Pathology of Debt

Henry C.K. Liu

Part I: Commercial Paper Market Seizure turns Banks into their own Vulture Investors

Part II:
The Commercial Paper Market and Special Investment Vehicles

This article appeared in AToL on November 28, 2007


Commercial paper is a short-term unsecured promissory note maturing in less than 270 days issued by banks for a fee on behalf of corporations and other borrowers to raise funds from investors with idle cash.  Commercial paper is a low-cost alternative to bank loans. Issuers are able to efficiently raise large amounts of funds quickly and without expensive Securities and Exchange Commission (SEC) registration by selling paper, either directly or through independent dealers, to a large and varied pool of institutional buyers.  Competitive, market-determined yields in notes whose maturity and amounts can be tailored to specific needs, can be earned by investors in commercial paper. Commercial paper is usually issued in denominations of $100,000 or more. Therefore, smaller investors can only invest in commercial paper indirectly through money market funds or indirectly through their pension funds.

Commercial paper has become an important debt market because of the advantages of commercial paper for both investors and issuers.  Commercial paper outstanding grew at an annual rate of 14% from 1970 to 1991, totaling $528 billion at the end of 1991. Until the recent market seizure, the commercial paper market was a $3 trillion market with half of the market consisting of bank-financed “conduits” of asset backed commercial paper (ABCP). The ABCP market shrank 13% in August 2007 as US companies struggled unsuccessfully to raise short-term funds to roll over maturing outstanding debts. 

Federal Reserve data showed an ongoing squeeze on credit that slashed ABCP outstanding by $194.7 billion in August 2007, $54.6 billion in September, and $13 billion in the first two weeks of October. The good news was that the drop has been smaller as time went on. The bad news was that the squeeze was beginning to affect companies outside the financial sector. The one-month slump in August was the steepest in seven years.

Outstanding commercial paper totaled $1.864 trillion in the week of October 10, off sharply from a high of $2.186 trillion hit in July. Issuance of ABCP was again hardest hit, since the sector has the greatest potential exposure to mortgages.

Characteristics of Commercial Paper

Securities offered to the public must be registered with the Securities and Exchange Commission according to the Securities Act of 1933.  Registration requires extensive public disclosure, including issuing a prospectus on the offering.  It is a time-consuming and expensive process. Most commercial paper is issued under Section 3(a)(3) of the 1933 Act which exempts from registration requirements short-term securities with certain characteristics.

The exemption requirements have been a factor shaping the characteristics of the commercial paper market.  The key requirement for exemption is that the maturity of commercial paper must be less than 270 days. In practice, most commercial paper has a maturity of between 5 and 45 days, with 30-35 days being the average maturity. Many issuers continuously roll over their commercial paper, financing a more-or-less constant amount of their assets using commercial paper.  The nine-month maturity limit is not violated by the continuous rollover of notes, as long as the rollover is not automatic but is at the discretion of the issuer and the dealer. Many issuers will adjust the maturity of commercial paper to suit the requirements of an investor.

Notes must be of a type not ordinarily purchased by the general public. In practice, the denomination of commercial paper is large: minimum denominations are usually $100,000, although face amounts as low as $10,000 are available from some issuers.  Typical face amounts are in multiples of $1 million, because most investors are institutions.  Issuers will usually sell an investor the specific amount of commercial paper needed.

That proceeds from commercial paper issues can be used to finance “current transactions”, which include the funding of operating expenses and the funding of current assets such as receivables and inventories. Proceeds cannot be used to finance fixed assets, such as plant and equipment, on a permanent basis. The SEC has generally interpreted the current transaction requirement broadly, approving a variety of short-term uses for commercial paper proceeds as proceeds are not traced directly from issue to use.  Firms are required to show only that they have a sufficient "current transaction" capacity to justify the size of the commercial paper program. For example, a particular level of receivables or inventory. Firms are allowed to finance construction as long as the commercial paper financing is temporary and to be paid off shortly after completion of construction with long-term funding through a bond issue, bank loan, or internally generated cash flow.  

Commercial paper is typically a discount security, similar to Treasury bills. The investor purchases notes at less than face value and receives the face value at maturity. The difference between the purchase price and the face value, called the discount, is the interest received on the investment. Commercial paper is, occasionally, issued as an interest-bearing note by request of investors. The investor pays the face value and, at maturity, receives the face value and accrued interest. All commercial paper interest rates are quoted on a discount basis.

