Highly Volatile Paper

On August 1, 1970, the ABC Corp. promises to pay to the order of bearer the sum of One Million Dollars . . .

If the name were an individual's, that would sound like the sort of marker a winning gambler might pick up in some fantastic, high-stakes crap game. In fact, it is a similar form of IOU--a sample of the unsecured and loosely regulated kind of corporate credit known as commercial paper. Until the collapse of the Penn Central, commercial paper was the nation's fastest-growing type of credit, but now it has become a prime source of financial worry. By issuing commercial paper, U.S. corporations have saddled themselves with an enormous burden of short-term debt that they may have increasing trouble refinancing or paying off.

Commercial paper is simply a written promise to pay issued by a company that wants to borrow money for a short period (usually 90 days, never longer than nine months) and generally bought by another corporation that has some spare cash to lend. The issuer need not register with the Securities and Exchange Commission, give the buyer a prospectus or back the promise with collateral. His word is his bond.

A few years ago, commercial paper was issued mostly by finance companies that wanted to raise money to relend to consumers. But when money became hard to borrow, big industrial corporations stepped up their marketing of paper through Wall Street brokerage houses as a way to raise otherwise unobtainable cash. Since 1965, the amount of commercial paper outstanding has more than quadrupled to $39.7 billion. At present, $1 of commercial paper is outstanding for every $2 of business loans by large commercial banks. Last year there was a $12 billion increase in commercial paper and a $15 billion rise in bank loans to business.

This gigantic expansion has had significant and not always salutary economic effects. Economist Raymond J. Saulnier believes that it was a major reason why the Federal Reserve's tight-money policy took so long to slow the pace of business. Commercial paper enabled many companies to escape the effects of the squeeze on bank credit, and the phenomenon went largely unremarked by economists because commercial paper is not counted as part of the nation's money supply.

For corporations, heavy reliance on commercial-paper borrowing is inherently risky. The issuing company incurs debt that must be almost continuously repaid by selling new paper or borrowing elsewhere; a temporary cash shortage or a drop in the company's credit rating can bring abrupt disaster.

The Penn Central case was a textbook example. After suffering grave operating losses, the railroad found itself with $152 million of commercial paper coming due this year. Unable to market new paper, or to get loans to pay off the old, the Penn Central had to declare bankruptcy.

Foiled Again? With that disaster, the glory days of commercial paper may be ending, and some new financial difficulties may be beginning. The big buyers of commercial paper are now carefully scrutinizing the credit worthiness of the issuers, and many companies may have difficulty selling new paper. They may then take their great borrowing demands to banks and the bond market, which are not quite prepared to handle it.

The result could well foil Federal Reserve strategy once more. The Federal Reserve has tried to put new money into banks gradually, because an open-handed policy might be inflationary. But Federal Reserve officials are also pledged not to permit a wave of corporate bankruptcies, and last week they acted to make sure banks have enough cash to meet demands from corporations seeking loans to pay off commercial paper. They invited banks to borrow more money directly from the Federal Reserve system itself. The Fed also removed the ceilings on interest that banks can pay on short-term certificates of deposit. These rates then jumped from about 61% to 8%, which is just about the going level for commercial paper. The rise should encourage treasurers of cash-rich companies to invest in bank certificates of deposit rather than lOUs. That sort of simmering down of the commercial-paper market could only be beneficial, for corporate borrowing practices should hardly be reminiscent of a permanent floating crap game.

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