Short-term loan? Ask ol’ Uncle Sam

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Published: October 13,2008

In the latest round of government intervention into a struggling economy, the Federal Reserve announced an initiative it hopes will prop up the sagging business loan market.

At issue is commercial paper, a form of short-term lending that many businesses rely on to keep their doors open.

Most major U.S. corporations and many leading financial institutions sell commercial paper, which essentially acts as the checking account for businesses. Money market fund managers and various institutional investors are the primary buyers of commercial paper. The transactions have slowed quite a bit with investors skittish about holding commercial paper for businesses that are in or could experience financial trouble. Because of that slowdown, the Fed will step in and become buyers.

“The Treasury believes this facility is necessary to prevent substantial disruptions to the financial markets and the economy and will make a special deposit at the Federal Reserve Bank of New York in support of this facility,” read a press release from the Federal Reserve.

Before the credit crisis struck, nearly $2 trillion worth of commercial paper was outstanding. Most of the loans were for short terms, usually never more than nine months and was considered a safe spot for investors to park their money. There was also a quick turnaround for resale.

That perception began to erode with the collapse of Lehman Brothers last month, followed by several of its competitors. Even companies not in some degree of trouble are at risk for default if new funding does not arrive when their current borrowing matures.

“The Fed action on commercial paper was very justified in my opinion,” said Dr. Lance A. Nail, dean and professor of finance at the University of Southern Mississippi College of Business.

The past month has seen an 11% decline in the amount of commercial paper outstanding, to a seasonally adjusted $1.6 trillion on October 1, down from $1.82 trillion on September 10. Investors have become unwilling to purchase long-term commercial paper, whose term is longer than a week or two, even from companies that have sterling credit.

The Fed’s move is designed to inspire confidence in commercial paper and loosen the stagnant credit market. It comes less than a week after Congress passed a financial rescue package that would take up to $700 billion of taxpayer money to buy mortgage-backed securities, assets whose value has plummeted, which is largely responsible for the implosion of institutions like Lehman Brothers and Bear Stearns.

Nail said the latest move will certainly benefit financial entities, but will also have a profound effect on non-financial institutions, such as businesses that depend on commercial paper to make payroll.

“The focus of the crisis has been on financial institutions and their ability to access credit markets, but non-financial institutions with working capital needs were also impacted by the credit squeeze. As (Federal Reserve Chairman Ben) Bernanke noted, the Fed’s intervention in buying commercial paper will take some of the credit crisis burden off of financial institutions and provide working capital to companies that might otherwise run out of cash.”

Commercial paper was not the only thing on the Fed’s agenda last week. In an emergency meeting, the benchmark lending rate was cut by a half-point to 1.5%. The move was part of an effort by central banks worldwide to hem in spreading credit fears.

Unlike the commercial paper announcement, Nail said the Fed’s decision to cut rates weeks ahead of its regularly scheduled rate-setting meeting will likely have no immediate impact.

“The decision to cut rates is part of a coordinated international central bank plan to lower borrowing costs around the globe, but I think the impact of those cuts will not have as great of an impact on the world economy as hoped,” Nail said. “Any positive impact will likely be long term and not short term. But, with the fear of inflation no longer a real concern, there is little downside to cutting rates.”

Contact MBJ staff writer Clay Chandler at clay.chandler@ msbusiness.com .

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