By Paul J. Davies, Anna Isaac and Caitlin Ostroff 

The normally staid corner of Wall Street where companies and banks borrow money for days or weeks at a time was suddenly at the center of a near financial meltdown last month. Some fund managers are concerned that problems remain despite the quick work of central banks to ease the funding strains.

Known as commercial paper, this more than $1 trillion market of short-term loans, used by companies to cover expenses such as payroll and paying suppliers, froze during March's coronavirus-induced mayhem.

One problem, say market participants: Trading was dominated by a limited cast of big investors who were seeking to sell big slugs of commercial paper through a smaller number of banks that arrange the financing, known as dealers. This led to bottlenecks.

"Like eight elephants trying to fit through three small doors," said David Callahan, head of the money-market management team at Lombard Odier Investment Managers.

The Federal Reserve acted on March 17 to prop up money-market funds, the main investors in commercial paper. A Fed lending facility was immediately used by Goldman Sachs Group Inc. and Bank of New York Mellon Corp. to swap commercial paper held in funds they managed in exchange for cash.

The extent of the freeze shocked money-market fund managers. "Like: Wait a minute, you don't have a bid on anything?" said Tim Robey, manager of Eaton Vance's in-house money-market fund, which manages spare cash on behalf of the investment firm's wider group of mutual funds.

Although trading has restarted, commercial-paper borrowing rates remain elevated. In late February, highly rated banks and companies would pay a few tenths of a percent more than base interest rates to borrow for three months. Those rates spiked to more than 2 percentage points in March, higher than the 1.5-percentage-point peak in 2008, during the last financial crisis, according to Goldman Sachs analysts. Rates have remained volatile, but as of Friday were about 1.2 percentage points above base rates.

With commercial-paper markets closed off, companies looked elsewhere for cash. Some raised longer-term debt in the bond markets, which can be more costly. Others, such as Boeing Co. and Anheuser-Busch InBev SA, drew on credit lines, a form of backup borrowing. The unexpected rush of credit-line borrowing taxed banks' balance sheets, limiting how much they could lend elsewhere.

It also matters for the wider financial system. Banks are paying higher rates on the commercial paper and similar instruments that they use to borrow money short term. This leads directly to high levels of Libor, the London interbank offered rate, the benchmark in setting borrowing costs on trillions of dollars in mortgages, commercial loans and derivatives.

Commercial-paper markets melted down in the 2008 financial crisis, requiring a Fed bailout. Major changes in financial regulation since then, meant to protect investors and the financial system, may have left the market vulnerable.

Regulations that require banks hold more capital to back their assets have made them reluctant to carry inventories of stocks or bonds or commercial paper, even during normal market conditions. At times of stress, like last month, they quickly ran out of space to hold even small amounts of inventory, hampering their ability to act as middlemen in the market.

Because trading in commercial paper is a low-margin business, scale matters. That has helped the biggest banks win more market share and means more business is done by fewer institutions, according to investors and bankers involved in the commercial-paper market.

The market has become more concentrated with a smaller number of big dealer banks, including Bank of America Corp., JPMorgan Chase & Co., Citigroup Inc. and Goldman Sachs; and big fund managers, such as Fidelity Investments and Vanguard Group.

The other big change since the last crisis: In the past, money-market funds reported a fixed $1-share price, with many investors assuming institutions would stand behind the value no matter what. New regulations came in 2016 that forced money-market fund managers to report share prices that went up and down in line with their assets. This was a reaction to the 2008 crisis, when the Reserve Primary Fund became the first to "break the buck," lowering its share price below $1 after Lehman Brothers commercial paper it held became worthless.

That change may have made commercial-paper money-market funds, also known as prime funds, more susceptible to outflows. Investors may also remember the events of 2008 and have simply become more wary about the risks of stashing cash in prime money funds.

Investors have sucked out $150 billion, or a fifth of assets from prime funds, since late February. With less money sloshing around, the cost to borrow in commercial paper markets jumped.

Much of that cash instead flowed into an even safer flavor of money-market funds, which invest solely in short-term Treasury bills and other government-backed debt. Those funds have grown by nearly $1 trillion, increasing their total assets by more than a third.

Those inflows played havoc with short-term Treasury markets, pushing yields on three-month bills into negative territory on March 26. Fidelity Investments, one of the leading money-market fund managers, closed three of its Treasury-only funds to new investors so that it wasn't forced to keep investing in money-losing paper.

Some are skeptical that rates will return to normal despite the Fed intervention. One of the Fed's programs buys new commercial paper from companies and banks that had top credit ratings when the program was announced last month.

That excludes lower-rated companies such as Marriott International Inc. that need cash the most, said Eaton Vance's Mr. Robey. Marriott said on March 8 that it had drawn down $2.5 billion from a revolving credit facility to support repayment of commercial paper. Marriott didn't respond to requests for comment about its current access to the markets.

"It's the tier-two guys: They're the ones that will need the cash," said Mr. Robey.

Write to Paul J. Davies at paul.davies@wsj.com, Anna Isaac at anna.isaac@wsj.com and Caitlin Ostroff at caitlin.ostroff@wsj.com

(END) Dow Jones Newswires

April 20, 2020 08:48 ET (12:48 GMT)