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Journal of Economic Perspectives—Volume 24, Number 1—Winter 2010—Pages 29–50

CCommercial paper is a short-term debt instrument issued by large corpora-ommercial paper is a short-term debt instrument issued by large corpora-

tions. For issuers, commercial paper is a way o raising capital cheaply attions. For issuers, commercial paper is a way o raising capital cheaply at

short-term interest rates. For investors, commercial paper oers returnsshort-term interest rates. For investors, commercial paper oers returns

slightly higher than Treasury bills in exchange or taking on minimal credit risk.slightly higher than Treasury bills in exchange or taking on minimal credit risk.

At the beginning o 2007, commercial paper was the largest U.S. short-term debt At the beginning o 2007, commercial paper was the largest U.S. short-term debt

instrument with more than $1.97 trillion outstanding. Most o the commercialinstrument with more than $1.97 trillion outstanding. Most o the commercial

paper was issued by the fnancial sector, which accounted or 92 percent o all com-paper was issued by the fnancial sector, which accounted or 92 percent o all com-mercial paper outstanding.mercial paper outstanding.

Commercial paper played a central role during the fnancial crisis oCommercial paper played a central role during the fnancial crisis o

2007–2009. Beore the crisis, market participants regarded commercial paper as a2007–2009. Beore the crisis, market participants regarded commercial paper as a

sae asset due to its short maturity and high credit rating. Two events changed thissae asset due to its short maturity and high credit rating. Two events changed this

perception. The frst event began to unold on July 31, 2007, when two Bear Stearns’perception. The frst event began to unold on July 31, 2007, when two Bear Stearns’

hedge unds that had invested in subprime mortgages fled or bankruptcy. In thehedge unds that had invested in subprime mortgages fled or bankruptcy. In the

ollowing week, other investors also announced losses on subprime mortgages.ollowing week, other investors also announced losses on subprime mortgages.

On August 7, 2007, BNP Paribas suspended withdrawals rom its three investmentOn August 7, 2007, BNP Paribas suspended withdrawals rom its three investment

unds because o its inability to assess the value o the mortgages and other invest-unds because o its inability to assess the value o the mortgages and other invest-

ment held by the unds. Given that similar assets served as collateral or a specifcment held by the unds. Given that similar assets served as collateral or a specifccategory o commercial paper—asset-backed commercial paper—many investorscategory o commercial paper—asset-backed commercial paper—many investors

became reluctant to purchase asset-backed commercial paper. The total value obecame reluctant to purchase asset-backed commercial paper. The total value o

asset-backed commercial paper outstanding ell by 37 percent, rom $1.18 trillionasset-backed commercial paper outstanding ell by 37 percent, rom $1.18 trillion

When Safe Proved Risky:Commercial Paper during theFinancial Crisis of 2007–2009

■■ Marcin Kacperczyk and Philipp Schnabl are both Assistant Professors of Finance, SternMarcin Kacperczyk and Philipp Schnabl are both Assistant Professors of Finance, Stern

School of Business, New York University, New York, New York. Kacperczyk is also a FacultySchool of Business, New York University, New York, New York. Kacperczyk is also a Faculty

Research Fellow, National Bureau of Economic Research, Cambridge, Massachusetts. TheirResearch Fellow, National Bureau of Economic Research, Cambridge, Massachusetts. Their

e-mail addresses aree-mail addresses are ⟨⟨[email protected]@stern.nyu.edu ⟩⟩ andand ⟨⟨[email protected]@stern.nyu.edu ⟩⟩..

doi=10.1257/jep.24.1.29

Marcin Kacperczyk and Philipp Schnabl



30 Journal of Economic Perspectives

in August 2007 to $745 billion in August 2008. Other categories o commercialin August 2007 to $745 billion in August 2008. Other categories o commercial

paper remained stable during this period.paper remained stable during this period.

The second event occurred on September 16, 2008, when the Reserve PrimaryThe second event occurred on September 16, 2008, when the Reserve Primary

Fund—a large money market und with $65 billion o assets under management—Fund—a large money market und with $65 billion o assets under management—

announced that it had suered signifcant losses on its $785 million holdings oannounced that it had suered signifcant losses on its $785 million holdings o

Lehman Brothers’ commercial paper. Instead o each o its shares being worthLehman Brothers’ commercial paper. Instead o each o its shares being worth

$1—a common rule in the money market industry—the Reserve Fund announced$1—a common rule in the money market industry—the Reserve Fund announced

its shares were worth only 97 cents. In other words, the und “broke the buck”—anits shares were worth only 97 cents. In other words, the und “broke the buck”—an

occurrence that had happened only once beore in the history o money marketoccurrence that had happened only once beore in the history o money market

unds. This news triggered the modern-day equivalent o a bank run, leadingunds. This news triggered the modern-day equivalent o a bank run, leading

to about $172to about $172 billion worth o redemptions rom the $3.45-trillion-worth moneybillion worth o redemptions rom the $3.45-trillion-worth money

market und sector. The run stopped on September 19, 2008—three days atermarket und sector. The run stopped on September 19, 2008—three days ater

it started—when the U.S. government announced that it would provide depositit started—when the U.S. government announced that it would provide deposit

insurance to investments in money market unds. Even though the announcementinsurance to investments in money market unds. Even though the announcement

halted the run on money market unds, most unds nonetheless reduced their hold-halted the run on money market unds, most unds nonetheless reduced their hold-

ings o all types o commercial paper because they deemed them too risky. Withinings o all types o commercial paper because they deemed them too risky. Within

one month ater the Reserve Fund’s announcement, the total value o commercialone month ater the Reserve Fund’s announcement, the total value o commercial

paper outstanding ell by 15 percent, rom $1.76 trillion to $1.43 trillion.paper outstanding ell by 15 percent, rom $1.76 trillion to $1.43 trillion.

