Credit barely eases after Fed plans to buy paper

Posted 10 8 2008 8:03AM

NEW YORK - The grip on the credit markets loosened just barely on Tuesday after the Federal Reserve said it would buy commercial paper, the unsecured short-term debt that companies sell for their short-term cash needs.

In the eyes of many market participants, the move to grease the commercial paper market could do more to get people lending again than the $700 billion bailout plan passed by Congress.

"It's the most effective move the Fed has done to date," said Axel Merk, portfolio manager at Merk Funds. "When that market seizes up, the economy stops working."

Still, no one is betting on a quick fix just yet for the credit markets, where companies go to borrow and lend. Annette Sykora, chairwoman of the National Automobile Dealers Association, said Tuesday the credit crunch and economic problems are likely to cause 700 auto dealers to go under this year.

The Federal Reserve said Tuesday that consumer borrowing fell at an annual rate of 3.7 percent in August, before the financial crisis became acute in September, forcing the government to approve a $700 billion rescue of the financial industry.

August's decline in consumer credit marked the first time that total borrowing had fallen since a 4.3 percent rate of decline in January 1998.

Demand for Treasurys let up slightly on Tuesday, but rates on commercial paper remained high, showing that confidence among potential lenders is far from restored.

"Main Street is going to have to still wait for the trickle-down effects," said John Atkins, a fixed-income analyst at IDEAGlobal.com. "In terms of direct impact, it's not going to be a panacea."

Lending between banks — which have been slammed by loan losses — remains extremely expensive.

The London Interbank Offered Rate, or LIBOR, for overnight dollar loans jumped to 3.94 percent on Tuesday from 2.25 percent Monday. LIBOR for three-month dollar loans rose at 4.32 percent, near its nearly nine-month high.

Both rates are well above the Fed's target rate for overnight loans of 2 percent. LIBOR is important not only because it indicates how willing banks are to lend, but also because many consumer rates are tied to it, including adjustable-rate mortgages.

In a sign of how much financial institutions have pulled back their lending, consumer borrowing fell in August for the first time in more than a decade.

On Monday, to address the rise in LIBOR, the Federal Reserve doubled its one-month loan and three-month loan offerings. Those moves and others brought the total amount of credit potentially outstanding through year end to $900 billion, the Fed said.

When the Fed buys commercial paper, it should help keep many companies operating more normally than they have been.

Commercial paper is a common way for large companies to maintain their cash flow. Demand for commercial paper has plummeted in recent weeks, as most investors have gotten too scared to put their money in anything but government debt. A big reason was that a money market fund "broke the buck" — or lost too many assets to cover each dollar invested — because it was exposed to the now-bankrupt Lehman Brothers Holdings Inc.

In the week ended Oct. 1, commercial paper outstanding fell to $1.61 trillion, seasonally adjusted, from $1.70 billion in the previous week. Since the summer of 2007, the market has shrunk from more than $2.2 trillion. Recently, it's been hard for many companies to issue commercial paper for more than overnight or a couple days, market participants say.

Money market funds are typically the largest holders of commercial paper, accounting for about one-third of outstanding commercial paper, according to Standard & Poors.

One source of concern is that the Fed only plans to buy the safest, top-tier commercial paper.

The riskier, lower-tier commercial paper is a smaller portion of the market, but has seen particularly low demand. The rate spread between top-tier and lower-tier commercial paper is typically 0.10 to 0.20 percentage points, Atkins said — and right now, it's about 3 percentage points, indicating a massive aversion to the lower-tier debt.

The rate on 90-day commercial paper issued by dealers slipped 0.09 percentage points to 4.31 percent, but was still well above where it was a month ago, according to Howard Simons, strategist with Bianco Research in Chicago. And the rate on 90-day asset-backed commercial paper was flat at 4.35 percent. Some other commercial paper rates actually edged up on Tuesday despite the Fed's plan.

The three-month Treasury bill, the ultimate safe asset, saw its yield rise to 0.81 percent from 0.49 percent late Monday. Still, a yield below 1 percent is very low in historical terms. The discount rate on the three-month T-bill was at 0.81 percent.

Longer-term Treasurys also dipped, despite a 508-point drop in the Dow Jones industrial average.

The 2-year note fell 2/32 to 101 1/32 and yielded 1.47 percent, up from 1.43 percent late Monday. The 10-year note fell 13/32 to 104 1/32 and yielded 3.51 percent, up from 3.45 percent. The 30-year bond fell 1 4/32 to 107 31/32 and yielded 4.04 percent, up from 3.98 percent.

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AP Business Writer Tom Krisher in Detroit and AP Economics Writer Martin Crutsinger in Washington contributed to this report.