1970 Commercial Paper Market Liquidity Crisis (US)

Penn Central Transportation Company (Penn Central) was the result of a 1968 merger of Pennsylvania Railroad and New York Central Railroad (SEC 1972). The resulting company was the largest railroad and the sixth-largest corporation in the country (Treiber 1970). However, due to management and infrastructure coordination issues, Penn Central struggled from the very early days of its merger. The postbankruptcy Securities and Exchange Commission (SEC) report to Congress described Penn Central as, “hav[ing] been born out of the weakness of the two constituent parts … [and] absent a major restructuring … the drift into bankruptcy was inevitable. The only question was the timing” (SEC 1972). After failed attempts to secure funding from the federal government or Federal Reserve (the Fed), Penn Central filed for bankruptcy on June 21, 1970 (Brimmer 1989). The ripples of Penn Central’s failure spread fast and far because of the heavy reliance of many nonfinancial corporations on short-term borrowing in the commercial paper market.

The commercial paper market had grown dramatically in the decade leading up to the bankruptcy of Penn Central. Total commercial paper outstanding had quadrupled from approximately $5 billion in 1960 to $20 billion by 1968 and then doubled to $40 billion by 1970 (Calomiris 1993). “As [Penn Central’s] financial condition deteriorated, management relied more heavily on the sale of commercial paper as a means of financing the losses being incurred … at its peak there was as much as $200 million of paper outstanding” (SEC 1972).

Although Penn Central represented just 0.5% of the total commercial paper market, fear quickly spread “that other large firms might not be able to meet their obligations” (Treiber 1970). Commercial paper obligations were relatively short term; the average maturity on finance company paper at the time was less than 30 days (Calomiris 1993). Corporations typically maintained backup lines of credit from their banks in case holders of commercial paper were unwilling to roll them over. However, unlike in the commercial paper market, when the banking system created a new loan, banks had to have a percentage of the value of the loan held in reserve. The expected sharp increase in demand for reserves moved the Federal Reserve to ensure banks would be able to borrow money from the Fed to satisfy the reserve requirement to make loans to “borrowers previously dependent on the issuance of commercial paper” (Burns 1970).

The Fed took multiple actions to provide liquidity to the commercial paper market, including: (1) reducing nonpecuniary costs to depository institutions borrowing from the discount window, (2) removing the Regulation Q ceiling on the interest rate of large-denomination certificates of deposit (CDs) depository institutions could hold, and (3) preparing to use their emergency lending authority under Section 13(3) of the Federal Reserve Act of 1913 if needed.

The primary tool for Fed emergency lending was the discount window. The relationships, documentation, and technical resources required for depository institutions to borrow had been well established long before the 1970 summer drop in the commercial paper market. At least for a brief period, depository institutions knew they could come to the discount window if they were struggling to find funding from other banks in the interbank market, known as the federal funds market.

Depository institutions incurred three costs by borrowing at the discount window: (1) a higher interest rate than what was offered in the federal funds market, (2) other nonpecuniary costs such as an exam from bank examiners at the Federal Reserve Bank from which they borrowed, and (3) the stigma associated with borrowing from the central bank that has historically signaled that the borrower “must be in trouble” (Gorton and Metrick 2013).

The Fed’s fear was that as the commercial paper market deteriorated, more corporations locked out of the commercial paper market would be unable to meet short-term obligations, would go to their banks for extensions of lines of credit, and the banks would not have sufficient reserves to provide the needed credit.

The funding need that the Fed wanted to influence in June 1970 was not in the interbank market but rather the commercial paper market, which had become a critical source of short-term funding for many large nonfinancial corporations in recent years. Lending directly to nonfinancial corporations in the commercial paper market would have required use of other emergency authorities (use of Section 13(3) authority is discussed later). During the weekend (June 19–21, 1970) leading up to the bankruptcy of Penn Central, leadership at the Federal Reserve Bank of New York (FRBNY) notified large depository institutions in the area that if they borrowed from the discount window with the purpose of funding corporations unable to access funds in the commercial paper market, then the Federal Reserve would allow them to “do so without incurring any costs other than the discount rate” (Calomiris 1993). The intended effect was to reduce the latter two costs of discount window borrowing, namely: the nonpecuniary costs and the stigma.