To stop the sudden decline in commercial paper, the Federal Reserve decid-To stop the sudden decline in commercial paper, the Federal Reserve decid-

ed—or the frst time in its history—to purchase commercial paper directly. Theed—or the frst time in its history—to purchase commercial paper directly. The

Federal Reserve started purchasing commercial paper on October 26, 2008, and itsFederal Reserve started purchasing commercial paper on October 26, 2008, and its

action promptly stabilized the market. By early January 2009, the Federal Reserveaction promptly stabilized the market. By early January 2009, the Federal Reserve

was the single largest purchaser o commercial paper and owned paper worth was the single largest purchaser o commercial paper and owned paper worth

$357 billion, or 22.4 percent o the market, through a variety o lending acilities.$357 billion, or 22.4 percent o the market, through a variety o lending acilities.

Throughout the year 2009, the Federal Reserve steadily reduced its holdings and byThroughout the year 2009, the Federal Reserve steadily reduced its holdings and by

October 2009 it held $40 billion o commercial paper, accounting or 3.4 percentOctober 2009 it held $40 billion o commercial paper, accounting or 3.4 percent

o the market.o the market.

We will oer an analysis o the commercial paper market during the fnan- We will oer an analysis o the commercial paper market during the fnan-

cial crisis. First, we describe the institutional background o the commercial papercial crisis. First, we describe the institutional background o the commercial paper

market. Second, we analyze the supply and demand sides o the market. Third, wemarket. Second, we analyze the supply and demand sides o the market. Third, we

examine the most important developments during the crisis o 2007–2009. Last,examine the most important developments during the crisis o 2007–2009. Last,

we discuss three explanations o the decline in the commercial paper market: we discuss three explanations o the decline in the commercial paper market:

substitution to alternative sources o fnancing by commercial paper issuers, adversesubstitution to alternative sources o fnancing by commercial paper issuers, adverse

selection, and institutional constraints among money market unds.selection, and institutional constraints among money market unds.

Basics of Commercial PaperBasics of Commercial Paper

In the United States, commercial paper has been an important source oIn the United States, commercial paper has been an important source o

fnancing since the nineteenth century. According to the Securities Industry andfnancing since the nineteenth century. According to the Securities Industry and

Financial Markets Association, in early 2007, total U.S. short-term debt fnanc-Financial Markets Association, in early 2007, total U.S. short-term debt fnanc-

ing—also reerred to as money market fnancing—accounted or approximatelying—also reerred to as money market fnancing—accounted or approximately

$5 trillion. Commercial paper was the largest instrument in this market with more$5 trillion. Commercial paper was the largest instrument in this market with more

than $1.97 trillion outstanding. The second-largest instrument was U.S. Treasurythan $1.97 trillion outstanding. The second-largest instrument was U.S. Treasury



Marcin Kacperczyk and Philipp Schnabl 31

bills, which accounted or $940 billion outstanding. Other important short-termbills, which accounted or $940 billion outstanding. Other important short-term

debt instruments were time deposits, repurchase agreements, short-term notes,debt instruments were time deposits, repurchase agreements, short-term notes,

and bankers’ acceptances.and bankers’ acceptances.11

Commercial paper is usually issued at a discount to a predetermined aceCommercial paper is usually issued at a discount to a predetermined ace

value, which means that investors acquire commercial paper at a price below the value, which means that investors acquire commercial paper at a price below the

ace value and receive the ace value at maturity. The dierence between theace value and receive the ace value at maturity. The dierence between the

purchase price and the ace value is the discount—that is, the interest received onpurchase price and the ace value is the discount—that is, the interest received on

commercial paper. In practice, the interest rate on commercial paper is a bit highercommercial paper. In practice, the interest rate on commercial paper is a bit higher

than the interest rate on Treasury bills o the same maturity and a bit lower thanthan the interest rate on Treasury bills o the same maturity and a bit lower than

the interest rate on loans o the same maturity such as LIBOR (London Interbankthe interest rate on loans o the same maturity such as LIBOR (London Interbank

Oered Rate), the benchmark interest rate paid on short-term lending amongOered Rate), the benchmark interest rate paid on short-term lending among

large banks (Stigum and Crescenzi, 2007).large banks (Stigum and Crescenzi, 2007).

