Why the credit crunch may deepen

With the $2 trillion commercial paper market locked up, it's harder for banks to lend money.

By Grace Wong, CNNMoney.com staff writer

LONDON (CNNMoney.com) -- Stock markets have regained some of their poise on rising hopes that the Federal Reserve will cut interest rates on Tuesday. But investors appear to be looking past one key warning sign: The $2 trillion market for commercial paper remains locked up - suggesting there could be more pain ahead for borrowers around the world.

The ongoing contraction in buying and selling commercial paper, a form of debt that financial institutions and companies rely on to raise money for short periods, is likely to keep pushing credit spreads wider and, in turn, pressure borrowers.

This usually liquid market has dried up in the last month as investors have shunned risk and opted instead for safe-haven investments like Treasury bonds.

The problems in the commercial paper market - usually considered a safe investment - have stemmed from a form of paper known as asset-backed commercial paper. This type of debt is backed by assets like home loans and has been spurned by investors in the wake of the subprime mortgage meltdown.

"There are still a lot of unknowns with exactly who has how much exposure to what, and there's still an overall unwillingness to take on commercial paper," said Kim Rupert, fixed-income analyst at Action Economics.

The problem is being exacerbated by the fact that paper is maturing on a near-constant basis. Most commercial paper matures within 30 to 40 days, but investors have been willing to renew only for shorter terms like one day or one week, analysts said.

"It's already a fairly short-term market. Now you're getting a regular occurrence where you have a lot of paper maturing on a particular day or week as paper is rolled over on a short-term basis," said Simon Adamson, a London-based bank analyst at CreditSights, an independent debt research firm.

The yield on commercial paper with a maturity of 30 days has jumped to 6.27 percent, up from 5.32 percent at the end of July.

At the center of the storm are off-balance sheet structures established by banks. These so-called conduits sell asset-backed commercial paper to make long-term investments, but have run into trouble as they haven't been able to find buyers for their short-term debt.

Conduits will find it harder and more expensive to fund maturing commercial paper. "[S]o banks ... will need to step in and provide the necessary funding," analysts at Fitch Ratings wrote in a note recently.

The ratings agency estimates that U.S. conduits hold about $890 billion of asset-backed commercial paper, while European conduits hold about $511 billion.

As long as banks are on the hook for this back-up funding, their revenue and earnings are likely to be pressured. Of even more concern: banks' ability to lend money is being constrained, which is pushing up interbank rates.

"The bottom line is that the money market is still finding it difficult to generate liquidity," said Luca Jellinek, head of interest-rate strategy at ABN Amro in London.

Banks are stuck with more long-term assets than they can finance. Until this changes, they aren't in a position to take on more loans, Jellinek said.

The squeeze on banks, which are also working to get billions of dollars worth of loans for pending leveraged buyouts off their balance sheets, comes as consumers and companies are already facing higher borrowing costs. If the credit crunch persists, consumer spending and corporate profits could be crimped. That scenario would be dire for economic growth.

While the commercial paper market remains seized up, some analysts point out that shakeouts in the market tend to occur quickly, which means the freeze may end soon.

The amount of outstanding asset-backed commercial paper fell to $980 billion at the end of August, down $195 billion from the end of July, according to the Federal Reserve. But the Fed's data also show the decline has been slowing.

"Commercial paper has contracted sharply for a month already, so the endgame is probably near, that is unless problems in the credit markets percolate more," Tony Crescenzi, chief bond market strategist at Miller Tabak & Co. in New York, wrote in a note.

The credit market is going through a dislocation where investors are reassessing how much they're being rewarded for putting their money at risk, and that takes time, analysts said.

Even though the fear that gripped financial markets just a few weeks ago appears to have dissipated, the commercial paper market remains dicey, which means another round of trauma could be ahead.  Top of page