Fearing the discount window actions would be insufficient and to enable banks to tap additional funding sources, on Tuesday, June 23, 1970, the Board of Governors, after consultation with the Federal Deposit Insurance Corporation (FDIC) and the Federal Home Loan Bank (FHLB), announced the amendment of Regulation Q by suspending ceilings on interest rates payable by member banks on CDs and other single-maturity time deposits in denominations of $100,000 or more with maturities of 30 through 89 days (Federal Reserve 1970).^FNThe New York Times reported that the Federal Deposit Insurance Corporation (FDIC) “took a parallel action for the banks it regulates” (Dale 1970). The Wall Street Journal reported that the Federal Home Loan Bank (FHLB) Board, at the time a lender-of-last-resort-like government sponsored entity for savings and loans institutions, would probably not lift their rate ceiling with the Fed and the FDIC: “because savings and loan institutions depend heavily on relatively low-yielding older mortgages, officials doubt that S&Ls could afford to make much use of greater interest rate leeway” (Wall Street Journal 1970).

In both the amendment to Regulation Q and the encouragement of use of the discount window, there were no official stipulations that the funds borrowed, at the discount window or via higher-rate CDs, be lent to corporate customers unable to turn over their commercial paper. However, Fed Chairman Arthur Burns reported that “in the nervous days that immediately followed, the country’s large banks played their part by mobilizing on a magnificent scale lines of credit for sound borrowers who were caught in a liquidity squeeze, and thus prevented a dangerous wave of bankruptcies across the country” (Burns 1970).

As the crisis unfolded, the Fed created plans to use its ultimate lender of last resort authority granted in Section 13(3) of the Federal Reserve Act if necessary. After outlining the actions taken by the Federal Reserve, Chairman Burns told a joint committee of Congress in July 1970, a month and two days after the Penn Central bankruptcy, “Furthermore, the Federal Reserve could—under unusual and exigent circumstances—utilize the limited power granted by the Federal Reserve Act to make direct loans to business firms on the security of government obligations or other eligible paper, provided the borrower is creditworthy but unable to secure credit from other sources” (Burns 1970; see also Schadrack and Breimyer 1970).

 Source: Calomiris 1993.

The discount window saw a substantial increase in use during the weeks following the Penn Central bankruptcy. Writing in the FRBNY’s December 1970 Monthly Review, Frederick C. Schadrack and Frederick S. Breimyer explained, "Member bank borrowings through the discount window, which had averaged about $660 million in the week ended June 17, rose to a peak of $1.7 billion during the week ended July 15, then gradually fell back to the $660 million level by the end of August" (Schadrack and Breimyer 1970).

Following the amendment to Regulation Q, there was a substantial increase in funds borrowed by depository institutions via large-denomination CDs. The Federal Open Market Committee (FOMC) minutes for its July 21, 1970, meeting note that the subsequent influx of funds was large; in the three weeks ended July 15, large-denomination CDs outstanding at weekly reporting banks increased by about $3 billion, “the most rapid advance on record” (FOMC 1970b). The regulatory ceiling was never reinstated, and the value of large CDs increased from $12.9 billion in June 1970 to $26.1 billion in December 1970 (Calomiris 1993).^FNAllan Meltzer, in his book A History of the Federal Reserve, noted that Governor George Mitchell “had always supported removing Regulation Q ceilings” (Meltzer 2009). Regarding bankers’ sentiment toward the rate ceiling, the Wall Street Journal reported on June 25, 1970, that in the years leading up to the crisis, “banks had chafed under the ceilings” (Review and Outlook; Liquidity, Inflation and the Fed). As shown in Figure 1 below, commercial bank loans to businesses increased.

Despite being ready “to make credit available to worthy borrowers facing unusual liquidity requirements that could not be met by obtaining funds from other sources,” the Federal Reserve did not need to make any emergency loans using the Section 13(3) authority (Mitchell 1970).