Almost all commercial paper is rated by one or more nationally accredited rat- Almost all commercial paper is rated by one or more nationally accredited rat-

ing agencies like Moody’s, Standard & Poor’s, or Fitch. Commercial paper sold ining agencies like Moody’s, Standard & Poor’s, or Fitch. Commercial paper sold in

the market typically has the highest short-term rating as many market participants—the market typically has the highest short-term rating as many market participants—

either by choice or by regulation—restrict their purchases to high-quality papers.either by choice or by regulation—restrict their purchases to high-quality papers.

Commercial paper is issued either via a dealer or directly by a corporation thatCommercial paper is issued either via a dealer or directly by a corporation that

needs to raise capital. In August 2006, about 80 percent o commercial paper wasneeds to raise capital. In August 2006, about 80 percent o commercial paper was

issued by dealers and the remaining 20 percent by corporations. Dealers chargeissued by dealers and the remaining 20 percent by corporations. Dealers charge

ees o 5 to 12.5 basis points or issuing commercial paper; the ees vary accordingees o 5 to 12.5 basis points or issuing commercial paper; the ees vary according

to the issuers’ credit history, issuance size, and market conditions. Dealers typicallyto the issuers’ credit history, issuance size, and market conditions. Dealers typically

advise issuers on pricing and they purchase positions that do not sell in the marketadvise issuers on pricing and they purchase positions that do not sell in the market

(Stigum and Crescenzi, 2007).(Stigum and Crescenzi, 2007).

Most investors in the commercial paper market purchase the paper at issu-Most investors in the commercial paper market purchase the paper at issu-

ance and hold it until maturity. Hence, there is little trading o commercial paperance and hold it until maturity. Hence, there is little trading o commercial paper

in secondary markets. Instead, many investors continuously roll over maturingin secondary markets. Instead, many investors continuously roll over maturing

commercial paper, which means that they purchase newly issued commercialcommercial paper, which means that they purchase newly issued commercial

paper rom the same issuer once their holdings o commercial paper mature. Aspaper rom the same issuer once their holdings o commercial paper mature. As

a result, issuers usually refnance the repayment o maturing commercial papera result, issuers usually refnance the repayment o maturing commercial paper

with newly issued commercial paper. However, the need to roll over maturing with newly issued commercial paper. However, the need to roll over maturing

commercial paper generates the risk that investors may not be willing to ref-commercial paper generates the risk that investors may not be willing to ref-

nance maturing commercial paper. This risk is oten called roll-over or liquiditynance maturing commercial paper. This risk is oten called roll-over or liquidity

risk. In this case, the issuer needs to fnd fnancing elsewhere to repay maturingrisk. In this case, the issuer needs to fnd fnancing elsewhere to repay maturing

commercial paper.commercial paper.

1 The commercial paper market also exists in Europe, although the market is smaller. In January 2007,according to Euroclear—a consortium o the main European securities depositories—total value o commercial paper outstanding in that market amounted to $691 billion. In many ways, the commer-cial paper market in Europe is similar to that in the United States; the key dierence is that oeringsare oten denominated in currencies other than the U.S. dollar. Nevertheless, many large issuers areactive in both markets and issue simultaneously in Europe and in the United States. We will ocus here

on the commercial paper market in the United States, though most o our analysis also applies to thecommercial paper market in Europe.




Supply Side of Commercial PaperSupply Side of Commercial Paper

From the perspective o a commercial paper issuer, one beneft o commercialFrom the perspective o a commercial paper issuer, one beneft o commercial

paper is that the issuer can avoid registration under the Securities Act o 1933, whichpaper is that the issuer can avoid registration under the Securities Act o 1933, which

is the set o rules that requires any frm issuing securities to provide a descriptionis the set o rules that requires any frm issuing securities to provide a description

o the company’s properties and business, o the security itsel, and o corporateo the company’s properties and business, o the security itsel, and o corporate

management, along with fnancial statements. Registration is generally consideredmanagement, along with fnancial statements. Registration is generally considered

an expensive and lengthy process. The exemption rom registration or commercialan expensive and lengthy process. The exemption rom registration or commercial

paper is usually based on Section 3(a)(3) o the 1933 Securities Act, which requirespaper is usually based on Section 3(a)(3) o the 1933 Securities Act, which requires

commercial paper issuers to satisy three criteria. First, the maturity o commercialcommercial paper issuers to satisy three criteria. First, the maturity o commercial

paper must not be more than 270 days. In practice, commercial paper typically haspaper must not be more than 270 days. In practice, commercial paper typically has

ar shorter maturities—between one and 90 days—with an average maturity o aboutar shorter maturities—between one and 90 days—with an average maturity o about

30 days. Second, commercial paper must not be targeted towards the general public.30 days. Second, commercial paper must not be targeted towards the general public.

Hence, issuers o commercial paper cater to institutional investors; usually oeringHence, issuers o commercial paper cater to institutional investors; usually oering

large denominations o $100,000 or more. Third, issuers o commercial paper mustlarge denominations o $100,000 or more. Third, issuers o commercial paper must

only use their proceeds rom issuing commercial paper to fnance current assetsonly use their proceeds rom issuing commercial paper to fnance current assets

such as receivables or inventory. In practice, this requirement implies that frmssuch as receivables or inventory. In practice, this requirement implies that frms

need to demonstrate that they have sufcient scale o current transactions to justiyneed to demonstrate that they have sufcient scale o current transactions to justiy

the size o their commercial paper programs (Hahn, Cook, and Laroche, 1993).the size o their commercial paper programs (Hahn, Cook, and Laroche, 1993).

