October 28, 2008
The Commercial Paper Market and the Fed’s Commercial Paper Funding Facility: Part 1 of a 2-part Series
The current financial crisis is a good reminder of how interconnected our financial system really is. The financial tsunami has engulfed seemingly unconnected and obscure corners of the credit market, making them front of mind for a general public that had probably never heard of them before (think SIVs, auction rate securities, monoline insurers, credit default swaps, variable rate demand notes, commercial paper, etc).
Recently, we have heard a lot [here, here, and here] about the issues in the very important but relatively unglamorous commercial paper market. Commercial paper (CP) is a short-term debt instrument issued by large banks and corporations with a maturity of one to 270 days.
Traditionally, companies use CP to finance day-to-day operations, borrowing cash they need to meet payroll or buy materials. Borrowing short-term money gives a company more flexibility to meet short-term needs, and is usually cheaper than issuing long-term debt. Companies can, and often do, roll over their CP as it matures, which effectively turns short-term debt into long-term debt, but at short-term interest rates.
In the past few years the commercial-paper market has grown dramatically, increasing by about 56 percent from 2005 until its peak in August 2007. Much of this growth has been in asset-backed commercial paper (ABCP), which jumped 76 percent over the same period. [Here is the Board’s most recent CP report.] In contrast to unsecured CP, which is backed by the name and assets of an entire company, ABCP is backed by a pool of specific assets, such as credit card debt, car loans, and/or mortgages.
CP generally carries low risk because of its short duration. With unsecured CP, the primary risk is some negative event that threatens the viability of an issuing company's business. But for ABCP, the primary risk is a shock to the value of the underlying asset—such as higher-than-expected mortgage defaults, and an uncertain trajectory for defaults in the future. Recently, both unsecured (especially financial firms) and asset-backed (especially mortgage-backed) CP markets have come under considerable stress.
Money market funds are significant buyers of CP because it typically offers a slightly higher yield than, say, short-term Treasury securities. Money market mutual funds and other institutional investors purchase about 60 percent of commercial paper in the market, according to mutual-fund tracking firm Crane Data.
Following the failure of a number of financial institutions and increased uncertainty about the quality of assets underlying some of the asset-backed paper, the problems in the CP market intensified in September. On the one hand, the demand from money market funds declined as they were faced with a rise in redemptions. This development contributed to a sharp decline in CP outstanding (see chart above). At the same time, investors began demanding higher interest rates in order to buy CP, which contributed to a widening of their spreads relative to the risk-free Treasury rate in September (see chart below).
Furthermore, there was a significant shortening in the maturity of new CP issued with only the most trusted programs able to issue out as far as six months at favorable rates, resulting in many firms needing to roll over their paper every day (see chart below).
In response to the deteriorating conditions, the Fed created the Commercial Paper Funding Facility (CPFF) in early October, which went operational yesterday (10/27). According to the Board of Governors, the new facility “is intended to improve liquidity in short-term funding markets and thereby increase the availability of credit for businesses and households.” The Board also said that “By eliminating much of the risk that eligible issuers will not be able to repay investors by rolling over their maturing commercial paper obligations, this facility should encourage investors to once again engage in term lending in the commercial paper market.”
In the CPFF, the New York Fed will lend to a Special Purpose Vehicle (SPV) which will purchase eligible highly-rated (A-1, P-1, F-1) 3-month CP and ABCP from U.S. issuers. According to the New York Fed, the rate charged on unsecured commercial paper will be the three-month overnight index swap (OIS) rate plus 100 basis points per annum, and the rate for ABCP will be three-month OIS plus 300 basis points per annum. Additionally, for unsecured commercial paper, the New York Fed said “a 100 basis points per annum unsecured credit surcharge must be paid on each trade execution date.” Looking back before September, three-month CP rates typically traded very close to three-month OIS rates. The jump in CP rates in September led them to trade much wider than the SPV spread.
Short-term debt markets have been under considerable strain in recent weeks as money market mutual funds and other investors have had difficulty selling assets to satisfy redemption requests and meet portfolio rebalancing needs. The CPFF is intended to support the issuers of CP by providing liquidity and supporting term lending in the CP markets. On Oct. 21, the Fed announced the creation of the Money Market Investor Funding Facility, which supplements the previously announced Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility, to free balance sheets at money market funds and to encourage them to resume their traditional role in securities lending and participation in other financing markets. This will be the topic of Thursday’s blog.
