Wednesday, December 03, 2008

Short Term

All over the world, credit markets are drying up. One of the worst problem areas is the commercial paper market, which is the source of operating funding for many banks and large corporation. The important question is seldom asked. Why are so many businesses, so dependent on commercial paper? The reason is very illuminating.

Short term interest rates are generally lower than longer term rates, because lenders demand higher returns to compensate them for the greater risk involved in tying up their money for a long time. Businesses and banks have taken advantage by substituting towards raising a considerable part of their funding on a short-term basis.

Banks have raised funding on the 90-day bill market to fund 15 year mortgages. Businesses have been raising funding using short-term commercial paper to fund equipment with a productive life of up to ten years. This has been profitable while short-term funding was abundant, but it was very risky. Short term funding is cheaper, but it is risky to use it to fund long-term liabilities. Hedge funds have funded some of their activities using overnight funding.

Borrowing short term to fund long-term liabilities is quite risky. If the short-term credit market dries up, the business or bank will be in trouble. They might be unable to roll over the credit, or they might have to pay very high interest rates to do it. That is what is happening now. Many businesses and banks that have borrowed short term to get lower interest rates are finding that they cannot role over their short term loans. The low interest rates were not the bargain they appeared to be.

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