As an alternative to Section 3(a)(3), issuers can also claim an exemption rom As an alternative to Section 3(a)(3), issuers can also claim an exemption rom

registration under Section 4(2), which restricts the sale o commercial paper to accred-registration under Section 4(2), which restricts the sale o commercial paper to accred-

ited investors and, in exchange, allows issuers to use the proceeds to fnance long-termited investors and, in exchange, allows issuers to use the proceeds to fnance long-term

assets. Issuers can also claim exemption under Section 3(a)(2), which requires com-assets. Issuers can also claim exemption under Section 3(a)(2), which requires com-

mercial paper to be ully supported by a bank guarantee (FitchRatings, 2001).mercial paper to be ully supported by a bank guarantee (FitchRatings, 2001).

Depending on the issuer, there are three categories o commercial paper:Depending on the issuer, there are three categories o commercial paper:

asset-backed, fnancial, and corporate commercial paper. For historical reasons,asset-backed, fnancial, and corporate commercial paper. For historical reasons,

the last two categories are sometimes simply reerred to as commercial paper.the last two categories are sometimes simply reerred to as commercial paper.

Corporate fnancial paper is also reerred to as nonfnancial commercial paper.Corporate fnancial paper is also reerred to as nonfnancial commercial paper.

To avoid conusion, we use the term “commercial paper” only when we reer to allTo avoid conusion, we use the term “commercial paper” only when we reer to all

three categories at once.three categories at once.

Over the last two decades, the commercial paper market has grown sub-Over the last two decades, the commercial paper market has grown sub-

stantially. This growth was mostly spurred by the development o asset-backedstantially. This growth was mostly spurred by the development o asset-backed

commercial paper, which was frst issued in the 1980s. The total value o the com-commercial paper, which was frst issued in the 1980s. The total value o the com-

mercial paper market in 1990 was $558 billion, o which 5.7 percent was asset-backedmercial paper market in 1990 was $558 billion, o which 5.7 percent was asset-backed

commercial paper, 59.9 percent was fnancial commercial paper, and 34.4 percentcommercial paper, 59.9 percent was fnancial commercial paper, and 34.4 percent

was corporate commercial paper. In January 2007, the total value o commer- was corporate commercial paper. In January 2007, the total value o commer-

cial paper accounted or $1.97 trillion, o which 56.8 percent was asset-backedcial paper accounted or $1.97 trillion, o which 56.8 percent was asset-backed

commercial paper, 34.4 percent was fnancial commercial paper, and 5.7 percentcommercial paper, 34.4 percent was fnancial commercial paper, and 5.7 percent

was corporate commercial paper. was corporate commercial paper.

Asset-backed Commercial Paper Asset-backed Commercial Paper

Asset-backed commercial paper is issued by o-balance-sheet conduits o large Asset-backed commercial paper is issued by o-balance-sheet conduits o large

fnancial institutions, where “o balance sheet” means that the assets and liabilitiesfnancial institutions, where “o balance sheet” means that the assets and liabilities

o the conduits are not included on the fnancial institutions’ balance sheets.o the conduits are not included on the fnancial institutions’ balance sheets.



When Safe Proved Risky: Commercial Paper during the Financial Crisis of 2007–2009 33

However, the assets are under the control o the fnancial institution in the senseHowever, the assets are under the control o the fnancial institution in the sense

that the conduit is a shell company that is managed by the fnancial institution.that the conduit is a shell company that is managed by the fnancial institution.

Conduits typically hold diversifed portolios o fnancial assets. In the 1980sConduits typically hold diversifed portolios o fnancial assets. In the 1980s

and early 1990s, most conduits only invested in short-term and medium-term assetsand early 1990s, most conduits only invested in short-term and medium-term assets

such as trade receivables (dues or goods sold) o the sponsoring fnancial institu-such as trade receivables (dues or goods sold) o the sponsoring fnancial institu-

tions’ clients. During the late 1990s, some conduits started investing in long-termtions’ clients. During the late 1990s, some conduits started investing in long-term

assets, including securitized assets such as mortgage-backed securities. By the earlyassets, including securitized assets such as mortgage-backed securities. By the early

2000s, most conduits invested in long-term assets, some o which were originated by2000s, most conduits invested in long-term assets, some o which were originated by

the fnancial institutions’ own clients and some o which were securitized assets orig-the fnancial institutions’ own clients and some o which were securitized assets orig-

inated by other fnancial institutions. As a result o this investment strategy, conduitsinated by other fnancial institutions. As a result o this investment strategy, conduits

developed a maturity mismatch between the long maturity o their assets and thedeveloped a maturity mismatch between the long maturity o their assets and the

short maturity o their asset-backed commercial paper. This maturity mismatchshort maturity o their asset-backed commercial paper. This maturity mismatch

exposed conduits to roll-over risk, the risk that investors would stop refnancing theexposed conduits to roll-over risk, the risk that investors would stop refnancing the

asset-backed commercial paper. The roll-over risk makes the conduit riskier or out-asset-backed commercial paper. The roll-over risk makes the conduit riskier or out-

side investors because the conduit may go bankrupt i all investors stop refnancingside investors because the conduit may go bankrupt i all investors stop refnancing

at the same time and the conduit cannot sell o its assets to repay investors.at the same time and the conduit cannot sell o its assets to repay investors.