By Mike Hammill and Andrew Flowers in the Federal Reserve Bank of Atlanta’s Research Department.
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October 09, 2008
How high is financial risk today?
On a day as brutal as today, it is hard to find any port to hide from the storm. Maybe that is exactly the time for some perspective. At Businomics Blog, Bill Conerly does his best (hat tip, Mark Thoma), making a point that I have heard repeated more than a few times: Taken from the long view, many measures of risk that we take as symptomatic of extreme market stress are not entirely without historical precedent. Dr. Conerly uses this graph of the “TED spread”—the 3-month Libor rate minus the yield on 3-month Treasury bills—to drive the point home:
Here are a couple more graphs on the same theme: The spread between 3-month LIBOR rates and the effective funds rate (which I emphasized in an earlier post)…
… and the spread between yields on commercial paper and secondary-market 3-month Treasury bills.
Comforting? Maybe not. As Conerly notes, your perceptions of the ugliness of the past month or so depends very much on what you believe to be the appropriate reference point. In the context of the period spanning the 60s and 70s the measures of risk and market stress depicted in these charts are not so impressive. However, if you believe that the world fundamentally changed in the 1980s—at the outset of the so-called “Great Moderation”—things are very dysfunctional at the moment.
For my part, I can’t help but recall the following exchange from the movie “No Country for Old Men” after two characters come across a gruesome murder scene.
Deputy Wendell: “It’s a mess, ain’t it sherriff.”
Sherriff Ed Tom Bell: “If it ain’t, it’ll do until the mess gets here.”
In other words, no matter what you compare it with the current environment is plenty challenging.
By David Altig, senior vice president and research director, Federal Reserve Bank of Atlanta
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September 18, 2008
What’s a swap line?
This morning the Federal Open Market Committee (FOMC) authorized a $180 billion expansion of its temporary reciprocal currency arrangements (swap lines). According to the Fed’s press release, the changes allow for “increases in the existing swap lines with the ECB and the Swiss National Bank” and for “new swap facilities…with the Bank of Japan, the Bank of England, and the Bank of Canada.”
“These measures…are designed to improve the liquidity conditions in global financial markets,” the release continued.
What did the Fed do and how will this action address some of the strain in liquidity conditions that recently have emerged?
A good place to start is by looking at what, exactly, a currency swap line is. A currency swap is a transaction where two parties exchange an agreed amount of two currencies while at the same time agreeing to unwind the currency exchange at a future date.
Consider this example. Today the Fed initiated a $40 billion swap line with the Bank of England (BOE), meaning that the BOE will receive $40 billion U.S. dollars and the Fed will receive an implied £22 billion (using yesterday’s USD/GBP exchange rate of 1.8173).
An underlying aspect of a currency swap is that banks (and businesses) around the world have assets and liabilities not only in their home currency, but also in dollars. Thus, banks in England need funding in U.S. dollars as well as in pounds.
However, banks recently have been reluctant to lend to one another. Some observers believe this reluctance relates to uncertainty about the assets that other banks have on their balance sheets or because a bank might be uncertain about its own short-term cash needs. Whatever the cause, this reluctance in the interbank market has pushed up the premium for short-term U.S. dollar funding and has been evident in a sharp escalation in LIBOR rates.
The currency swap lines were designed to inject liquidity, which can help bring rates down. To take the British pound swap line example a step further, the BOE this morning planned to auction off $40 billion in overnight funds (cash banks can use on a very short-term basis) to private banks in England.
In effect, this morning’s BOE dollar auction will increase the supply of U.S. dollars in England, which would work to put downward pressure on rates banks charge each other.
Consistent with this move, the overnight LIBOR rate fell from about 5.03 percent yesterday to 3.84 percent today.
The bottom line is that the Fed, by exchanging dollars for foreign currency, has helped to provide liquidity to banks around the world. This effort can help to bring interbank rates back down at a time when restrictively high rates can choke off access to financing that banks and other businesses need to operate.
By Mike Hammill in the Atlanta Fed’s research department
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September 16, 2008
The left and right of it all
What a wild day it was on Monday in U.S. and global financial markets. We heard it quipped that the problem with financial institution balance sheets is that “on the left hand side nothing is right and on the right hand side nothing is left.” This is clearly an exaggeration, but it does raise the question: What do people look at when gauging the rightness or leftness of balance sheets?
