Commercial Paper Crisis

["Henry C.K. Liu" <hliu@xxxxxxxxxxxxxx>]

An overview of the commerical paper market

The one day rate for AA financial commercial parper peaked at 6.62 on January 2, 2001.   It bottomed at 1.64 on January 18, 2002.  It traded at 1.89 on Jan 31, 2002.

There are about $1.25 trillion of outstanding CP for financial companies in the US credit markets.  The nonfinancial CP volume peaked around $350 billion in Jan. 2001 and is now around $210 billion.  The nonfinancials have been having difficulties accessing the CP market since 2001.  News to that efffect concerning Ford, DB/Chrysler and GM have been in the news in past months.

http://www.fordfinancial.com/commercialpaper/
http://investor.chryslerfinancial.com/debt/

The communication sector is now in deep crisis.
It all began rather innocently:
Nokia signed a USD 500 million US-Commercial Paper Program on March 12, 1997. The dealers of the Program were Credit Suisse First Boston (CSFB) and Merrill Lynch, and the issuing and paying agent was Citibank N.A. The issuer in the Programme was Nokia Capital, Inc. guaranteed by Nokia Corporation. Nokia´s Program has a A 1 rating by Standard & Poor´s and a P-1 rating by Moody´s Investors Service.    According to Mr Timo Korvenpää, Group Treasurer, Nokia was re-entering the US-Commercial Paper market to further diversify its funding sources.

When CP rates are at historical lows, the net effect is to keep the walking dead companies alive, a situation well recognized in Japan in recent years.

When companies cannot roll over their CP because of a drop of credit rating, they generally have to resort to drawing down their revolving bank credit line at much higher cost which in turn puts further stress on their already falling credit ratings.  In a high leverage situation, the downward spiral can undo a major corporation is days.

Take Tyco for example:

New York, February 15, 2002: It is called a hair cut on Wall Street, and it hurts. Tyco International Ltd is expected to get clipped by $1 billion to $3 billion if it sells CIT Group, the commercial financing firm it bought in June for $10 billion.

The company, which is grappling with a heavy debt load and is trying to soothe skittish investors, is negotiating from a position of weakness as it seeks a quick sale of CIT.

 ?They want to sell out to strong hands, but the strong hands have the upper hand, and they?re going to put in a low bid,? said David Hendler, an analyst with bond research firm CreditSights Inc.

General Electric Co?s GE Capital unit is widely seen as the likeliest bidder, but its penchant for buying assets on the cheap could derail any deal. Analysts believe CIT is worth between $7 billion and $9 billion, meaning Tyco will almost certainly book a loss on its nine-month-old purchase. Both GE Capital and Tyco declined to comment.

Tyco and CIT were dealt serious blows earlier this month, when they were shut out of the commercial paper market and rating agencies downgraded their debt on concerns about Tyco?s finances. Commercial paper represents a critical source of borrowing for firms like CIT, which was forced to turn to $8.5 billion in more expensive bank loans when it lost access to commercial paper.

?CIT cannot effectively compete in the market place if it cannot play in the commercial paper markets,? a source close to CIT said. ?Their inability to sell commercial paper, and their having to take down short-term debt to cover obligations, has forced CIT into the position of having to sell right away.?

In response to Tyco?s plan to sell or spin off the former S&P 500 Company, potential buyers have been circling CIT, whose operations range from aircraft leasing to small business loans.

In addition to GE Capital, other potential bidders include banking heavy weights Fleet Boston Financial Corp and Citigroup Inc, sources have said.

Shares of Tyco fell 7.5 per cent to $26.75 on Thursday amid investor uncertainty over its plans to break up the conglomerate.

The stock is off more than 40 per cent since those plans were unveiled on January 22. ? Reuters

The problem is global:
A new procedure has been implemented (13 november 2001) by Euroclear group enabling GE Capital, the  largest issuer of " Billets de Trésorerie ", to deliver on a sameday basis an EONIA Index linked BT not only to Euroclear France clients but also to Euroclear Bank participants.

This new procedure explains the operating process  between the Issuer, its Issuing and Paying Agent (i.e." domiciliataire ") Euroclear France and Euroclear Bank.

" This development was driven by GE Capital, the largest issuer of commercial paper in Europe. GE Capital is actively seeking to offer its floating rate commercial paper to institutional investors accross Europe " says Tony Marcello, Assistant Treasurer and Manager Corporate Treasury of GE Capital.