Until the 1980s, most commercial paper was issued in physical form in which the obligation of the issuer to pay the face amount at maturity is recorded by printed certificates that are issued to the investor in exchange for funds. A safekeeping agent hired by the investor held the certificates, until presented for payment at maturity. The "settling" of the transaction, (the exchange of funds for commercial paper first at issuance and then at redemption, occur in one day. On the day the commercial paper is issued and sold, the investor receives and pays for the notes and the issuer receives the proceeds. On the day of maturity, the investor presents the notes and receives payment. Commercial banks, in their role as issuing, paying, and clearing agents, facilitate the settling of commercial paper by carrying out the exchanges between issuer, investor, and dealer required to transfer commercial paper for funds. When new paper is not sold to roll over the matured paper, the bank must pay the investors of the maturing paper and hold the unsold paper in its own account until sold. This requires the bank to record the outstanding paper it holds on its balance sheet, increasing its liability that raises reserve and capital requirements, and lowering its profit margin. 

An increasing amount of commercial paper is being issued in book-entry form whereby entries in computerized accounts are replacing the physical commercial paper certificates. Book-entry systems will eventually completely replace the physical printing and delivery of notes. The Depository Trust Company (DTC), a member of the U.S. Federal Reserve System, a limited-purpose trust company under New York State banking law and a registered clearing agency with the Securities and Exchange Commission, a clearing cooperative operated by member banks, began in September 1990 converting most commercial paper transactions to book-entry form.

The advantages of a paperless system are significant.  In the long run the fees and costs associated with the book-entry system will, be significantly less than under the physical delivery system. The expense of delivering and verifying certificates and the risks of messengers failing to deliver certificates on time will be eliminated.  As all transactions between an issuing agent and a paying agent will be settled with a single end-of-day wire transaction, the problem of daylight overdrafts, which arise from non-synchronous issuing and redeeming of commercial paper will be reduced. This electronic processing deprives issuers and creditors of precious hours for remedial response in a crisis.

CP Market participants

Commercial paper is issued by a wide variety of domestic and foreign firms, including financial companies, banks, and industrial firms. Finance companies are the biggest issuers.  Finance companies provide consumers with home loans, unsecured personal loans and retail automobile loans. They provide businesses with a variety of short- and medium-term loans including secured loans to finance purchases of equipment for resale. Some finance companies are wholly owned subsidiaries of industrial firms that provide financing for purchases of the parent firm's products. For example, a major activity of General Motors Acceptance Corporation (GMAC) is the financing of purchases and leases of General Motor's vehicles by dealers and consumers. General Electric Capital, and Ford Motor Credit are two other big issuers. 

The financial issuer category also includes securities firms and insurance firms.  Securities firms issue commercial paper as a low-cost alternative to other short-term borrowings such as repurchase agreements and bank loans, and they use commercial paper proceeds to finance a variety of security broker and investment banking activities.  Insurance companies issue commercial paper to finance premium receivables and operating expenses.

Commercial bank holding companies issue commercial paper to finance operating expenses and various non-bank activities. Due to declines in the perceived creditworthiness of many major domestic bank issuers, bank holding companies have recently decreased their commercial paper issues.

More than 500 non-financial firms also issue commercial paper. Non-financial issuers include public utilities, service and industrial companies. Commercial paper is used by Industrial and service companies to finance working capital (accounts receivable and inventory) on a permanent or seasonal basis, to fund operating expenses, and to finance, on a temporary basis, construction projects. Public utilities also use commercial paper to fund nuclear fuels and construction. 

Currently more than 1,700 companies in the Unites States issue commercial paper. Financial companies comprise the largest group of commercial papers issuers, accounting for nearly 85% of the commercial paper outstanding. Financial-company paper is issued by firms in commercial, savings and mortgage banking; sales, personal and mortgage financing; factoring; finance leasing and other business lending; insurance underwriting; and other investment activities. The remaining commercial paper, around 15%, is issued by non-financial firms such as manufacturers, public utilities, industrial concerns and service industries, down from 25% in 1990.

Marketing Commercial Paper

There are two methods of marketing commercial paper. The issuer can sell the paper directly to the buyer or sell the paper to a dealer firm, which re-sells the paper in the market. The dealer market for commercial paper involves large securities firms and subsidiaries of bank holding companies. Most of these firms also are dealers in US government securities. Direct issuers of commercial paper usually are financial companies which have frequent and sizable borrowing needs, and find it more economical to place paper without the use of an intermediary. On average, direct issuers save a dealer fee of 1/8 of a percentage point, or $125,000 on every $100 million placed. This savings compensates for the cost of maintaining a permanent sales staff to market the paper.

In addition, direct issuers often have greater flexibility in adjusting the amounts, interest rates and maturities of issues to suit the needs of investors with whom they have continuing relationships. Dealer-placed paper usually is issued by nonfinancial companies and smaller financial companies. The size and frequency of the borrowings usually don't warrant maintenance of a sales staff by the issuer.

