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October 08, 2008

Despite Rate Cuts, Credit Markets Remain Frozen Economy

Central banks around the world cut interest rates overnight. Has it helped? Not yet. Bloomberg:

Overnight corporate borrowing costs jumped, default risk increased and the bond market remained all but closed after central banks worldwide cut interest rates, showing unprecedented government intervention was failing to aid companies struggling to finance themselves.

Overnight rates on dealer-placed commercial paper rose 56 basis points to 3.5 percent, while the cost of protecting corporate bonds from default rose. Two issuers sold $750 million of U.S. company bonds this week, compared with the weekly average this year of $16.8 billion.

The coordinated rate cuts come as companies struggle to fund daily operations and economists say the world is already mired in a recession. The Federal Reserve joined the European Central Bank and four others today in lowering interest rates by as much as half a percentage point in a coordinated effort to unlock short-term credit markets frozen since Lehman Brothers Holdings Inc. filed for the biggest bankruptcy in history on Sept. 15.

"We've reached the point where so many of these government plans have fizzled that the reaction is reserved until we actually see the impact," said Christopher Low, chief economist at FTN Financial in New York. "They can't stop a recession. What they can do hopefully is prevent a really nasty recession." [...]

"The reality is there's no private sector balance sheet willing to step in so the Fed and the Treasury are becoming the only balance sheet," said Mark Kiesel, executive vice president at Pacific Investment Management Co., the manager of the world's biggest bond fund. "In a market that lacks trust and confidence the private sector is on the sidelines." [...]

Corporate borrowing options have dwindled as the investment-grade bond market remained all but closed for a fifth week. Companies from newspaper firm Gannett Co. to electricity producer Southern Co. have been forced to tap credit lines or forego raising debt because of the market's disruption. [...]

The difference between what banks and the Treasury pay to borrow money for three months, the so-called TED spread, widened to 3.87 percentage points, after widening to as much as 4.03, the most since Bloomberg began compiling the data in 1984.

"I do believe over time policy will work," said Kiesel, who oversees $180 billion of corporate bonds in Newport Beach, California. "The problem with all these measures is it operates with a lag and the deleveraging is real time. The deleveraging cycle is operating on a real time basis much faster than policy can overcome it."

The world economy has already fallen into its first recession since 2001, according to JPMorgan Chase & Co. economists Bruce Kasman and David Hensley. The U.S. is "definitely in a recession," Low said.

Money-market funds, the biggest buyers of commercial paper, began to flee the market three weeks ago, pushing yields to the highest since January and persuading the Fed yesterday to backstop the market.

Prime money-market funds have pulled $200.3 billion of assets from commercial paper since Sept. 16, the day after Lehman filed for the biggest bankruptcy ever, and built up their safer government debt holdings instead, according to IMoneyNet Inc., a research firm based in Westborough, Massachusetts, that tracks money funds.

Big companies derive cash flow from sales of "commercial paper" — short-term IOUs that pay interest. When the IOUs reach maturity, the companies "roll them over" by selling new ones. Before long, if credit markets don't thaw, we are going to see a lot of commercial paper reaching maturity, and companies will be unable to find private sector buyers to roll them over. The Fed will have to buy them — something which was never part of the Fed's mandate, until yesterday. Otherwise, we'd see a lot of big companies going into default.

Posted by Jonathan at October 8, 2008 03:41 PM  del.icio.us digg NewsVine Reddit YahooMyWeb



I know it sounds old fashioned, but profitable companies with positive cash flow don't need to sell commercial paper IOUs.

Posted by: Alan von Altendorf at October 8, 2008 07:15 PM

Some companies don't have money coming in all the time. Lots of retail businesses' sales are seasonally skewed, for example. Ditto for construction in many climates. Or maybe they only get paid upon completion of a lengthy project or when they make infrequent sales of really big-ticket items. For whatever reasons, their income may be "lumpy," and commercial paper lets them smooth out their cash flow so they can meet their ongoing expenses -- payroll, rent, etc.

Posted by: Jonathan at October 8, 2008 08:00 PM

Cutting interest rates when lending is limited means the banks can trade among themselves.

Who cares? Well - I don't know anyone, personally, that is affected positively by this.

Perhaps my realm of affect is very narrow.

Posted by: Steven at October 8, 2008 11:52 PM

It might be a good time to take a fresh look at "The Limits of Growth", published by in 1972, and roundly dismissed at the time.

Posted by: edward Beardsley at October 9, 2008 02:26 AM