Euroclear has extended the deadlines for index communications between Euroclear France and Euroclear Bank to provide to BT issuers a sameday issuance for one day securities.

" This new procedure confirms that the " Billets de Trésorerie " are not domestic instruments any more and can circulate all across Europe. This also confirms that any financial product under French law (dematerialised) can be provided to all international investors ", says Philippe Bertholle, Department Head in the Sales division of Euroclear France.

STAMFORD, CONN. - October 20th, 1999 - GE Capital Aviation Services (GECAS), a wholly owned subsidiary of GE Capital, has completed the financing of four A330-200 aircraft for Flightlease, a wholly-owned subsidiary of SAir Group of Switzerland. The aircraft have been sub-leased to Swiss Air under a long-term operating lease.

These four aircraft were part of a 10 aircraft order by Flightlease and were purchased in September and October 1999 by GECAS. This cross-border financing involved a US leveraged lease. GE Capital arranged 100% of the financing through a combination of a GE Capital equity investment and
non-recourse debt provided by an off balance sheet asset backed commercial paper conduit. This structure enabled Flightlease to achieve 100% financing of the equipment cost and off-balance sheet treatment for the aircraft lease at an attractive lease rate.
http://www.gecas.com/News19991022.asp

http://www.federalreserve.gov/releases/cp/

Commercial paper consists of short-term, unsecured promissary notes issued primarily by corporations. Maturities range up to 270 days but average about 30 days. Many companies use commercial paper to raise cash needed for current transactions, and many find it to be a lower-cost alternative to bank loans.

http://www.federalreserve.gov/releases/cp/about.htm

Commercial paper is short-term, unsecured debt issued in the form of promissory notes, and sold by financial organizations as an alternative to borrowing from banks or other institutions. The paper is usually sold to other companies which invest in short-term money market instruments.

Because commercial paper maturities don't exceed nine months and proceeds typically are used only for current transactions, the notes are exempt from registration as securities with the United States Securities and Exchange Commission.

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 75 percent of the commercial paper outstanding at mid-year 1990. 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 outstanding at mid-year 1990 -- over 25 percent -- was issued by nonfinancial firms such as manufacturers, public utilities, industrial concerns and service industries. (It is now down to 15%.)

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 U.S. 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 unweighted 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.

Commercial paper maturities range from 1 day to 270 days, but most commonly is issued for less than 30 days. Paper  usually is issued in denominations of $100,000 or more, although some companies issue smaller denominations. 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.

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 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.

Standard and Poor's ratings are A-1, A-2, or A-3; Moody's uses P-1, P-2, or P-3; McCarthy uses MCM-1 to MCM-6;  Fitch uses F-1 to F-4, and Duff uses Duff 1+, Duff 1, Duff 1-, Duff 2, and Duff 3.

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 from Moody's and Standard & Poor's is most widely accepted by investors. Investors in the commercial paper market include private pension funds, money market mutual funds, governmental units, bank trust
departments, foreign banks and investment companies. There is limited secondary market activity in commercial paper,  since issuers can closely match the maturity of the paper to the investors' needs. If the investor needs ready cash, the dealer or issuer usually will buy back the paper prior to maturity.
http://www.ny.frb.org/pihome/fedpoint/fed29.html

Large institutions have long managed their short-term cash needs by buying and selling securities in the money market since the early 1970's. Today, a broad array of domestic and foreign investors uses these versatile, short-term securities to help to make the money market the largest, most efficient credit market in the world driving assets from $4 billion in 1975 to more than $1.8 trillion today.

So what is this money market stuff all about? Well for starters it is a fixed income market, similar to the bond market. The major difference being that the money market specializes in very short term debt securities.

The money market is a securities market dealing in short-term debt and monetary instruments. Money market instruments are forms of debt that mature in less than one year and are very liquid.

That sounds easy enough, so why do many brokers not offer you the ability to buy money market securities? The reason is that money market securities trade in very high denominations, therefore the individual investor has limited access to them. The easiest way for us to gain access is through money market mutual funds, or sometimes through a money market bank account. These accounts and funds pool together the assets of thousands of investors and buy the  money market securities on their behalf.

Some investors purchase treasury bills and other money market instruments directly from Federal Reserve Banks or through other large financial institutions with direct access to these markets.

There are several different instruments in the money market, offering different returns and different risks, lets take a look at some of the major ones.