Interest rates on commercial paper often are lower than bank lending rates, and the differential, when large enough, provides an advantage which makes issuing commercial paper an attractive alternative to bank credit. Commercial paper rates are quotes on a discount basis. When any security is sold at a discount, the purchaser pays less than the face amount of the paper. The yield is the difference between the purchase price and the face amount.

Daily interest rates on commercial paper are reported weekly by the Federal Reserve Bank of New York covering maturities of 7 days to 180 days for dealer and directly placed paper. These rates are un-weighted arithmetic averages of offering rates -- the rates at which dealers or issuers are willing to sell. The rates are reported to the New York Fed daily by seven direct issuers and five major dealers for paper of industrial firms with "Aa" bond ratings. Before averaging, fractions are rounded to two decimal places.

The most often cited rates on commercial paper are the 30-, 90- and 180-day dealer-placed paper rates, which are published weekly by the Federal Reserve Board of Governors in the “Selected Interest Rates” H.15 statistical release. The report lists the
most recent week's daily rates and averages for recent  weeks and the preceding month. The five daily figures are used to compute the average for a normal business week. A four-day average is used for a holiday week.

Commercial Paper Rating Agencies

Five organizations currently rate commercial paper. These ratings have a strong influence on rates for commercial paper, although the published rates reflect only paper of companies with “Aa” bond ratings. Standard and Poor’s Inc. rates about 1,700 issuers and Moody’s Investors Services Inc. rates more than 1,400 issuers. McCarthy, Crisanti, Naffei, Inc. rates about 650 issuers. Fitch Investor Services Corp. rates more than 240 issuers. Duff and Phelps, Inc. rates more than 100 issuers.

Ratings are reviewed frequently and are determined by the issuer’s financial condition, bank lines of credit and timeliness of repayment. Unrated or lower rated paper also is sold, but paper with the highest ratings is most widely accepted by investors. Investors in the commercial paper market include pension funds, money market mutual funds, governmental units, bank trust departments, foreign banks and investment companies. Only limited secondary market activities exist in commercial paper, since issuers can closely match the maturity of the paper to investors needs. If an investor needs ready cash, the dealer or issuer usually will buy back the paper prior to maturity.

Clueless S&P Report on Commercial Paper Market

January 31, 2007, six months before the credit market crisis, Standard & Poor’s issued a report: US Commercial Paper Outlook: Steady Expansion, which predicted “US commercial paper (CP) issuance to continue expanding at a strong double-digit clip in 2007, amid heightened investor interest. The inverted yield curve––with the 90-day commercial paper yield exceeding the 10-year Treasury by 53 basis points (bps) at year-end––has pulled in players from the long end of the market. We expect to see rapid gains for both financial CP and asset-backed paper, though non-financial issuers are likely to slip into a measured issuance mode, as they reassess their working capital needs in a slow-paced economy. In the interim, the demand for short-term funding is continuing apace; while inventory rebuilding efforts are likely to mark time, the hectic pace of M&A should keep issuance elevated as firms work out their bridge financing needs. Our interest rate projections indicate little rollover risk for issuers, though investors could become more wary past mid-year. Risk and term spreads are razor thin at present, and this situation could persist until later this year, when the Fed embarks on rate cuts to mitigate against sub-par growth.” S&P was as wrong in its CP market prediction as it was on its ratings on subprime CDOs.

Total CP Outstanding

Total CP outstanding rose by 21.5% in 2006 to $1.98 trillion. 2006 gains were evenly spread out, with a 29.6% gain for non-financial CP, a 26.5% gain for asset-backed paper and a 13.6% gain for financial issuers. S&P projected another banner year in 2007 for both financial and asset-backed paper, but expected non-financial CP issuance to track a more sober 1.8% growth path after the huge 2006 gain. At $171 billion, non-financial CP issuance was still quite anemic in 2006 relative to its high of $350 billion in August 2000, accounting for just 8.9% of the market. Excluding foreign issuance, this share was only 7.4% (or $147.4 billion). The strong cash balance position and relatively inexpensive longer-term financing reduced reliance on non-financial CP issuance in recent years.

The growth had been concentrated in asset-backed commercial paper (ABCP) which had been expected to post another outsized gain in 2007, pushing such issuance toward the $1.3 trillion mark from an already high $1.05 trillion in 2006. The rising share of the market being securitized implies that the market was not yet mature. Standard & Poor’s expected securitizations to continue rising relative to the total. Basel II regulations were expected to boost ABCP, since the decrease in regulatory capital requirements for off-balance-sheet exposures is viewed as a powerful incentive to securitize.