To protect outside investors against roll-over risk, the fnancial institutionTo protect outside investors against roll-over risk, the fnancial institution

that manages the conduit typically provides credit guarantees to outside investors.that manages the conduit typically provides credit guarantees to outside investors.

Under these credit guarantees, the fnancial institution promises to pay o matur-Under these credit guarantees, the fnancial institution promises to pay o matur-

ing asset-backed commercial paper in case the conduit is unable to do so. From aning asset-backed commercial paper in case the conduit is unable to do so. From an

investor’s perspective, the combination o credit guarantees and conduit’s assetsinvestor’s perspective, the combination o credit guarantees and conduit’s assets

substantially reduces the deault risk o asset-backed commercial paper (Moody’ssubstantially reduces the deault risk o asset-backed commercial paper (Moody’s

Investors Service, 2003).Investors Service, 2003).

Using data rom credit rating agencies, Acharya, Schnabl, and Suarez (2009)Using data rom credit rating agencies, Acharya, Schnabl, and Suarez (2009)

show that, in January 2007, 296 conduits were authorized to issue asset-backedshow that, in January 2007, 296 conduits were authorized to issue asset-backed

commercial paper in the United States and Europe. The conduits were supportedcommercial paper in the United States and Europe. The conduits were supported

by a total o 126 sponsoring fnancial institutions. Most sponsoring fnancial institu-by a total o 126 sponsoring fnancial institutions. Most sponsoring fnancial institu-

tions were large commercial banks—based in the United States and Europe—manytions were large commercial banks—based in the United States and Europe—many

o which sponsored more than one conduit. In total, commercial banks accountedo which sponsored more than one conduit. In total, commercial banks accounted

or $903 billion—or 74.8 percent—o asset-backed commercial paper outstanding.or $903 billion—or 74.8 percent—o asset-backed commercial paper outstanding.

For example, the largest fnancial institution sponsoring conduits in the UnitedFor example, the largest fnancial institution sponsoring conduits in the United

States was Citigroup with 16 conduits and $92.6 billion o asset-backed commercialStates was Citigroup with 16 conduits and $92.6 billion o asset-backed commercial

paper outstanding. The largest fnancial institution sponsoring conduits in Europepaper outstanding. The largest fnancial institution sponsoring conduits in Europe

was the Dutch Bank ABN Amro with nine conduits and $68.6 billion o asset- was the Dutch Bank ABN Amro with nine conduits and $68.6 billion o asset-

backed commercial paper outstanding. Besides commercial banks, large sponsorsbacked commercial paper outstanding. Besides commercial banks, large sponsors

o conduits also included structured investment groups ($182 billion), mortgageo conduits also included structured investment groups ($182 billion), mortgage

lenders ($72 billion), and other fnancial institutions ($79 billion).lenders ($72 billion), and other fnancial institutions ($79 billion).

About 74.1 percent o outstanding commercial paper was issued by conduits About 74.1 percent o outstanding commercial paper was issued by conduits

with ull credit guarantees. Acharya, Schnabl, and Suarez (2009) show that ull with ull credit guarantees. Acharya, Schnabl, and Suarez (2009) show that ull

credit guarantees are structured to avoid capital requirements required or assetscredit guarantees are structured to avoid capital requirements required or assets

held by banks directly. They argue that the avoidance o capital requirements washeld by banks directly. They argue that the avoidance o capital requirements was

an important driver behind the growth o asset-backed commercial paper. Anan important driver behind the growth o asset-backed commercial paper. An

additional 18.4 percent o outstanding commercial paper was issued by conduitsadditional 18.4 percent o outstanding commercial paper was issued by conduits

with extendible notes guarantees. Extendible notes guarantees are similar to ull with extendible notes guarantees. Extendible notes guarantees are similar to ull




credit guarantees except that conduits can extend the commercial paper’s maturitycredit guarantees except that conduits can extend the commercial paper’s maturity

or a limited period o time. The remaining 7.5 percent was issued by structuredor a limited period o time. The remaining 7.5 percent was issued by structured

investment vehicles, which are conduits that issue longer-term debt in addition toinvestment vehicles, which are conduits that issue longer-term debt in addition to

asset-backed commercial paper. Credit guarantees o structured investment vehiclesasset-backed commercial paper. Credit guarantees o structured investment vehicles

typically cover asset-backed commercial paper, but not the longer-maturity debt.typically cover asset-backed commercial paper, but not the longer-maturity debt.

