Commercial Paper

Jim Kelly

BA543-002

May 12, 2005

What to Expect (all in 20 Minutes)

• Definition• A Brief History• The Contemporary Commercial Paper• Issuers and Dealers• Buyers• Credit Ratings• Recent Innovations• Foreign Markets• Concluding Remarks• Answer A Few Insightful Questions

What is Commercial Paper?

• Unsecured, Negotiable Promissory Note• Made Payable on a Stated Date• Typically Issued at a Discount• Short-Term: Maturity of 3 to 270 Days in

the U.S.• Does Not Require SEC Registration• Maturity < 90 Days; Collateral for the

Federal Reserve

A Brief History Lesson

• Colonial Commercial Paper: The Yanks and the Sox (See Map)

• 1840s: Interest Rates First Published• The Reconstruction• The Panic of 1907• The Great Depression• The Post-War Boom• Penn Central Crisis of 1970• Mercury Finance Company Default of 1997

The Contemporary Commercial Paper Market

• Average Maturity of Commercial Paper = 30-35 Days

• Small Secondary Market• Most Issuers (At Their Discretion)

Continuously Roll Over Debt• Sold in Large Denominations• Commercial Paper Rates

– 1½% to 3% Below the Prime Rate– 1/8% to ½% Above the T-Bill Rate

Contemporary Market – Recent Growth

• Explosive Growth in Commercial Paper Outstandings (12% CAGR):– 1981: $160B– 1991: $530B – 2001: $1,530B

• Federal Reserve CP Statistics• Chart of Nonfinancial CP Outstandings

Issuers

• Finance Companies– GMAC– GE Capital– Ford Motor Credit– Merrill Lynch– JP Morgan– PepsiCo

• Short-Term Needs and a Very High Credit Rating

Intermediaries

• Investment Banks and Commercial Bank Holding Companies Place More Than 70% of all CP. The Big Three Investment Banking Firms Are:– Goldman Sachs– Lehman Brothers– Merrill Lynch

• Underwriting Spread of 5 to 10 Basis Points• Internal Sales Forces

Buyers and Consumers

• CP is a Highly Liquid, Low Risk Asset (See Chart)

• Money Market Mutual Funds (1/3 of All CP)• Commercial Bank Trust Departments (1/4

of All CP) • Industrial Firms• Insurance Companies• Colleges and Universities• Large Corporations

Creditworthiness

• Credit Ratings Issued by A Credit Agency– Standard and Poor’s– Moody’s– Duff and Phelps– Fitch

• Almost All Issuers Maintain 100% Backing Through Bank Lines of Credit

• Credit Enhancements Are Leased from Higher-Rated Firms

Credit Ratings

• Strong Correlation Between Commercial Paper Debt Ratings and Term Debt Ratings

• Somewhat Archaic System (Credit Cliff)Term Rating Term Ratings

OutstandingsCP Rating CP Ratings

Oustandings

AAA to A 68% Tier-1 88%

A- to BBB 20% Tier-2 7%

BBB- and lower

10% Tier-3 and lower

4%

Unrated 2% Unrated 1%

Recent Innovations

• Asset-Backed Securities– Special-Purpose Entities (SPEs) or Special Purpose

vehicles (SPVs)– Moving Assets and Liabilities Off the Corporate Balance

Sheet

• FASB Does Not Require the Disclosure of Off-Balance Sheet Activities

• Highly Rated Asset-Backed Paper is an Easy Sell• “Independence Day” Financed Through CP Tied to

Film Receivables

Foreign Markets

• European Commercial Paper Market– Longer Maturities Due To Different

Regulatory Environment– Active Secondary Market– Higher Default Rate– Dealers Play a Much More Active Role

• Japan

• France

Concluding Remarks

• Growth in Commercial Paper Signals Decreasing Role of Commercial Banks in Corporate Financing (See Chart)

• Higher Interest Rates Increase Activity• No Significant Defaults Since 1970;

The Market is Untested• Still a High Reliance on the Banking

System for Insurance

Questions?