Question

When too much commercial paper is used, banks are left with a riskier set of borrowers in the commercial loan market.” Is this statement true or false? Explain

Answer 1

Commercial paper is one of the largest money market instruments and has long been viewed as a safe haven for investors seeking low risk. However, during the financial crisis of 2007-2009, the commercial paper market experienced twice the modern-day equivalent of a bank run with investors unwilling to refinance maturing commercial paper. Commercial paper is a short-term debt instrument issued by large corporations. For issuers, commercial paper is a way of raising capital cheaply at short-term interest rates. For investors, commercial paper offers returns slightly higher than Treasury bills in exchange for taking on minimal credit risk. At the beginning of 2007, commercial paper was the largest U.S. short-term debt instrument with more than $1.97 trillion outstanding. Most of the commercial paper was issued by the financial sector, which accounted for 92 percent of all commercial paper outstanding. Commercial paper played a central role during the financial crisis of 2007-2009. Before the crisis, market participants used to regard commercial paper as a safe asset due to its short maturity and high credit rating. Two events changed this perception. The first event began to unfold on July 31, 2007, when two Bear Stearns’ hedge funds that had invested in subprime mortgages filed for bankruptcy. In the following week, other investors also announced losses on subprime mortgages. On August 7, 2007, BNP Paribas suspended withdrawals from its three investment funds because of its inability to assess the value of the mortgages and other investment held by the funds. Given that similar assets served as collateral for a specific category of commercial paperassetbacked commercial paper—many investors became reluctant to purchase asset-backed commercial paper. The total value of asset-backed commercial paper outstanding fell by 37 percent, from $1.18 trillion in August 2007 to $745 billion in August 2008. Other categories of commercial paper remained stable during this period. The second event occurred on September 16, 2008, when the Reserve Primary Fund—a large money market fund with $65 billion of assets under management— announced that it had suffered significant losses on its $785 million holdings of Lehman Brothers’ commercial paper. Instead of each of its shares being worth $1—a common rule in the money market industry—the Reserve Fund announced its shares were worth only 97 cents. In other words, the fund broke the buck—an occurrence that had happened only once before in the history of money market funds. This news triggered the modern-day equivalent of a bank run, leading to about $172 billion worth of redemptions from the $3.45 trillion worth money market fund sector. The run stopped on September 19, 2008—three days after it started—when the U.S. government announced that it would provide deposit insurance to investments in money market funds. Even though the announcement halted the run on money market funds, most funds nonetheless reduced their holdings of all types of commercial paper because they deemed them too risky. Within one month after the Reserve Fund’s announcement, the total value of commercial paper outstanding fell by 15 percent, from $1.76 trillion to $1.43 trillion. To stop the sudden decline in commercial paper, the Federal Reserve decided— for the first time in its history—to purchase commercial paper directly. The Federal Reserve started purchasing commercial paper on October 26, 2008 and its action promptly stabilized the market. By early January 2009, the Federal Reserve was the single largest purchaser of commercial paper and owned paper worth $357 billion, or 22.4% of the market, through a variety of lending facilities. Throughout the year 2009, the Federal Reserve steadily reduced its holdings and in October 2009 it held $40 billion of commercial paper accounting for 3.4% of the market.

Asset-backed commercial paper is issued by off-balance sheet conduits of a large financial institution, where off-balance sheet means that the assets and liabilities of the conduit are not included on the financial institution’s balance sheet. However, the assets are under the control of the financial institution in the sense that the conduit is a shell company which is managed by the financial institution. ABS or CDOs, or collateralized debt obligations, are financial tools that banks use to repackage individual loans into a product sold to investors on the secondary market. CDOs are called asset-backed commercial paper if the package consists of corporate debt. Banks call them mortgage-backed securities if the loans are mortgages. If the mortgages are made to those with a less than prime credit history, they are called subprime mortgages.

Banks sold CDOs to investors for three reasons:

1. The funds they received gave them more cash to make new loans.
2. It moved the loan's risk of default from the bank to the investors.
3. CDOs gave banks new and more profitable products to sell. That boosted share prices and managers' bonuses.