From a credit quality perspective, 2006 developments were already mixed, with more downgrades (39 versus 37 in 2005) and more upgrades (34 versus 19 in 2005). While S&P saw no cause for immediate concern, non-financial CP ratings were a shade more negative in 2006. S&P noted that 25 CP programs were on negative CreditWatch, which were concentrated in the utility and media and entertainment sectors. Then the crisis of 2007 hit.

Bank Exposure

As investors shunned commercial paper issued by finance companies that were secured by asset-backed securities, the issuing companies drew on their bank credit lines to redeem the maturing paper and gave new paper to the banks for collateral. The New York Fed’s announcement clarifies that its discount window is prepared to accept these new commercial paper backed by asset-backed securities as acceptable collateral from banks for loans with which to fund bank credit lines to otherwise distressed borrowers.

Fed data show the supply of ABCP slumped by a record $77 billion in the week to August 22. Overnight yields on top-rated commercial paper dropped 5 basis points to 6.04 percent but still up 78 basis points in the past 30 days.  As of August 22, Fed data show about 86% of all ABCP coming due within seven days, and about 50% maturing overnight. Yields on the $1.2 trillion market for ABCP had been rising because the money market funds might have to liquidate assets quickly to pay back short-term debt. That could set off spiraling losses in the money market for other structured finance instruments even if synthetic “mark-to-model” face values had not yet been adjusted to “mark-to market” reality as the housing crisis deepens to further adversely affect the credit market.

About $125 billion in ABCP had been withdrawn from the market in September, a sign that banks were stepping in under their liquidity agreements to make good on their customers maturing debt in the commercial paper market.

Seasonally adjusted outstanding commercial paper fell $90.2 billion to $2.04 trillion in the week ended Wednesday August 24, after falling $91.1 billion in the previous week. Most of the decline came in ABCP. In August, ABCP fell more than $170 billion from the level at the end of July. The previous monthly record was a decline of $78 billion in January 2001 that signaled the “Early 2000s” recession identified by the National Bureau of Economic Research (NBER). As of the week of October 17, outstanding commercial paper was $1.88 trillion, down $300 billion from $2.18 trillion in the first week of August.

About 43% of the assets in SIVs are financial institution debt. If the SIVs were forced to make fire sales to raise cash, it would drive down prices and lift funding costs for banks, which could respond by tightening the supply of credit. Investors are demanding much higher yields on bank debt because of concern over the effect on their balance sheets of the subprime mortgage meltdown.

Citigroup, with another $11billion of writedowns on its holdings of subprime-related investments, was forced to pay 1.9 percentage points more than US Treasuries in the second week of November, 0.7 points more than a similar sale three months ago before the August liquidity crisis on a 10-year $4 billion bond issue. Yields on financial bonds are on average 1.49 percentage points more than Treasuries, while the premium on industrial bonds is 1.34 points.

For the first time since the beginning of the liquidity boom several years ago, credit default swaps on financial companies are now trading in line with, or even wider than, industrial companies, costing more to insure financial debt against default.

After the August liquidity crisis, Citigroup paid $25million more in annual borrowing charges to raise $4 billion in 10-year fixed rate bonds compared with a similarly structured deal in February. It also paid $5 million more in annual interest rate fees than a similarly structured bond in August, showing the outlook for the largest US bank has deteriorated further from the height of the crisis at the end of the summer. In a further sign of falling confidence in the bank, insurance for Citigroup bonds against default in credit derivatives now costs more than for emerging market countries such as Mexico and Malaysia.

Troubled bond insurer ACA Capital Holdings is reported facing credit rating cuts, which would set off a chain reaction requiring banks to put an estimated additional $60 billion of CDO obligations on their balance sheets. Standard & Poor’s reviewed ACA’s “A” rating in early November when the company reported a $1.04 billion third-quarter loss. ACA noted in a SEC filing in the third week of November that it would not meet collateral obligation requirements if its rating should fall below “A-”.

ACA is one of nine key bond insurers threatened with credit rating downgrade. Together, the nine are responsible for insuring about $2.4 trillion of debt. Bear Stearns’ private equity group bought a 29% stake in ACA for $100 million in 2004. Market capitalization of ACA fell to $29 million after its stock fell 93% in 2007. If ACA defaults, Merrill Lynch may have to take an additional $3 billion writedown from CDO exposure. Shares of ACA fell another 22.7% to $0.85 on November 21, while Merrill Lynch traded down 3.5% to $51.81 and Bear Stearns dropped 2.8% to $91.28.

Next: The Credit Guns of August heard around the world