A lot of the discussion about asset quality has focused on mortgage backed securities (MBS). The size of the MBS market has experienced phenomenal growth over the last decade or so—MBS issuance grew from around $500 billion in 1997 to over $2 trillion in 2007. As the name suggests, an MBS is a bond that is backed by the collateral of mortgages—either by mortgages guaranteed by Freddie Mac or similar institutions or other pools of mortgages. The MBS, or pieces of it, are then sold to investors, with the principal and interest payments on the individual mortgages used to pay investors.
Underlying the performance of MBS is the performance of mortgages themselves. Mortgage delinquency has been rising for some time, and especially for subprime mortgages.
One of the features of the U.S. financial system is that the debt of financial institutions tends to be weighted toward long-term obligations while the financing has been predominately from short-term borrowing. As the performance of the assets has deteriorated the need for liquidity has risen sharply.
The demand for cash was especially acute on Monday, as can be seen in the large intra-day variability in the federal funds market. Federal funds are the reserve balances of depository institutions held at the Federal Reserve. At times on Monday the federal funds rate traded well above the target of 2 percent before the New York desk intervened with an additional $50 billion injection of reserves. This Bloomberg news story describes Monday’s large movements in the federal funds market.
The demand for liquidity at 1 and 3 month horizons also surged, as indicated by the dollar LIBOR spread over OIS at 1 and 3 month horizons. LIBOR (the London Inter-Bank Offered Rate) is the interest rate at which banks in London are prepared to lend unsecured funds to first-class banks. As such it is a guide world-wide for the rate banks use to lend to each other. In the U.S., it is usually not far off from the fed funds rate. But after the emergence of the financial turmoil last fall the LIBOR has risen relative to the fed funds rate. The OIS (Overnight Index Swap) rate is a measure of the expected overnight fed funds rate for a specified term (1 or 3 months, for example). The LIBOR/OIS spread can be used as measure of the amount of liquidity or stress in short-term unsecured cash markets.
LIBOR spreads edged higher last week amid uncertainty about financial firms, and both spreads jumped higher on Monday and Tuesday, with both at or close to new highs.
Tuesday is another day, but some things will remain the same, including the focus of attention on the left and right of financial institution balance sheets, and the debate about the appropriate role of government in all this.
By John Robertson and Mike Hammill in the Atlanta Fed’s research department
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July 17, 2007
US Assets: Still Looking Tasty
It appears that the appetite for dollar-denominated assets is not sated quite yet. From Bloomberg:
International buying of U.S. financial assets unexpectedly climbed to a record in May as investors snapped up American stocks and corporate bonds.
Total holdings of equities, notes and bonds climbed a net $126.1 billion, from $80.3 billion the previous month, the Treasury said today in Washington...
Brad Setser does his usual fine job with the details:
Demand for US equities and corporate bonds was particularly strong, which does suggest the persistence of private demand for US assets abroad. Private investors tend to buy corporate bonds and equities; central banks tend to buy Treasuries and Agencies -- though that is changing.
What causes me trouble is the split between private and official purchases, and specifically the absence of any official inflows in the May TIC data.
In case you need visual confirmation:
Brad isn't buying it:
I have a hard time believing that. May was a record month for official reserve growth. China, Russia and Brazil all added to their reserves like crazy. Those three together combined to add close to $100b to their reserves – and a host of other countries were adding to their reserves too. That money has to go somewhere...
... the Fed’s custodial data doesn’t show a comparable fall off in official demand in May (June is another story).
The Treasury helpfully explains why the custodial data may differ from its own data:
- Differences in coverage: The most important reason for differences between holdings reported in the TIC and the FRBNY custody accounts is a difference in coverage. First, not all foreign official holdings of Treasury securities as reported by the TIC system are held at FRBNY. In particular, Treasury securities held by private custodians on the behalf of foreign official institutions are included in the TIC but not in the FRBNY figures. In this sense, the coverage of the TIC system is broader than that of the FRBNY custody holdings. Second, the custody holdings at FRBNY include securities held for some international organizations as well as for foreign official institutions. In this sense, the coverage of the FRBNY custody holdings is broader than the foreign official designation in the TIC system.
That description suggests advantage Treasury to me, but Brad offers other reasons for distrusting the official (that is, government) flows reported in the TIC data, and sticks to his guns on the belief that central bank diversification continues on. I won't -- can't really -- argue. But at the very least the latest report does little to vanquish the sense that global asset demand retains a strong attraction to the USA.
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