Bills for Bulls

By James H. Nolt

One of oldest forms of credit, and still one of the most important is a bill. When most of you think of “bill” you might think of a restaurant tab or a dollar bill. To keep concepts clear, in this column I will always use the term “note” for paper money such as dollar bills. If you take a look at your money, you will notice it calls itself a “Federal Reserve note,” not a bill. Likewise, when I refer to a “bill,” I never mean a request for payment.

The credit instrument known as a bill is the opposite of a request for payment. It is a promise to pay in the future. It is a way for business people and governments to conserve their liquid capital by promising to pay in the future, out of future income. Bills, rather than money, are the near universal means of payment for merchants and governments since medieval times at least.

Bills are not always called by that name. They are often called “commercial paper” when issued by corporations. When banks issue them, they are often called “banker’s acceptances,” but the function is the same. They are also known as “promissory notes,” but to avoid confusion between bills and notes, I will only use the term “notes” for currency, such as Federal Reserve notes. “Letters of credit” are often financed by bills.

A bill involves a promise to pay a specified amount (the face value) at a specified future date (the maturity date, usually a few months in the future). Bills are typically sold at a small discount to their face value, thus reflecting an implicit interest rate between their market value today and their promised face value at maturity. When short-term interest rates are mentioned in the news media, these are almost always derived from typical discount rates on high-quality bills, not actual bank lending rates. Bills are typically negotiable, that is, they may be sold from one investor to another many times before maturity.

As we saw last week, the magic of bills is that you can pay for assets while increasing your capital. Of course, you promise to pay in the future when the bill matures, but it is common that when a bill matures it will not be paid off by expending capital reserves but simply “rolled over” by issuing a fresh bill to pay off the maturing one. Alternatively, maturing bills might be retired using long-term credit in the form of bonds, which we will discuss next week.

Since, in principle, any business or government can issue bills, cash is unnecessary, except for people whose credit is not good enough (i.e., most people). Everyone who is creditworthy will prefer to pay using bills, newly created credit, instead of using scarce currency or bank balances. Economic textbooks generally do not explain this. They teach a mythical version of money and banking instead, pretending that payments are mediated by a fixed stock of regulated money rather than a flexible anarchy of credit.

Now comes the real mystery. If most businesses and governments can pay with credit, in the form of bills, etc., what keeps them honest? Is it possible to over-issue short-term debt? In short, yes.

This is where bears and bulls re-enter the story. Bulls, almost by definition, are those who eventually over-issue credit, who keep leveraging their capital with credit to chase profits in a booming market or growing economy. They are throwing bills onto the market and paying off maturing bills with new ones. As long as their cost of borrowing, the discount rate on their bills, is below their rate of profit, this is a winning game.

The bread and butter business of investment banking (or merchant banking as the British aptly call it) is discounting bills. Investment banks are often the ones to buy bills from the public at a discount to their face value, expecting to redeem them with the issuer for the full face value at their maturity date. They earn their profit on the difference between the face value of the bill at maturity and the discount price they pay for it.

Large investment banks—and here indeed is a case where size does matter—will be discounting the bills of many different governments, merchants and other businesses. Since they buy so many bills, they will own a statistically significant sample of the total volume of bills of each issuer. If an issuer is too profligate, too bullish, the largest investment banks will notice first that their stack of bills from this issuer is growing worryingly large in relation to the net capital that issuer is believed to possess.

Bankers are likely to know the most, among outside observers, about the capital and business prospects of issuers, because they require information, for example business records and plans, as a quid pro quo for loans. Of course, publicly traded corporations have a calculable capitalization based on the current value of their outstanding stock.

Furthermore, investment banks employ analysts to study markets and business conditions and watch for problems. If one arena seems increasingly problematic, say, the cotton trade, then investment banks might become more wary of bills issued by cotton traders.

When banks become wary, they become bearish. They may use their power over credit to discriminate against the bills of any business, sector or government that seems dangerously over-leveraged. Banks have two choices. The most radical is to refuse to discount a bill at all. The more subtle option is to accept it, but lower the price, i.e. increase the discount rate on that issuer’s bills, increasing its cost of credit.

Banks do not have to collude to exercise this credit rationing power. If the largest bank refuses to discount a particular bill or offers too low a price, its owner is free to take it to another bank. If that bank is more bullish regarding the issuer than the first bank, it might give a better price. But if a bill has been refused or deeply discounted by any major investment bank, and this becomes known, others will typically worry too about its value and the solvency of the issuer.

Nearly all economic crises throughout history start in the bill market. When many issuers have been too bullish for too long, like a game of musical chairs, some of them will be denied credit when the music stops. Debtors who yesterday thought they were playing a profitable game suddenly find they have no chair. They are bankrupt. If this happens broadly enough, the result is a general economic crisis.

Next week we will examine how bills are used strategically by bears and bulls to establish and attack positions. Bills function like weapons in the financial war.



James H. Nolt is a senior fellow at World Policy Institute and an adjunct associate professor at New York University.

[Photo courtesy of Michael Duxbury

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