Financial Commercial PaperFinancial Commercial Paper

Financial commercial paper is issued by large fnancial institutions. In con-Financial commercial paper is issued by large fnancial institutions. In con-

trast to asset-backed commercial paper, fnancial commercial paper is issued bytrast to asset-backed commercial paper, fnancial commercial paper is issued by

the institution directly and not via a conduit. Also, fnancial commercial paper isthe institution directly and not via a conduit. Also, fnancial commercial paper is

unsecured and the issuer does not pledge assets as collateral. Financial commercialunsecured and the issuer does not pledge assets as collateral. Financial commercial

paper is considered a low-risk asset because o its short maturity and the act that itspaper is considered a low-risk asset because o its short maturity and the act that its

issuers are large institutions with strong balance sheets. I the balance sheet o anissuers are large institutions with strong balance sheets. I the balance sheet o an

issuer deteriorates, investors usually become reluctant to roll over maturing com-issuer deteriorates, investors usually become reluctant to roll over maturing com-

mercial paper and the issuer has to exit the commercial paper market.mercial paper and the issuer has to exit the commercial paper market.

The main issuers o fnancial paper are oreign fnancial institutions, account-The main issuers o fnancial paper are oreign fnancial institutions, account-

ing or $455 billion o commercial paper in early 2007. Many oreign issuers areing or $455 billion o commercial paper in early 2007. Many oreign issuers are

U.S. subsidiaries o oreign banks, which are set up primarily to access the U.S.U.S. subsidiaries o oreign banks, which are set up primarily to access the U.S.

commercial paper market. The two main U.S. issuers o fnancial commercialcommercial paper market. The two main U.S. issuers o fnancial commercial

paper are captive fnance companies and bank-related fnance companies. Captivepaper are captive fnance companies and bank-related fnance companies. Captive

fnance companies are subsidiaries o automobile companies or manuacturingfnance companies are subsidiaries o automobile companies or manuacturing

companies that issue commercial paper to secure fnancing or their parent compa-companies that issue commercial paper to secure fnancing or their parent compa-

nies (Fabozzi and Mann, 2005). In January 2007, total liabilities o captive fnancenies (Fabozzi and Mann, 2005). In January 2007, total liabilities o captive fnance

companies accounted or $1.87 trillion, o which $165 billion was commercialcompanies accounted or $1.87 trillion, o which $165 billion was commercial

paper. Some o the largest captive fnance companies issuing fnancial commercialpaper. Some o the largest captive fnance companies issuing fnancial commercial

paper are those owned by General Motors, General Electric, and Toyota (Stigumpaper are those owned by General Motors, General Electric, and Toyota (Stigum

and Crescenzi, 2007; Standard and Poor’s, 2009).and Crescenzi, 2007; Standard and Poor’s, 2009).

Bank-related fnance companies are unding subsidiaries o large bank hold-Bank-related fnance companies are unding subsidiaries o large bank hold-

ing companies. Many bank holding companies use such unding subsidiaries toing companies. Many bank holding companies use such unding subsidiaries to

issue commercial paper and pass the proceeds downstream into the bank. Bankissue commercial paper and pass the proceeds downstream into the bank. Bank

holding companies choose such a structure because banks themselves are usuallyholding companies choose such a structure because banks themselves are usually

not allowed to issue commercial paper. Some bank holding companies also issuenot allowed to issue commercial paper. Some bank holding companies also issue

commercial paper to fnance nonbank activities. In January 2007, total liabilitiescommercial paper to fnance nonbank activities. In January 2007, total liabilities

o bank holding companies equaled $757 billion, o which $79 billion were ino bank holding companies equaled $757 billion, o which $79 billion were in

the orm o commercial paper. Some o the largest bank holding companies issu-the orm o commercial paper. Some o the largest bank holding companies issu-

ing fnancial paper are those o Citibank and American Express (Saunders anding fnancial paper are those o Citibank and American Express (Saunders and

Cornett, 2008; Standards and Poor’s, 2009).Cornett, 2008; Standards and Poor’s, 2009).

Corporate Commercial PaperCorporate Commercial Paper

Corporate commercial paper is issued by nonfnancial businesses. In JanuaryCorporate commercial paper is issued by nonfnancial businesses. In January

2007, total credit market debt o nonfnancial businesses was $9.16 trillion o which2007, total credit market debt o nonfnancial businesses was $9.16 trillion o which

$145 billion was commercial paper, accounting or 1.6 percent o total liabilities.$145 billion was commercial paper, accounting or 1.6 percent o total liabilities.

Like fnancial commercial paper, corporate commercial paper is unsecured andLike fnancial commercial paper, corporate commercial paper is unsecured and

only large, creditworthy frms with strong balance sheets can issue commercialonly large, creditworthy frms with strong balance sheets can issue commercial




paper. Most issuers are in the largest size quintile o publicly traded corporations.paper. Most issuers are in the largest size quintile o publicly traded corporations.

For these frms, commercial paper is an important source o fnancing, repre-For these frms, commercial paper is an important source o fnancing, repre-

senting about 30 percent o their current liabilities (Downing and Oliner, 2007).senting about 30 percent o their current liabilities (Downing and Oliner, 2007).

Among the main issuers o corporate fnancial paper are General Electric and Among the main issuers o corporate fnancial paper are General Electric and

Coca-Cola (Standard and Poor’s, 2009).Coca-Cola (Standard and Poor’s, 2009).

