Reflecting the drying up of credit availability in the commercial paper market, commercial paper rates have surged. For example, the 7-day rate for asset-backed commercial paper has jumped to 4.50% from the roughly 2.5% rate that prevailed over the past few months. A continuation of this trend would be problematic for the economy, as the commercial paper market is where entities go to raise working capital to produce goods and services.
The total amount of commercial paper outstanding peaked in July 2007 at $2.22 trillion before contracting abruptly to about $1.9 trillion a month later and $1.8 trillion two months later. Conditions had been relatively tranquil since then, which is not surprising for the commercial paper market, a Darwinian market that purges weak issuers in rapid fashion, as evidenced by the fact that there have been only 7 defaults in the commercial paper market since Penn Central defaulted on its paper in 1970.
Issuers with mortgage-related exposures have been pushed out of the market, which is what makes this latest round of seizing up worrying, because the issuers that remain are considered far more stable entities with more predictable cash flows.
These data provide all the more justification for the Federal Reserve's policy response to recent events and for a further enlargement of the Fed's balance sheet, which will likely occur next through the paying of interest on bank reserves, a strategy that lets the Fed pump boatloads of money into the financial system without repercussion on the fed funds rate. (For more on Fed moves, see video)
It also makes more imperative that the Treasury Department purchase mortgage-backed securities to both remove unwanted assets from the Street and help get at the core of the financial crisis, home prices.
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