The Commercial Paper Market Gets Perilous

Many thanks to all my commenters on yesterday's post about illiquidity in the money market. It turns out that commercial paper (CP) – which is normally the most boring backwater of international finance you could possibly imagine – becomes a seriously important source of systemic risk when liquidity starts to dry up.

Today's WSJ fronts a long explanation of how obscure German bank IKB blew up; the short version is, basically, that it suddenly found itself unable to roll over its CP. Other problems in recent days have been CP-based, too, such as WestLB Mellon's Brightwater vehicle. And commenter Ken Houghton has a long memory:

Drexel didn't go out of business because their liabilities exceeded their assets; they went out of business because no one would roll over their CP.

A quick introduction to CP, for those of you unfamiliar with it. Think of a conversation like this:

A: Can I borrow $10 till tomorrow?
B: Sure.
A: I'm good for it, you know.
B: But you're not earning any money tomorrow, how will you pay me back?
A: Oh, there's lots of liquidity at the short end of the yield curve.
B: In English, please?
A: You're going to lend it to me.
B: Lend what to you?
A: The $10 I need to pay you back.
B: Ah.

This is the kind of scheme which works until it doesn't. CP is a safe investment, because it's maturing very soon – often, literally, tomorrow. On the other hand, the entire CP edificie – which is mind-bogglingly enormous – is predicated on CP issuers being able to roll over their debts, and borrow what they have to repay. When that's no longer the case, and lenders start shying away, very nasty consequences indeed can ensue.