Sharp drop in business lending - again

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NEW YORK (CNNMoney.com) -- A key form of lending to major businesses and banks contracted for the sixth week in a row, just days before the Federal Reserve plans to start buying up large amounts of the short-term business debt known as commercial paper.

Total commercial paper outstanding shrunk by $61.5 billion, or 4.1%, to a seasonally adjusted $1.45 trillion in the week ended Oct. 22, according to the latest figures from the Federal Reserve released Thursday. A year ago, there was $1.9 trillion outstanding.

Commercial paper is short-term debt that big businesses and financial institutions sell primarily to money market fund managers and other institutional investors. The companies use the loans to fund day-to-day business operations but the market has dried up as confidence on Wall Street has waned.

The latest weekly contraction marks the second-biggest percentage drop during the recent slide, and is much greater than the 2.6% decline in the previous week.

Commercial paper outstanding, which is now at its lowest point since April 2005, has been steadily declining since Lehman Brothers' bankruptcy filing on Sept. 15. In fact, since then, total commercial paper has plunged by 20.2% - the greatest drop on record.

"Before this all started, everyone would give GE or AT&T a loan," said Bill Larkin, portfolio manager at Cabot Money Management. "Today, the market has changed: People want clear conditions and higher yields."

Still, some economists say the Fed's efforts to buy up large amounts of commercial paper will pay off.

"This isn't really all that surprising," said Lyle Gramley, a former Fed governor and current economist with the Stanford Group. "The Fed really hasn't gotten started. Once the Fed steps in, the market will go back up again."

The Fed will be buying high-quality, three-month commercial paper, which has had the fewest buyers on the market. The lack of buyers is worrisome for companies looking for financing for the last few months of the year.

"Rollovers of long-term stuff has become more difficult, which is a big part of the reason why the Fed moved in," said Gramley.

More than 80% of commercial paper outstanding in the past week matured in just one to nine days, as opposed to the 4% that matured in 81 or more days. Before Lehman's collapse, the three-month paper made up more than 11% of the market.

Not everyone agrees that the Fed's actions will have the intended impact, since it doesn't address the crimped sellers of lower quality paper.

"The bigger problem is with the smaller companies," said Michael Cheah, bond fund manager with AIG SunAmerica. "Life has been tough for them because no one wants to lend them money - not even the Federal Reserve."

Another sign that panic in the market has not yet settled down is that interest rates on commercial paper loans to financial firms, which finally dropped near pre-Lehman levels last week, rose again this week.

Lower interest rates make it easier for companies to lend to one another, so rising rates are just another sign that it will take some time for the credit crisis to come to an end.

But Gramley preached patience, saying rates were rising ahead of the anticipated Fed injection. "If you can hang on until Monday, you'll see rates drop again," he said.