Historically, commercial paper issuers used the proceeds rom issuance to coverHistorically, commercial paper issuers used the proceeds rom issuance to cover

their short-term fnancing needs or working capital and inventory. Over time, manytheir short-term fnancing needs or working capital and inventory. Over time, many

issuers started rolling over maturing commercial paper at regular requencies, thusissuers started rolling over maturing commercial paper at regular requencies, thus

eectively fnancing a constant share o their activities via commercial paper. Kahl,eectively fnancing a constant share o their activities v ia commercial paper. Kahl,

Shivdasani, and Wang (2008) estimate that, on average, commercial paper borrow-Shivdasani, and Wang (2008) estimate that, on average, commercial paper borrow-

ing represents 36 percent o investment outlays among commercial paper issuers.ing represents 36 percent o investment outlays among commercial paper issuers.

Demand Side of Commercial PaperDemand Side of Commercial Paper

Money market unds and mutual unds are the main investors in commercialMoney market unds and mutual unds are the main investors in commercial

paper. In January 2007, money market unds and mutual unds owned commercialpaper. In January 2007, money market unds and mutual unds owned commercial

paper worth $767 billion, or 31.4 percent o the market, according to the Federalpaper worth $767 billion, or 31.4 percent o the market, according to the Federal

Reserve Flow o Funds data. Other important investor classes were oreign investorsReserve Flow o Funds data. Other important investor classes were oreign investors

($299 billion), state and local governments ($205 billion), unding corporations($299 billion), state and local governments ($205 billion), unding corporations

($198 billion), and nonfnancial corporate businesses ($109 billion). Individual($198 billion), and nonfnancial corporate businesses ($109 billion). Individual

households own little commercial paper directly, but they own commercial paperhouseholds own little commercial paper directly, but they own commercial paper

indirectly through their ownership o money market unds and mutual unds.indirectly through their ownership o money market unds and mutual unds.

The dominant role o money market unds and mutual unds as commer-The dominant role o money market unds and mutual unds as commer-

cial paper investors is relatively new. Money market unds emerged in the 1970scial paper investors is relatively new. Money market unds emerged in the 1970s

as an alternative to bank deposits that paid regulated interest rates below market-as an alternative to bank deposits that paid regulated interest rates below market-

determined rates on commercial paper. Over time, money market unds grew in sizedetermined rates on commercial paper. Over time, money market unds grew in size

and totaled $2.4 trillion at the start o 2007 (Federal Reserve Flow o Funds data).and totaled $2.4 trillion at the start o 2007 (Federal Reserve Flow o Funds data).

An important characteristic o money market unds is that, contrary to bank An important characteristic o money market unds is that, contrary to bank

deposits, investments in money market unds were not traditionally insured by thedeposits, investments in money market unds were not traditionally insured by the

government. Although money market unds seek to preserve the value o an invest-government. Although money market unds seek to preserve the value o an invest-

ment at $1 per share, it is possible that investors in money market unds can realizement at $1 per share, it is possible that investors in money market unds can realize

a loss on their investments. The main risks aced by money market unds includea loss on their investments. The main risks aced by money market unds include

changes in interest rates and deault on their investments (or example, deaults onchanges in interest rates and deault on their investments (or example, deaults on

commercial paper).commercial paper).

To limit risks o money market und investments, commercial paper holdingsTo limit risks o money market und investments, commercial paper holdings

o money market unds are regulated under Rule 2a-7 o the Investment Companyo money market unds are regulated under Rule 2a-7 o the Investment Company

Act o 1940. Rule 2a-7 limits commercial paper holdings o money market unds to Act o 1940. Rule 2a-7 limits commercial paper holdings o money market unds to

commercial paper that carries either the highest or second-highest rating or short-commercial paper that carries either the highest or second-highest rating or short-

term debt rom at least two o the nationally recognized credit rating agencies.term debt rom at least two o the nationally recognized credit rating agencies.

Money market unds must not hold more than 5 percent o their assets in securi-Money market unds must not hold more than 5 percent o their assets in securi-

ties o any individual issuer with the highest rating and not more than 1 percentties o any individual issuer with the highest rating and not more than 1 percent

o their assets in securities o any individual issuer with the second-highest rating.o their assets in securities o any individual issuer with the second-highest rating.

Also, total holdings o securities with the second-highest rating must not exceed Also, total holdings o securities with the second-highest rating must not exceed




5 percent o the unds’ assets. Notably, the rules requiring diversifcation reduce5 percent o the unds’ assets. Notably, the rules requiring diversifcation reduce

exposure to idiosyncratic risk but cannot reduce exposure to systematic risk whichexposure to idiosyncratic risk but cannot reduce exposure to systematic risk which

aects all commercial paper issuers at the same time.aects all commercial paper issuers at the same time.

