Many investors are unaware of the largest short-term credit market in our economy known generically as commercial paper.
Commercial paper is very short-term debt companies and some governments use to finance immediate cash needs when revenues don’t cover current expenses.
Large corporations, including banks, issue this short-term debt on a regular basis, often for hundreds of millions of dollars.
Commercial Paper Market
Commercial paper must mature within 270 days. This keeps it from having to be registered with the Securities and Exchange Commission.In a normal economy, companies issue this paper (borrow money) on such a routine basis that it is almost a clerical transaction.
Commercial paper is, for the most part, unsecured, which means the company does not back the loan with specific assets.
Instead, the company’s credit rating and reputation in the market are what backs the loan and assures the lender of repayment. Since the loans are for such short periods, lenders are reasonable confident of repayment.
At least that’s how it works in a normal economy. When times get tough, lenders become more risk adverse and may refuse to lend to companies with suspect balance sheets.
Fear in the Market
This is what happened in late summer and early fall of 2008. Because of fears about the economy, the traditional sources of commercial paper quit lending.Companies use commercial paper to cover inventories and accounts receivables. They are prevented by the SEC from using commercial paper to finance fixed assets such as plants or equipment.
When the commercial paper market dries up, companies must scramble to cover short-term cash needs. If commercial paper is not available to companies, it can lead to layoffs, plant or store closings and other serious steps to preserve cash.
This market is not available to individuals directly, although many investors indirectly participate in commercial paper transaction through a money market mutual fund.
The short-term lending market, which normally works unseen by most investors, is vital to the day-to-day operations. In normal times, it is not even a consideration for most investors. However, when the commercial paper market freezes, it becomes very important to all investors.
