans.
Smaller lenders don’t have that sort of credit line. “It’s a lot tougher now to get a loan if you’re a smaller player,” says Zoltan Pozsar, senior economist at Economy.com. “The smaller institutions that were unable to get liquidity can now go to the discount window at the Fed.”
Banks can borrow from the Fed at the discount rate, using investment-grade securities, including mortgage-backed securities, as collateral. The Fed is allowing loans for up to 30 days, renewable after that. Typically, loans at the so-called discount window are overnight loans.
Normally, banks are reluctant to borrow from the Fed’s discount window because it’s a sign of financial weakness. “There’s a big stigma attached to it,” says Kim Rupert, managing director at Action Economics.
Nevertheless, some banks may tap their credit at the Fed. “They’re already in the dumps,” Rupert says. “They have nothing to lose.”
Analysts think the Fed’s move Friday has helped settle the credit markets. “So far, it seems to have worked,” Pozsar says. “There could be more (discount-rate cuts) coming in the next few days or weeks if things deteriorate.”