Commercial paper

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Introduction to commercial paper markets

The commercial paper market experienced considerable strain in the weeks following Lehman Brothers’ bankruptcy on September 15, 2008. The Reserve Primary Fund—a prime money market mutual fund with $785 million in exposure to Lehman Brothers—“broke the buck” on September 16, triggering an unprecedented flight to quality from high-yielding to Treasury-only money market funds.

These broad investor flows within the money market sector severely disrupted the ability of commercial paper issuers to roll over their short-term liabilities.

As redemption demands accelerated, particularly in high yielding money market mutual funds, investors became increasingly reluctant to purchase commercial paper, especially for longer dated maturities. As a result, an increasingly high percentage of outstanding paper had to be refinanced each day, interest rates on longer term commercial paper increased significantly, and the volume of outstanding paper declined sharply. These market disruptions had the potential to constrain the economic activities of commercial paper issuers.

Indeed, a large share of outstanding commercial paper is issued or sponsored by financial intermediaries, and the difficulties they faced placing commercial paper further reduced their ability to meet the credit needs of businesses and households.

In light of these strains, the Federal Reserve announced the creation of the Commercial Paper Funding Facility (CPFF) on October 7, 2008, with the aim of supporting the orderly functioning of the commercial paper market. Registration for the CPFF began October 20, 2008, and the facility became operational on October 27. The CPFF operated as a lender of-last-resort facility for the commercial paper market. It effectively extended access to the Federal Reserve’s discount window to issuers of commercial paper, even if these issuers were not chartered as commercial banks.

Unlike the discount window, the CPFF was a temporary liquidity facility that was authorized under section 13(3) of the Federal Reserve Act in the event of “unusual and exigent circumstances.” It expired February 1, 2010.1

The goal of the CPFF was to address temporary liquidity distortions in the commercial paper market by providing a backstop to U.S. issuers of commercial paper. This liquidity backstop provided assurance to both issuers and investors that firms would be able to roll over their maturing commercial paper. The facility enabled issuers to engage in term lending funded by commercial paper issuance, which in turn enhanced the ability of financial intermediaries to extend crucial credit to U.S. businesses and households.

The CPFF did not address the solvency of issuing firms. Rather, the focus was on shielding the allocation of real economic investment from liquidity distortions created by the run on high-yielding money market instruments that had been triggered by the bankruptcy of Lehman Brothers. The facility was explicitly designed to protect the Federal Reserve from potential credit losses.

Issuance to the CPFF was either secured by collateral or subject to an additional surcharge, which was calibrated to protect the Federal Reserve from any potential credit losses.

This paper offers an overview of the Commercial Paper Funding Facility. We explain the economic role of the commercial paper market as a source of funding for various financial intermediaries. We briefly review the events surrounding the turmoil that led to the creation of the CPFF.

Our study also presents operational details of the CPFF and documents its usage and effectiveness. In addition, we discuss the economics of the facility in the context of the financial system and in relation to the Federal Reserve’s role as lender of last resort. Also considered are issues associated with the risk of moral hazard that have been raised following the launch of the CPFF.

Background on the commercial paper market

The commercial paper market is used by commercial banks, nonbank financial institutions, and nonfinancial corporations to obtain short-term external funding. There are two main types of commercial paper: unsecured and asset-backed.

Unsecured commercial paper consists of promissory notes issued by financial or nonfinancial institutions with a fixed maturity of 1 to 270 days, unless the paper is issued with the option of an extendable maturity.

Unsecured commercial paper is not backed by collateral, which makes the credit rating of the originating institution a key variable in determining the cost of issuance.

Asset-backed commercial paper (ABCP) is collateralized by other financial assets and therefore is a secured form of borrowing. Historically, senior tranches of asset-backed securities (ABS) have served as collateral for ABCP. As such, ABCP is a financial instrument that has frequently provided maturity transformation: While the underlying loans or mortgages in the ABS are of long maturity (typically five to thirty years), ABCP maturities range between 1 and 270 days.

Institutions that issue ABCP first sell their assets to a bankruptcy-remote special-purpose vehicle (SPV).2 The SPV then issues the ABCP, which is backed by the assets in the vehicle and also by backup credit lines of the sponsoring institution. If the sponsoring institution enters bankruptcy, the assets of the SPV do not become part of the sponsor’s pool of assets.

All commercial paper is traded in the over-the-counter market, where money market desks of securities broker-dealers and banks provide underwriting and market-making services.