At first, CDOs were a welcome financial innovation. They provided more liquidity in the economy. CDOs allowed banks and corporations to sell off their debt. That freed up more capital to invest or loan. The spread of CDOs is one reason why the U.S. economy was robust until 2007.

The invention of CDOs also helped create new jobs. Unlike a mortgage on a house, a CDO is not a product that you can touch or see to find out its value. Instead, a computer model creates it. Thousands of college and higher-level graduates went to work in Wall Street banks as "quant jocks.” Their job was to write computer programs that would model the value of the bundle of loans that made up a CDO. Thousands of salespeople were also hired to find investors for these new products.

As competition for new and improved CDOs grew, these quant jocks made more complicated computer models. They broke the loans down into "tranches," which are simply bundles of loan components with similar interest rates.

Here's how that works. Adjustable-rate mortgages offered "teaser" low-interest rates for the first three to five years. Higher rates kicked in after that. Borrowers took the loans, knowing they could only afford to pay the low rates. They expected to sell the house before the higher rates were triggered.

The quant jocks designed CDO tranches to take advantage of these different rates. One tranche held only the low-interest portion of mortgages. Another tranche offered just the part with the higher rates. That way, conservative investors could take the low-risk, low-interest tranche, while aggressive investors could take the higher-risk, higher-interest tranche. All went well as long as housing prices and the economy continued to grow.

Unfortunately, the extra liquidity created an asset bubble in housing, credit cards, and auto debt. Housing prices skyrocketed beyond their actual value. People bought homes so they could sell them. The easy availability of debt meant people used their credit cards too much. That drove credit card debt to almost $1 trillion in 2008.

The banks that sold the CDOs didn't worry about people defaulting on their debt. They had sold the loans to other investors, who now owned them. That made them less disciplined in adhering to strict lending standards. Banks made loans to borrowers who weren't credit-worthy. That ensured disaster.

What made things even worse was that CDOs became too complicated. The buyers didn't know the value of what they were buying. They relied on their trust of the bank selling the CDO. They didn't do enough research to be sure the package was worth the price. The research wouldn't have done much good because even the banks didn't know. The computer models based the CDOs' value on the assumption that housing prices would continue to go up. If they fell, the computers couldn't price the product.

This opaqueness and the complexity of CDOs created a market panic in 2007. Banks realized they couldn't price the product or the assets they were still holding. Overnight, the market for CDOs disappeared. Banks refused to lend each other money because they didn't want more CDOs on their balance sheet in return. It was like a financial game of musical chairs when the music stopped. This panic caused the 2007 banking crisis.

The first CDOs to go south were the mortgage-backed securities. When housing prices started to drop in 2006, the mortgages of homes bought in 2005 were soon upside-down. That created the subprime mortgage crisis. The Federal Reserve assured investors it was confined to housing. In fact, some welcomed it and said that housing had been in a bubble and needed to cool down.

What they didn't realize was how derivatives multiplied the effect of any bubble and any subsequent downturn. Not only banks were left holding the bag, but they were also holding the pension funds, mutual funds, and corporations. It was until the Fed and the Treasury started buying these CDOs that a semblance of functioning returned to the financial markets.

Commercial finance companies need to earn a "spread." In this respect, they are just like banks and benefit from a steep yield curve. Unlike banks that have a large depositor base, their perceived credit risk is an extremely important factor that affects the rate at which they can obtain funding.

If the commercial finance company is seen as deteriorating and risky, it doesn't matter how steep the yield curve is; they will have to pay more for funding, and this will squeeze margins. If they cannot resolve the crisis quickly enough, other problems will arise, as well. Customers could start to draw down lines of credit, further impacting liquidity. Also, the longer the bad press continues, the more small business customers they could lose, leading to further squeezes in profitability.

If an economic tsunami hits, in the form of skyrocketing short-term rates and a credit crunch, it can be devastating to a commercial finance company – and even cause eventual bankruptcy, if the conditions exist for an extended period.