Commercial paper: Wikis

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In the global money market, commercial paper is an unsecured promissory note with a fixed maturity of 1 to 270 days. Commercial Paper is a money-market security issued (sold) by large banks and corporations to get money to meet short term debt obligations (for example, payroll), and is only backed by an issuing bank or corporation's promise to pay the face amount on the maturity date specified on the note. Since it is not backed by collateral, only firms with excellent credit ratings from a recognized rating agency will be able to sell their commercial paper at a reasonable price. Commercial paper is usually sold at a discount from face value, and carries shorter repayment dates than bonds. Typically, the longer the maturity on a note, the higher the interest rate the issuing institution must pay. Interest rates fluctuate with market conditions, but are typically lower than banks' rates.[1]

Contents

Overview

U.S. Commercial Paper types outstanding at end of each year 2001 to 2007
Total U.S. CP outstanding each week. Note the Federal reserve changes its methods of calculation

As defined by American law, commercial paper is a financial instrument that matures before nine months (270 days), and is only used to fund operating expenses or current assets (e.g., inventories and receivables) and not used for financing fixed assets, such as land, buildings, or machinery.[2] By meeting these qualifications it may be issued without U.S. federal government regulation, that is, it need not be registered with the U.S. Securities and Exchange Commission.[3] Commercial paper is a type of negotiable instrument, where the legal rights and obligations of involved parties are governed by Articles Three and Four of the Uniform Commercial Code, a set of non-federal business laws adopted by all 50 U.S. States except Louisiana.[4]

At the end of 2009, more than 1,700 companies in the United States issue commercial paper. As of 2008 October 31, the U.S. Federal Reserve reported seasonally adjusted figures for the end of 2007: there was $1.7807 trillion (short-scale, or 1,780,700,000,000) in total outstanding commercial paper; $801.3 billion was "asset backed" and $979.4 billion was not; $162.7 billion of the latter was issued by non-financial corporations, and $816.7 billion was issued by financial corporations.[5]

History

Commercial paper, in the form of promissory notes issued by corporations, have existed since at least the 19th century. For instance, Marcus Goldman, founder of Goldman Sachs, got his start trading commercial paper in New York in 1869. [6]

Issuance

There are two methods of issuing paper. The issuer can market the securities directly to a buy and hold investor such as most money market funds. Alternatively, it can sell the paper to a dealer, who then 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 Treasury securities. Direct issuers of commercial paper usually are financial companies that have frequent and sizable borrowing needs and find it more economical to sell paper without the use of an intermediary. In the United States, direct issuers save a dealer fee of approximately 5 basis points, or 0.05% annualized, which translates to $50,000 on every $100 million outstanding. This saving compensates for the cost of maintaining a permanent sales staff to market the paper. Dealer fees tend to be lower outside the United States.

Line of credit

Commercial paper is a lower cost alternative to a line of credit with a bank. Once a business becomes established, and builds a high credit rating, it is often cheaper to draw on a commercial paper than on a bank line of credit. Nevertheless, many companies still maintain bank lines of credit as a "backup". Banks often charge fees for the amount of the line of the credit that does not have a balance. While these fees may seem like pure profit for banks, in some cases companies in serious trouble may not be able to repay the loan resulting in a loss for the banks.
Advantage of commercial paper:

  • High credit ratings fetch a lower cost of capital.
  • Wide range of maturity provide more flexibility.
  • It does not create any lien on asset of the company.
  • Tradability of Commercial Paper provides investors with exit options.

Disadvantages of commercial paper:

  • Its usage is limited to only blue chip companies.
  • Issuances of Commercial Paper bring down the bank credit limits.
  • A high degree of control is exercised on issue of Commercial Paper.
  • Stand-by-credit may become necessary

Defaults

Defaults on high quality commercial paper are rare, and cause concern when they occur.[7] Notable examples include:

  • On June 1970, Penn Central defaulted on a debt of $82 million
    This led to Fed intervention.[7]
  • On January 31, 1997, Mercury Finance, a major automotive lender, defaulted on a debt of $17 million, rising to $315 million.
    Effects were small, partly because default occurred during a robust economy.[7]
  • On September 15, 2008, Lehman Brothers caused two money funds to break the buck, and led to Fed intervention in money market funds.

See also

References

External links

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