In the United States, commercial paper is cleared and settled by the Depository Trust Company (DTC).3 Commercial paper provides institutions with direct access to the money market. In traditional bank-intermediated financial systems, borrowing institutions obtain loans from commercial banks, which in turn are funded primarily by deposits. Since the early 1980s, however, the U.S. financial system has undergone a major transformation, as an ever increasing fraction of credit intermediation migrated from banks to financial markets.

One way to gauge the degree to which this process of disintermediation affected the commercial paper market is to compare outstanding commercial paper with the money stock. Commercial paper represented only 30 percent of the money stock measure (M1) in 1980. It overtook M1 in mid-1998 and, at its peak, was 60 percent larger than M1 in August 2007 (Chart 1).4

The sharp contractions of commercial paper in 2007 and 2008 led the ratio of commercial paper to M1 to fall below 72 percent in the second half of 2009, a fraction not seen since the mid-1990s.

The mix of unsecured commercial paper and ABCP in the market has varied considerably over the last few years, as ABCP represented more than 45 percent of the market between 2001 and 2007. The rise of ABCP is intertwined with the growth of securitization. Since 1998, financial intermediaries have increasingly relied on ABCP as a source of funding for assets warehoused for securitization.5 In the decade prior to the crisis, ABCP increased from $250 billion in 1997 to more than $1 trillion by 2007 (that is, from roughly 20 percent to as much as 50 percent of outstanding commercial paper), fueled by the considerable distribution of residential mortgage exposure through structured finance products.

Outstanding commercial paper peaked at a total market value of $2.2 trillion in August 2007. At that time, ABCP accounted for more than 52 percent of the total market, while financial commercial paper accounted for an additional 38 percent and nonfinancial commercial paper approximately 10 percent.

Between August 15, 2007, and September 15, 2008, the market experienced a notable decline associated with mounting credit problems of ABCP collateral. The initial decline of outstanding ABCP is often used to date the beginning of the first wave of the 2007-09 financial crisis.6

As the deterioration of the U.S. housing market accelerated in the summer of 2007, the riskiness of the ABS used as collateral in ABCP transactions increased. As a result, ABCP issuers struggled to issue commercial paper.

Between September 2007 and January 2008, total assets of commercial banks grew unusually fast as many ABS that were previously funded in the ABCP market were moved from the balance sheets of ABCP issuers to those of commercial banks.

As a result of a drying up of funding in the ABCP market, commercial banks started to fund the ABS in unsecured money markets, such as the Libor (London interbank offered rate), Eurodollar, and commercial paper markets, all of which would also become compromised at the peak of the crisis as credit risk reached extreme levels.

Major commercial paper issuers

The Flow of Funds Accounts of the Federal Reserve provide an overview of issuers in the commercial paper market since the early 1980s (Chart 2). In the past decade, ABS issuers were the largest issuers of commercial paper, usually in the form of ABCP. Commercial paper funding of ABS stopped growing after Enron’s bankruptcy in 2001, as changes in accounting and regulatory practices concerning off-balance-sheet entities required that additional capital be held against the entities on the balance sheet.7

At the end of 2003, capital regulation regarding off-balance-sheet conduits changed, and the growth of ABS-issued commercial paper resumed. Indeed, the growth in ABS issuance goes hand in hand with the growth of outstanding ABCP.

The second-largest issuers of commercial paper in recent years have been foreign issuers of U.S.-dollar-denominated paper, which include foreign banks and other financial institutions. Other issuers of commercial paper include finance companies, nonfinancial corporations, and commercial banks.

For commercial banks, commercial paper issuance is relatively expensive; a combination of deposits—checking deposits, term deposits, or certificates of deposit—and borrowing in the federal funds market is usually a less expensive funding alternative than commercial paper (Chart 3), although a bank holding company might issue commercial paper more readily given the limited availability of deposits and financing that can be transferred from its commercial banks.8

However, commercial paper does provide a marginal source of funding to the commercial banking sector and, at times—and at least for certain issuers—commercial paper rates are actually lower than other money market rates, such as Eurodollar rates.

As credit conditions deteriorated in the second half of 2007, many commercial banks took back onto their balance sheets obligations that were formerly held in off-balance-sheet vehicles and funded in the ABCP market. As a result, funding for these loans, mortgages, and securities migrated from the ABCP market to the unsecured interbank market, leading to a widening of the spread between Libor and the federal funds rate.


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