Commercial paper

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In the global money market, commercial paper is an unsecured promissory note with a fixed maturity of one 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. 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. 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.[1] 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 each of the 50 U.S. States.

Commercial paper is defined in Canada as having a maturity of not more than one year and is exempt from dealer registration and prospectus requirements.[2]

At the end of 2007, 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 total was issued by non-financial corporations, and $816.7 billion was issued by financial corporations.[3]

Contents

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. [4]

Issuing commercial paper

There are two methods of issuing paper. The issuer can market the securities directly to a buy and hold investor such as most money 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.

Commercial paper versus bank line of credit

Commercial paper is a lower cost alternative to a line of credit with a bank. Once a business becomes large enough, and maintains a high enough credit rating, then using commercial paper is always cheaper than using a bank line of credit. Nevertheless, many companies still maintain bank lines of credit to act as a "backup" to the commercial paper. In this situation, 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, if the company ever actually needs to use the line of credit it would likely be in serious trouble and have difficulty repaying its liabilities.

Defaults

Defaults on high quality commercial paper are rare, and cause concern when they occur.[5] Notable examples include:

  • June 1970: Penn Central, $82 million
    This led to Fed intervention.[5]
  • January 31, 1997: Mercury Finance (a major automotive lender), $17 million, rising to $315 million
    Effects were small, partly because default occurred during a robust economy.[5]
  • September 15, 2008: Lehman Brothers
    This caused two money funds to break the buck, and led to Fed intervention in money market funds.

See also

Notes and references

  1. ↑ 15 U.S.C. Section 77c(a)(3)
  2. ↑ Ontario Securities Commission National Instrument 45-106 (Section 2.35) Accessed 2007-01-30
  3. ↑ Federal Reserve. "FRB: Commercial Paper Outstanding". Retrieved on 2008-10-31. "Data as of October 29, 2008"
  4. ↑ Uhtermyer Urges Money Bill Changes; Approves Measure, but Wants Commercial Paper Defined in Its Strict Meaning in The New York Times of September 23, 1913 Commercial Paper Should Be Changed; Gardin Thinks Three Years Sufficient for Transition to European Practice in The New York Times of March 1, 1914
  5. ↑ 5.0 5.1 5.2

External links

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