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3 PATHOLOGY OF DEBT PART 2: Commercial paper and
pesky SIVs By Henry C K Liu
activities. Insurance companies use
it 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
credit worthiness of many major domestic bank
issuers, bank holding companies have recently
reduced their commercial
paper issues.
More than 500 non-financial
firms, including public utilities and service and
industrial companies, also issue commercial paper,
for purposes ranging from funding nuclear fuel to
financing working capital (accounts receivable and
inventory) on a permanent or seasonal basis,
operating expenses and, on a temporary basis,
construction projects.
Of the more than
1,700 companies in the Unites States that
currently issue commercial paper, financial
companies account for nearly 85% of the amount
outstanding. These operate 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 15% issued by
non-financial firms is 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 it
in the market. The dealer market for involves
large securities firms and subsidiaries of bank
holding companies. Most of these firms also are
dealers in US government securities. Direct
issuers usually are financial companies that 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
US$125,000 on every US$100 million placed. This
saving 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 that makes issuing the paper an
attractive alternative to bank credit. Commercial
paper rates are quoted on a discount basis. When
any security is sold at a discount, the purchaser
pays less than the paper's face amount. 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 seven 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 and their ratings
have a strong influence on rates for commercial
paper as a whole, 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 Service Inc rates
more than 1,400. McCarthy, Crisanti, Naffei, Inc
rates about 650, Fitch's Investor Service more
than 240 and Duff and Phelps, Inc more than 100.
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 On 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 US$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 US$171 billion,
non-financial CP issuance was still quite anemic
in 2006 relative to its high of US$350 billion in
August 2000, accounting for just 8.9% of the
market. Excluding foreign issuance, this share was
only 7.4% (or US$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, which had been
expected to post another outsized gain in 2007,
pushing such issuance toward the US$1.3 trillion
mark from an already high US$1.05 trillion in
2006. The rising share of the market being
securitized implies that the market was not yet
mature. S&P 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. The ratings company noted that
25 CP programs were on negative CreditWatch,
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 was secured by asset-backed
securities, the issuers drew on their bank credit
lines to redeem the maturing paper and gave new
paper to the banks for collateral. The New York
Fed clarified after the August 17 lowering of the
Discount
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