For the past month, I have been writing that when I weigh the actions of the Fed and other Central Banks against what we know is actually going on in the world economy and financial markets - it just hasn’t added up. I’ve been doing more thinking about this issue and what I must be missing than I have ever done on another topic. As a result, this will be a very long post. Sorry for that.

When it comes to the current intervention, I’ve consulted with experts in international finance and monetary policy and most of them are as perplexed as I am. The actions of the Fed and Central Bankers are so disproportionately extreme that they seem historic to me so I am looking for an historic event. Usually monetary policy follows a series of lagged economic data and reacts to it. This time around, it seems like Central Bankers are getting in front of a liquidity crisis that they fear but has not yet appeared in full force. A few days ago, I included Commercial Paper in a list of problems that I didn’t feel were equivalent to the Fed’s actions. After doing a lot of research and thinking, I believe I was wrong. If I was to bet on one thing that would be worthy of the intervention - it’s Commercial Paper.

Since many investors are not that familiar with Commercial Paper, I’ll just give you a decent link from Fidelity. For simplicity sake, just consider Commercial Paper short-term IOU’s from companies assumed to be of extremely high-quality and low credit risk. About 2000 US companies use CP to fund their short term needs. In good times, investors get access to comparatively high yields with minimal risk and liquidity from maturities that range from overnight to 270 days. In good times, when they come due they are just rolled over to the same investor or there is sufficient demand from new investors. That has stopped in the $1 Trillion Asset-Backed Commercial Paper (ABCP) segment. We are not in the good times right now.

In the risk factors of CP that you’ll find in any prospectus including these assets, there will likely be a mention about how there is minimal risk because of the short maturities. That has been broken. Default risk assumptions have also been trivialized and those have also been broken. Reinvestment risk is hardly ever discussed and that has definitely been broken. Investors have taken a lot for granted in the CP market for many years and that ignorance is costing our markets dearly.

In Europe, the ABCP market has increased about 18 times in the past decade. In the US, the total CP market has grown from $959 Billion in 1997 to about $2 Trillion today and the ABCP has increased about 5-fold. The growth in this area is like subprime and CDOs so it’s not unexpected that controls have gotten “out of control.” And once again, the ratings agencies are at the heart of this issue. Just as they did with the subprime fiasco, you can fully expect that they will be rushing in at this late date to downgrade commercial paper. Unfortunately, the Asset-Backed Commercial Paper has credit concerns because it finances things like credit card and trade receivables, as well as car loans and oh yeah, subprime mortgages. So if you believe the consumer is in trouble and a recession is on the way, it’s probably easy to understand why investors don’t want to touch this stuff.

I strongly recommend that you take a break from this long post and read a very telling article written in 1998 by economists at the St. Louis Fed. Here’s an excerpt from the conclusion:

Since the early 1970s, the commercial paper market has matured considerably. Commercial paper is now one of the more, if not the most, important instruments in the U.S. money market, thanks in large part to rating systems and backup lines of credit. As a result, the market is well-equipped to deal with small- to moderate-sized defaults.

Still, because no Penn Central-sized crisis has occurred in the past 27 years, the market remains essentially untested. Although the insurance that banks provide against “rollover risk” reduces the probability that a severe liquidity crunch could occur, the insurance also, however, transfers the liquidity risk from commercial paper issuers to the banking system. This guarantees that any potential liquidity crisis would be much more severe. It’s this risk of a systemic shockwave that makes it necessary for the Fed to keep an eye on the commercial paper market as it heads toward the $1 trillion mark.

The Fed has been worrying about this problem for decades - ever since Penn Central and Mercury Finance but CP has not been tested for over ten years and never at the $2 Trillion level. They are being tested now and this time, it’s a global problem that is much, much bigger.

According to Fitch, banks worldwide have $891 billion at risk because of credit agreements on asset-backed commercial paper programs. If they cannot roll the CP over, they have to put it on their books as loans and that affects their capital and reserves in dramatic ways. Meanwhile, they have to pay back investors and seize the collateral which puts them in the position of collecting payments they are not set up to deal with.

As companies draw on emergency lines of credit to cover for the shortfall in CP funding, the banks are rapidly taking on much bigger levels of riskier debt than they had anticipated. And don’t forget that banks use CP to raise funds for their own operations so the freezing of the CP market is a double-whammy. At some point, banks might find it difficult to make new loan commitments to fund the rest of the economy until this situation becomes clearer. Right now, banks are hesitant to lend to each other and if they cannot trust other banks where can they turn? This really is a death spiral that ends up with the Lenders of Last Resort - the Central Bankers.

In the US, we’ve largely escaped a systemic problem but individual names have been brought to their knees. More than 20 companies including H&R Block, Countrywide, Luminent Mortgage and Thornburg Mortgage have been unable to roll over asset-backed commercial paper. Meanwhile, Commercial Paper is locking up financial markets around the globe from Canada to Europe to Asia including banks and hedge funds. While big name banks like State Street, Lloyds TSB, Royal Bank of Scotland, and HSBC have billions in ABCP conduits, smaller banks are also at risk.

One of the biggest problems is that as this crisis continues, investors are less willing to take the same risk for longer periods. They fear that a 90-day commercial paper commitment might not hold up for that long so they are shortening the maturity to one month. One month notes become weeklies where you have to deal with the reinvestment risk 4 times in the same 30-day period. Similarly, weekly notes are becoming overnights - in fact, some estimates have about 25% of the European ABCP market being financed with overnights. This process is pushing up yields to levels not seen in the past seven years and it’s creating a backlog of ABCP that is forcing the banks to put the loans on their books. Meanwhile, the former CP investors who are getting paid off by the banks are investing the cash in Treasury Securities which explains the persistent declines in the T-bill yields.

Until now, almost everything I’ve talked about is related to banks and corporations but it’s important to remember that if the Commercial Paper market stays locked up, consumers will find it difficult to get capital to make purchases that fuel the economy. More importantly, I am increasingly concerned about individuals and their perception of safety in what they consider to be “cash” deposits. Commercial Paper affects retail depositors because it is a significant holding of most money market mutual funds. If there ever was a threat to Breaking the Buck, Commercial Paper is it.

The longer this situation persists, the worse it gets. You can keep track of the Commercial Paper market by clicking on this link to information compiled by the Fed. If you read the major financial media stories on the drawdown of CP on Thursday, you might assume that things are getting better as the amount of ABCP declines. But just remember that the money is coming from somewhere to reduce those balances and that somewhere is the banks. I don’t feel like it’s just going to get better on its own and this looks like a much bigger problem than subprime. When you consider the subprime losses, bridge equity loans and now the commercial paper loans sitting on bank balance sheets, it’s hard to be optimistic about the earnings in the financial sector.

So I am looking at all the Fed intervention to date and when I make the assumption that they have been trying to free up the CP market, it makes a lot more sense. First they tried to encourage banks to lend to each other, then they tried to get banks to borrow from the discount window and extended the maturity dates to prevent the compounding of the ABCP maturity compression, and then they allowed the banks to offer ABCP as collateral for discount window borrowings. Unfortunately, as that ABCP comes due I don’t see how the Fed can keep it as acceptable collateral. At some point, there is a day of reckoning and it is fast approaching.