Fed May See Lending to Companies, States as Next Crisis Fronts

By Scott Lanman and John Brinsley

Oct. 6 (Bloomberg) -- Federal Reserve Chairman Ben S. Bernanke may find the next fronts of the financial crisis to be just as chilling as last month's downfall of Wall Street titans: its spread to corporate America and state and local governments.

Companies from Goodyear Tire & Rubber Co. and Duke Energy Corp. to Gannett Co. and Caterpillar Inc. are being forced to tap emergency credit lines or pay more to borrow as investors flee even firms with few links to the subprime-mortgage debacle. California Governor Arnold Schwarzenegger says his and other states may need emergency federal loans as funding dries up.

A cash crunch on Main Street would endanger companies' basic functions -- paying suppliers, making payrolls and rolling over debt. The widening of the crisis suggests that Bernanke and Treasury Secretary Henry Paulson may have further fires to put out even as the Treasury sets up the $700 billion financial- industry rescue plan approved last week.

``The rest of the economy is clearly being affected right now by the tightness of credit,'' said Kurt Karl, chief U.S. economist at Swiss Reinsurance Co. in New York. ``It's just gathering momentum in the wrong direction.''

The market for commercial paper, which typically matures in 270 days or less and is used to help pay for expenses such as payroll and rent, shrank to a three-year low of $1.6 trillion in the week to Oct. 1, Fed data show.

Gannett, the largest U.S. newspaper publisher, said Oct. 1 it drew on a revolving credit line to ensure it had funds to repay its commercial paper.

Duke, Caterpillar

Duke Energy, the owner of utilities in five U.S. states, last week tapped about $1 billion from a $3.2 billion credit agreement after concluding it may not be able to meet its plan for new financing. Caterpillar, the biggest maker of earthmoving equipment, had to pay the biggest premiums over Treasuries in at least three decades at a sale of five-year and 10-year notes.

``Credit is the lubricant that oils the engine of the economy'' and if it dries up ``then the engine seizes up,'' said Republican Representative Michael Conaway of Texas, who switched his vote last week to support the financial rescue. The inability of a major corporation to renew its short-term loans would have ``a devastating impact on the economy.''

Even as confidence grew that Congress would pass the bailout, banks hoarded cash, indicating the proposed purchases of devalued mortgage assets may not be able to stop the credit crunch from widening.

No `Quick Turnaround'

``It's not going to solve all the problems, and don't expect a quick turnaround,'' said Mickey Levy, chief economist at Bank of America Corp. in New York. ``This is the typical time of the credit cycle where banks are tightening lending standards.''

Corporate bond sales shrank to $1.25 billion last week, capping the worst four-week slump since 1999.

Lending between banks is also seizing up. The gap between the three-month London interbank offered rate and the overnight indexed swap rate, a gauge of cash scarcity among banks, climbed to a record 2.80 percentage points three days ago.

Republican Representative Jerry Moran of Kansas, in an interview with Bloomberg Television, encouraged the Fed to consider guaranteeing loans between banks.

``We will continue to use all of the powers at our disposal to mitigate credit-market disruptions,'' Bernanke said in a statement Oct. 3. He delivers a speech on the economy tomorrow.

Fed Powers

The central bank has power to extend credit to any company under ``unusual and exigent circumstances.'' It already used that authority this year to avert the failure of Bear Stearns Cos., take over American International Group Inc. and lend to banks to shore up money-market funds. The Treasury last month set up a program selling debt to help the Fed expand its balance sheet.

Investors anticipate the Fed will cut rates in an attempt to lower borrowing costs and encourage banks to lend. Futures prices show 100 percent odds of a half-point reduction in the 2 percent benchmark rate at or before the Oct. 28-29 policy meeting.

State and local governments having trouble meeting cash needs may push for help. Schwarzenegger told Paulson in an Oct. 2 letter that California and other states ``may be forced to turn to the federal Treasury for short-term financing'' if the crisis doesn't ease.

``If states can't access the credit markets because of market conditions, then the Treasury should consider providing it,'' said Ben Watkins, a member of the debt committee of the Government Finance Officers Association, a group of public finance officials.

Services Endangered

Without funding, states ``can't operate the health-care system, schools, roads and other services they provide,'' said Watkins, who also serves as head of Florida's bond sales.

Market disruptions forced Oregon to cancel a $21 million sale of bonds for the state university system and several other planned issues are in jeopardy, State Treasurer Randall Edwards said. ``There's really no market, there's no buyers out there,'' Edwards said.

State and local government funding ``has to be a concern for Bernanke and Paulson,'' said Adam Posen, deputy director of the Peterson Institute for International Economics in Washington. ``There are two issues now: stop the immediate panic and restructure the financial system.''

Those aren't the only areas Fed and Treasury officials may be concerned about.

Since 2005, New York Fed President Timothy Geithner has been pushing to reduce risks in the $54.6 trillion credit- default swaps market. Concerns rose after the Fed had to rescue AIG with an $85 billion loan to cover obligations at a unit that sold protection against debt default.

``We're not at the end of the line yet,'' said former Fed Governor Lyle Gramley, now senior economic adviser at Stanford Group Co. in Washington.

To contact the reporter on this story: Scott Lanman in Washington at slanman@bloomberg.net; John Brinsley in Washington at jbrinsley@bloomberg.net.