1 Reason Bank Stocks Could Plummet in a Financial Crisis 2.0

By Markets Fool.com

Earlier this month, the New York Post reported that new regulations are having a serious and unintended consequence on the commercial paper markets, a key source of liquidity for businesses and financial firms around the world.

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The last time there was a significant freeze in the commercial paper market was in September 2008, immediately following the collapse of Lehman Brothers. That freeze caused severe panic and sent the market into a freefall. If the market freezes again, expect the same.

What is commercial paper, and why is this such a big deal?
While it sounds complicated, commercial paper is nothing more than short-term debt. When credit markets are functioning properly, businesses use them to obtain funding to meet daily operating needs by borrowing and repaying short-term loans on a day-to-day or month-to-month basis.

Today, U.S. commercial paper is a $1.8 trillion market. All of these loans help businesses manage their cash and optimize the structure of their balance sheets. They are used to buy inventory, pay employees, and keep the lights on. Without these loans, a business may not be able to do any of those critical things. The repercussions of a liquidity shortfall in this market would be catastrophic.

A quick look back to 2008 highlights just how critical the commercial paper market really is. According to then-Treasury Secretary Hank Paulson, blue-chip company General Electric nearly ran out of operating funds as a result of the frozen debt markets. In his book On the Brink, Paulson states that GE CEO Jeff Immelt requested access to special government lending facilities because the company was finding it "very difficult" to obtain financing "for any term longer than overnight."

In other words, a massive, bulwark company like General Electric was struggling to obtain the funding it needed to open the doors every morning. Keeping the commercial paper market functional is not just important -- it is absolutely necessary.

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What is the cause of a potential freeze today?
As part of the Dodd-Frank and consumer-protection financial-reform legislation passed after the financial crisis, financial firms are required to move a significant portion of their liquidity into Treasuries and other government-guaranteed short-term assets. These assets are called "high-quality liquid assets." The legislation's aim is to ensure that banks and financial firms have liquid assets on the books of the highest quality and stability.

An unintended consequence, though, is that it is forcing several key players out of the short-term commercial paper market. Instead of holding short-term corporate debt, they are moving those dollars into longer-term U.S. Treasuries.

This has resulted in a reduction in available short-term credit for the corporations that use commercial paper to operate. JPMorgan ChaseCEO Jamie Dimon explained this mechanism to the House Financial Services Committee in 2009:

The significant tightening of credit that we have all seen over the last several months must be understood in the wider context of the overall credit markets. Nonbank lenders, such as money market funds and hedge funds, constitute 70 percent of our nation's credit markets --providing credit, for example, through their holdings in commercial paper. Understandably, as their own investors have pulled back, these institutions have done the same, either by not extending any credit or by dramatically shortening the duration of the commercial paper they are willing to purchase. The result has been a further tightening of liquidity in the financial markets.

That was in February 2009, with the financial crisis still roiling markets worldwide. While the risk of this happening has since dropped considerably, the underlying mechanism today remains the same, as do the potential consequences to the real economy.

Should investors be worried?
Even if a few key firms exit the commercial paper business, the impact to the overall market will most likely bemanageable. The New York Post specifically points to Fidelity's pulling approximately $100 billion from the market. That's a huge sum of money, but even so, it seems unlikely that could significantly freeze the $1.8 trillion market.

However, if a group of large participants exited at the same time, the result could be disastrous.The Federal Reserve recognized this and cast a spotlight on the risk in its January Open Market Committee minutes earlier this year. The committee said that "the increased role of bond and loan mutual funds, in conjunction with other factors, may have increased the risk that liquidity pressures could emerge in related markets if investor appetite for such assets wanes."

This risk is certainly a concern, but it's far from a certainty.In my view, it would be a mistake to exit the stock market today based solely on this alone. The events of 2008 were a perfect storm; I don't see evidence that such a calamity will reoccur, at least not today.

That being said, this does reinforce a proceed-with-caution approach to large financial stocks, given the challenge of understanding, regulating, and ultimately investing in such an interconnected system.

The article 1 Reason Bank Stocks Could Plummet in a Financial Crisis 2.0 originally appeared on Fool.com.

Jay Jenkins has no position in any stocks mentioned. The Motley Fool owns shares of General Electric Company and JPMorgan Chase. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.