Commercial Paper - The Weakest Link Bearsish view

Lets address a key point that most mainstream analysts seem to have missed.

By Jason Farkas
Tue, 01 Dec 2009 14:30:00 ET
(Editor's Note: This article originally appeared in Jason Farkas' October 30 "Weekly Insight" column of EWI's intensive Currency and Interest Rates Specialty
Services.)
With all the talk about the end of the Great Recession, I continually ask myself the following questions: Am I just being a pessimist for believing in a deflationary
depression? Am I a fool to fight those who make the rules (Congress, the Fed and the Treasury)?
Based on the number of similar inquiries we see, many Elliott Wave International's readers ask themselves the same questions. So, lets address a key point that
most mainstream analysts seem to have missed: It's not the strongest link in the chain that matters -- its the weakest, and sometimes also the least visible.
For instance, take the commercial paper market, which is debt maturing in 9 months or less. It was not on the investment public's radar screens prior to 2008, and
it still isn't. Yet this market is likely the most important one in terms of keeping the entire financial system liquid. Why? Because most large banks fund their high
leverage with very short-term loans.
Lehman Brothers and Bear Stearns each had an entire department dedicated to making calls to lenders each morning to negotiate the terms of their 24-hour loans
-- so they could, in turn, continue to hold assets and loan money. And they were not the first to learn that borrowing short and lending long can destroy a
company. The same mismatch in assets and liabilities was integral in the following failures, because short-term funding often disappears when the appetite for
risk wanes:
1931 -- New Yorks Bank of the United States
1984 -- Continental Illinois
1989 -- LTCB of Japan
1997 -- Credit Lyonnais

1974 -- Herstatt Bank, Germany

1988 -- First Republic of Texas
1991 -- Southeast Bank of Miami
1998 -- LTCM

This chart ("Commercial Paper Outstanding, Weekly, Seasonally Adjusted") shows that presently the issuance of financial and non-financial commercial paper is
now back at 2006 levels.

Citigroup, GE, UBS, Prudential, Rabobank, ING and Societe Gernerale -- all have substantial commercial paper borrowing. But if funding for it dries up, wont
the Fed just expand its commercial paper intervention, you may argue? Probably. But they won't prevent a panic -- the banking failures of '08-'09 proved that
those who run banks have not learned how to do that.
During a panic, the weakest institutions are at risk first, but once a panic begins to wash over larger and larger players, well-run banks find that they cant swim
against the tide either. Even if JP Morgan Chase (arguably the strongest bank) hadn't acquired Bear Stearns (arguably the weakest), its losses were estimated to be
in the billions, because JP Morgan Chase had massive exposure to similar markets. After the Lehman bankruptcy, AIGs naked short exposure put the solvency of
its counter-parties (Goldman, JP Morgan, etc.) at risk, sort of like when a bookie cant afford to pay out a big winner.

And that's why I don't think I'm a fool to keep fighting those who make the rules: The Fed and Treasury can only respond to a crisis. They didnt anticipate
commercial paper problems in '08-'09, and they wont anticipate the soon-to-be-encountered ones either. Yes, they will intervene, but first the problems must be
acute enough to get them to act.
And here is reason that I don't think that I'm a pessimist for believing that the "Great Recession" was just a warm-up and we are headed toward a full-blown
deflationary depression: When the weakest links in the financial arena fail, the whole chain will break, causing a wholesale collapse that will eventually be called
a true depression.