How commercial paper works

Tuesday, October 7, 2008

Following this economic crisis is almost like getting a degree in finance. The latest term-of-the-day is "commercial paper." Reporter Jeff Tyler asks an economist to help unravel that one.

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More on The Economy, Wall Street, Fed. Budget/Govt. Spending, America's Financial Crisis

TEXT OF STORY

Kai Ryssdal: So John Dimsdale just told you what the Fed's move into commercial paper will mean for the larger economy--the big picture if you will. But what about the small picture? Say, a mid-size company with supplies to buy and payrolls to meet. How does commercial paper get a company like that from one day to the next? We asked Marketplace's Jeff Tyler for an explainer.

Jeff Tyler: Commercial paper is . . . Well, I'll let Ken Beauchemin, an economist with Global Insight, explain.

Ken Beauchemin: Commercial paper is, simply put, an IOU. Usually short term lending - three months to six months into the future.

So who uses these IOUs? Big companies and institutions. For an example, let's create a fictional coffee wholesale business. According to Chris Lowe, chief economist with FTN Financial, the company might want to use commercial paper to fund its initial purchase of coffee.

Chris Lowe: They haven't sold any yet. Because of that, they don't have any cash on hand. So they take a loan, essentially, by selling commercial paper into the market.

Lowe says companies mostly use commercial paper to fund things like inventory or payroll.

Lowe: Maybe they are counting on a big sale at the end of the month, but they need to pay their employees in the middle of the month.

Where is the money coming from? Most commercial paper is bought by money-market funds .Again, Ken Beauchemin.

Beauchemin: It is a favorite of the money-market mutual funds because, usually, it's pretty high quality.

But due to the financial crunch, the market for commercial paper has dried up. Making it difficult for companies to get short term loans. Hence the actions by the Fed, which said today that it will make some of those loans itself. That could be a big boon to companies looking to shore up inventories ahead of the holiday season.

I'm Jeff Tyler for Marketplace.

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