Investors Flee Commercial Paper Markets

This post first appeared on Minyanville.

The bailout of the financial system has officially become a typical Washington dog-and-pony show. Partisan politics, it turns out, do in fact trump economic expediency and our elected officials' desire to act in the best interests of their constituency.

Meanwhile, back in reality, the short-term money market -- the oil that greases the gears of the financial system -- is coagulating.

According to the Wall Street Journal, cash is flowing out of the commercial paper market at an alarming rate. In the past two weeks, the market contracted by $113 billion, the largest amount since last summer when the Federal Reserve was forced to take unprecedented steps to unfreeze credit markets.

Companies use commercial paper investments to squeeze a little extra return out of cash they have lying around on their balance sheets. These securities, which typically last a few days or weeks, yield more than traditional money market accounts and were once considered nearly as safe as cash.

Proceeds are then lent out to companies that don’t keep much cash on hand and need to take out short term loans to fund their day-to-day operations.

The seizing up of these markets is affecting businesses large and small.

The Journal notes that payroll processor Paychex (PAYX), which relies on vast pools of liquidity to distribute paychecks for 500,000 American companies, is moving working capital into more secure instruments, some backed by the now nationalized Fannie Mae (FNM) and Freddie Mac (FRE).

Small businesses, on the other hand, that rely on short term loans to bridge the gap between cash outlays and payment for services are having to tap more expensive long term debt.

The cost of many of these loans is tied to the London interbank offer rate, or LIBOR, which remains at record highs. LIBOR represents the amount banks pay to borrow from other banks, and when uncertainty and fear reach the levels we’re currently experiencing, trust all but evaporates. Institutions brave enough to lend charge heftily for their trouble, and the ripple effects can be felt throughout the economy as the lion’s share of interest rates on adjustable rate mortgages and other consumer debt are tied to LIBOR.

As most traders sat down for dinner last night, be it at their desk or in their dining room, news broke that Washington Mutual (WM) had finally succumbed to losses in its massive loan portfolio. JP Morgan (JPM), again the beneficiary of a government orchestrated bailout, snapped up the ailing thrift’s deposit base.

While the removal of one of the most injured players from the financial field is an inevitable step towards repairing our broken system, the fallout isn’t likely to make banks any more willing to part with their precious cash.

Investors hate the unknown, and Washington is currently doling out uncertainty in vast quantities. Markets remain on edge and clogged, with all hopes of becoming unstuck hinging on a bailout plan that’s looking less and less likely to play out as Wall Street had hoped.