What’s This Stuff about Commercial Paper and Liquidity?

I got a question from a member of the Stool Pigeons Wire message board over at Capitalstool.com this morning about the breakdown in the commercial paper market. Actually it was a series of good questions from a stoolie who goes by the monicker Schonthaler. It forced me to stop and think about the all important basics of what’s going on here. Here are his questions:

What are the ingredients required for liquidity to return to the market? Not that it will for months, and months, but what is required? What’s the recipe?

Also, what exactly is commercial paper? And why do you think that both the bond and stock market will collapse once folks get all they are going to get out of their commercial paper?

Is the commercial paper that large that the money coming out of commercial paper can support both bond and stock prices, or is it just enough, once exhausted, to tip the scales to the down side? Link

And my response:

Thanks for the questions.

OK. First of all, price is set at the margin. It only takes a tiny change in liquidity levels to move prices. The vast majority of holders of any asset class are simply bystanders. Price is set by the traders, the ones moving their cash buying and selling at any given time.

Yep, the commercial paper market is enormous. It’s money that companies and investors lend to each other outside banking channels for a short term. Money market fund assets are almost entirely commercial paper, except for those holding only Treasuries. There are three kinds– non-financial company CP, financial company PC, and asset backed PC (ABCP-short term paper backed by other debt, mostly of dubious or no quality). The third is where the problem is right now, although I suspect the second group may be right behind.

Liquidity will return to the market when confidence is restored. Once confidence is broken, it takes at least half a generation to be restored. With most ABCP holders unable to get all their money back, or in some cases, any money back, we are just at the beginning of the period of loss of confidence. The Asset Backed Commercial Paper market is broken, and it’s just starting. It will take many, many years to restore confidence. The ABCP market is by far the largest of the CP markets, comprising around $900 billion worth of paper today, according to the Fed’s data. Two months ago that figure was $1.2 trillion.

The cash from the paper that’s been paid back has moved on to other markets, sending rates on Treasuries crashing, and also propping the stock market and the prices of some hard assets. But here’s the problem. Because of the very short life of CP, typically 30 days with a maximum of 90 days, that cash flight into other asset classes is going to come to a dead stop very soon. Cash strapped holders and issuers will then have to start liquidating those asset classes they just rolled into. It’s going to be hideously ugly. (Are T-bonds and notes a short here? Watch the charts for signals.)

The rest of the holders of CP are being forced to roll over their paper into an extended maturity, with the expectation that they will get paid back when the current market seizure eases. Well, guess what. If the paper backing that paper is worthless, as most of what’s left out there probably is, then Bwa Ha Ha. Yo ain’t gittin yo money back. When that becomes apparent to the institutional holders and hopers, what happens next in the market is going to be a sight to behold.

I know somebody on the inside of one of these big institutional holders, and believe me, they still think they will get their money back, but underneath that facade, they are sweating bullets. They are in a state of shock, because never in their wildest dreams did they ever think that they wouldn’t get their money back when their CP matured. Now, they really have no clue and they know they have no clue. They had $500 million of CP due to roll over and they were supposed to get their cash. It didn’t come when the paper matured, and now 3 weeks later they have gotten back half of it, and were forced to extend the maturity on the rest. That’s the part that’s worthless, but they still hope they will get their cash.

This is just one medium sized institution. There are hundreds, perhaps thousands, of institutions all over the world of varying sizes in just the same boat right now. And here’s another thing. The stories you read in the press about these problems, mostly in the European and Canadian media, with almost no mention in the US Wall Street-Washington Axis lackey media, are grossly, grossly understating the extent of the problem. A few economists and pundits in Europe have been sounding the alarm, but few are paying attention. It’s too hard for most people to fathom.

But in a couple of months, we’re all going to have to face it, because it will be out in the open, and the effects will be cataclysmic.

That triggered another question from stoolie Lemur that really got my rant mojo going. His comment:

Great explanation. But I am puzzled as to why this is not priced into the markets (at least to some extent) already. I know there are many who believe the efficient market theory is bunk but is it not surprising the index’s would be holding up so well given the above.

And my response:

Well, not to me. My thought has been, and I’ve said it in the WSE Pro and on the boards before, and above, “The cash from the paper that’s been paid back has moved on to other markets, sending rates on Treasuries crashing, and also propping the stock market and the prices of some hard assets.”

So, in the short run this is bullish, if I am correct about this. And I don’t know if I am, but this is my guess. My guesses on the big picture have been pretty darned good for years.

I’ve also stated many many times that I don’t believe for one second that the market discounts anything. It’s a price setting mechanism, based on liquidity flows, that’s all.

People think what they are told to think, and the conventional wisdom has always been that the market is a discounting mechanism. That’s just bull in my mind.

I worked for many years with discounting models in real estate, and it’s all rubbish. The real estate pros just made up a bunch of ridiculous assumptions to justify prices when their pockets were bulging with cash, and when they were cash poor their assumptions were bleakly pessimistic, and also dead wrong.

If investors are “pricing in” or discounting, then they are pricing in whatever just happened to their liquidity levels, not what’s going to happen in the future. They price in yesterday, not tomorrow, because in the aggregate they have no idea whatsoever is going to happen tomorrow. A few people are good guessers, but they are an infinitesimal minority. They are people with cash when nobody else has any. They are the real opportunity seekers and sensers. The rest are just clueless, buying when they have cash, and selling when they need it.

Discounting is bunk. Prices are a meter of liquidity, that’s all. That’s why I rely on technical analysis, and liquidity measures only.