Borrowing short-term money from banks is often a labored and uneasy situation for many corporations. Their desire to avoid banks as much as they can led to the wide scale popularity of Commercial Paper.

Commercial paper is an unsecured, short-term loan issued by a corporation typically for financing accounts receivable and inventories. It is usually issued at a discount reflecting current market interest rates. Maturities on commercial paper usually don't range any longer than nine months.

For the most part, commercial paper is a very safe investment because the financial situation of a company can easily be predicted over a few months. Furthermore, typically only companies with high credit ratings and credit worthiness issue commercial paper and over the past 35 years there have only
been a handful of cases where corporations defaulted on their commercial paper repayment.

Commercial paper can usually be bought through full-service brokers or banks.

Asset backed commercial paper (ABCP) is a device used by banks to get operating assets such as trade receivables funded by issuance of securities. Traditionally, banks devised ABCP conduits as a device to put their current asset credits off their balance sheets and yet provide liquidity support to their clients.

For example, assume Bank A has a client X, whose working capital needs are funded by the bank. If the bank wants to release the regulatory capital that is locked in this credit asset, the bank can set up a conduit, eseentially an SPV that issues commercial paper. The conduit will buy the receivables of the
client and get the same funded by issuance of commercial paper. The bank will be required to provide some liquidity support to the conduit, as it is practically impossible to match the maturities of the commercial paper to the realisation of trade receivables. Thus, the credit asset is moved off the balance
sheet giving the bank a regulatory relief.

So depending upon whether the bank provides full or partial liquidity support to the conduit, ABCP can be either fully supported or partly supported.

ABCP conduits are virtual subsets of the parent bank. If the bank provides full liquidity support to the conduit, for regulatory purposes, the liquidity support given by the bank may be treated as a direct credit substitute in which case the assets held by the conduit are aggregated with those of the bank.

Not only are ABCP conduits set up by banks, there are also large issuers who set up their own conduits.

As per Asset-backed Commercial Paper Trends and Advances IV, as of June 30, 2000, ABCP outstandings volume exceeded $570 billion. By the end of year 2001, the outstanding ABCP volume had
reached USD 745 billion, up from USD 641 billion year-end 2000.

Some the notable administrators of ABCP in the US market are:
Citigroup N.A, ABN-AMRO Bank N.V., Banc One, N.A., JPMorgan Chase, General Electric Capital Corp., Westdeutsche Landesbank Girozentrale, Rabobank Nederland, Liberty Hampshire Co. LLC, Societe Generale, Bank of America National Trust & Savings Association, Canadian Imperial Bank of Commerce, Barclay's Bank PLC, Credit Suisse First Boston,  First Union National Bank, Charlotte, Bayerische Landesbank Girozentrale, General Motors Acceptance Corp., Firstar Bank, N.A., and Dresdner Bank AG.

The key danger is the entire credit superstructure is the principle of the imtermeidaries of credit to borrow short term to finance long term.  This was less dangerous if the gap between short term and long term credit is narrower than gains from long term appreication.  But in a contracting economy, it can be a fatal scenario, particularly if falls in short term rates raises the credit requirment fo the short term borrower, freezing out previously qualified ones.
 
I have also posted on the Repo time bomb which is a short term borrowing conduit for financial institutions.
Repo is short for "Repurchase Agreement".

Those who deal Government Securities use repos as an overnight borrowing. A dealer or other holder of government securities (usually T-Bills) sells the securities to a lender and agrees to repurchase them at an agreed future date at an agreed price. They are usually very short-term - overnight, but the loan can be for upwards of 30 days or more. This short-term maturity means repos provide lenders with an extremely low risk return, at least in theory.

Repos are popular because they can virtually eliminate credit problems, but a number of significant losses over the years suggests that lenders in this market have not always checked their collateralization closely enough. Repos operate slightly differently in other markets.

There are also a couple different varieties of repos:

Reverse Repo - the complete opposite of a repo, the dealer buys government securities from an investor and then sells them back at a later date and price.

Term Repo - exactly the same as a repo except the term of the loan is greater than 30 days.

In these days of interest rate volatility, the market value of treasuries are also volatile, making repos more risky to the lender.

It is now dawning on regulators that derivatives are widely used not to hedge risks but to disguise loans and risk free swaps.  This will become a major problem on the credit ratings of many institutions, which in turn will further threaten their access to the short term credit market, which they rely on to support their long term loans.

Henry C.K. Liu