Penn Central Failed and Froze the Commercial Paper Market
A railroad bankruptcy in 1970 caused a funding crisis in a market that had been considered nearly risk free, and prompted the first modern use of the Fed's emergency lending.
What Commercial Paper Is
Commercial paper is short term unsecured borrowing issued by corporations, typically maturing within a few months. Companies use it to fund working capital, and investors treat it as a cash equivalent because the maturity is short and issuers are large.
The critical feature is that it must be continuously refinanced. A company relying on commercial paper is not borrowing for ninety days, it is borrowing for ninety days repeatedly and indefinitely, and it depends on being able to reissue each time.
The Failure
Penn Central was a large railroad formed by merger, and it had substantial commercial paper outstanding. Its operating position deteriorated, and in 1970 it filed for bankruptcy, defaulting on that paper.
The default was significant in itself and far more significant in its effect on the market as a whole.
Investors had treated commercial paper as nearly risk free. One default made them examine every issuer, and examining takes time that a firm refinancing this week does not have.
The Contagion Mechanism
Because investors had regarded the instrument as safe, many held it without conducting detailed credit analysis of each issuer.
Once a major issuer defaulted, the reasonable response was to stop buying until the credit quality of each name could be assessed. That response was individually rational and collectively catastrophic, because the market depended on continuous rollover.
Perfectly solvent companies with maturing paper suddenly could not refinance, not because anyone doubted them specifically but because buyers had paused generally. A funding market can close for reasons entirely unrelated to any particular borrower.
The Response
The Federal Reserve encouraged banks to extend credit to companies unable to roll their paper, and made clear that the discount window was available to banks providing that support.
That intervention worked. Companies obtained bank credit as a substitute, the immediate crisis passed, and the commercial paper market reopened once investors had reassessed issuers.
It is an early example of the central bank acting to keep a funding market functioning rather than rescuing a specific institution, and the same approach appeared in 2008 and 2020 in more elaborate forms.
The Enduring Lesson
The transferable principle is that short term funding markets are stable until they are not, and the transition is abrupt rather than gradual.
The risk in relying on commercial paper is not that the rate rises, which is manageable. It is that the market becomes unavailable at any rate. This is why companies maintain committed bank credit facilities as backstops, arrangements a bank contractually must honour, precisely so that a market closure does not become an insolvency.
The same structure recurs in every subsequent funding crisis, from repo markets in 2008 to money market funds in 2020.
The Bottom Line
Penn Central's default closed a market to companies that had done nothing wrong. Anything requiring continuous refinancing carries the risk that refinancing stops being available, which is why committed backstops exist.