Importantly, these regulations prevent money market unds rom purchasingImportantly, these regulations prevent money market unds rom purchasing

long-term assets such as mortgage-backed securities. However, the availability olong-term assets such as mortgage-backed securities. However, the availability o

asset-backed commercial paper provided money market unds with an opportu-asset-backed commercial paper provided money market unds with an opportu-

nity to invest in such securities indirectly. In act, some observers argue that thenity to invest in such securities indirectly. In act, some observers argue that the

growth o the asset-backed commercial paper market was uelled by demand romgrowth o the asset-backed commercial paper market was uelled by demand rom

money market unds, which eventually spurred the rise in housing prices beoremoney market unds, which eventually spurred the rise in housing prices beore

the fnancial crisis. As a result, the asset-backed commercial paper market enabledthe fnancial crisis. As a result, the asset-backed commercial paper market enabled

transorming short-term assets into long-term assets—a unction which is typicallytransorming short-term assets into long-term assets—a unction which is typically

reserved or fnancial institutions operating under strict bank regulations.reserved or fnancial institutions operating under strict bank regulations.

To analyze the importance o commercial paper or money market unds, weTo analyze the importance o commercial paper or money market unds, we

use data provided by iMoneyNet. These data are the most comprehensive sourceuse data provided by iMoneyNet. These data are the most comprehensive source

o money market unds’ asset holdings and cover, among others, all taxable moneyo money market unds’ asset holdings and cover, among others, all taxable money

market unds, representing 84.5 percent o money market und holdings. We ocusmarket unds, representing 84.5 percent o money market und holdings. We ocus

on taxable money market unds because nontaxable money market unds holdon taxable money market unds because nontaxable money market unds hold

primarily tax-exempt instruments issued by state and municipal governments.primarily tax-exempt instruments issued by state and municipal governments.

As o January 2007, there were 473 taxable money market unds holding assets As o January 2007, there were 473 taxable money market unds holding assets

worth $1.95 trillion. About one-third o the unds were Treasury unds, which hold worth $1.95 trillion. About one-third o the unds were Treasury unds, which hold

almost exclusively government debt and government-backed agency debt. Thealmost exclusively government debt and government-backed agency debt. The

other two-thirds were prime unds that also invest in nongovernment assets suchother two-thirds were prime unds that also invest in nongovernment assets such

as commercial paper. In January 2007, the largest asset class held by money marketas commercial paper. In January 2007, the largest asset class held by money market

unds was commercial paper, accounting or $634 billion or 32.5 percent o totalunds was commercial paper, accounting or $634 billion or 32.5 percent o total

asset holdings. The other asset classes included government debt and government-asset holdings. The other asset classes included government debt and government-

backed agency debt ($585 billion), repurchase agreements ($390 billion), bankbacked agency debt ($585 billion), repurchase agreements ($390 billion), bank

obligations ($297 billion), and other assets ($45 billion).obligations ($297 billion), and other assets ($45 billion).

Most large money market unds are geared towards institutional investors. AMost large money market unds are geared towards institutional investors. A

study by Moody’s Investor Service (2007a) shows that in January 2007, the largest 15study by Moody’s Investor Service (2007a) shows that in January 2007, the largest 15

institutional prime unds accounted or a total o $459 billion worth o assets. Insti-institutional prime unds accounted or a total o $459 billion worth o assets. Insti-

tutional prime unds hold a large number o dierent money market instruments,tutional prime unds hold a large number o dierent money market instruments,

and money market unds are thereore considered well diversifed. Nevertheless,and money market unds are thereore considered well diversifed. Nevertheless,

money market unds are highly exposed to risks in the fnancial industry as whole.money market unds are highly exposed to risks in the fnancial industry as whole.

Assets originated by the fnancial industry—measured as the total o fnancial Assets originated by the fnancial industry—measured as the total o fnancial

commercial paper, structured securities, bank obligations, and repurchase agree-commercial paper, structured securities, bank obligations, and repurchase agree-

ments—accounted or 91.4 percent o money market und assets.ments—accounted or 91.4 percent o money market und assets.

Commercial Paper during the Financial CrisesCommercial Paper during the Financial Crises

Commercial Paper and Financial Crises in Historical PerspectiveCommercial Paper and Financial Crises in Historical Perspective

Although the commercial paper market is generally a stable source o Although the commercial paper market is generally a stable source o

fnancing, periodically there have been large and sudden declines in its size.fnancing, periodically there have been large and sudden declines in its size.

The most prominent example is the Penn Central ailure (or discussion, seeThe most prominent example is the Penn Central ailure (or discussion, see




Calomiris, 1994; Calomiris, Himmelberg, and Wachtel, 1995). In June 1970, theCalomiris, 1994; Calomiris, Himmelberg, and Wachtel, 1995). In June 1970, the

transportation company Penn Central declared bankruptcy—the largest corpo-transportation company Penn Central declared bankruptcy—the largest corpo-

rate bankruptcy up to that point—and as a result o its bankruptcy, deaulted onrate bankruptcy up to that point—and as a result o its bankruptcy, deaulted on

its commercial paper. Once Penn Central deaulted, investors lost confdenceits commercial paper. Once Penn Central deaulted, investors lost confdence

in other corporate commercial paper issuers and stopped refnancing maturingin other corporate commercial paper issuers and stopped refnancing maturing

commercial paper. Within three weeks o Penn Central’s bankruptcy, corporatecommercial paper. Within three weeks o Penn Central’s bankruptcy, corporate

commercial paper outstanding dropped by more than 9 percent, rom $32 bil-commercial paper outstanding dropped by more than 9 percent, rom $32 bil-

lion to $29 billion. The Federal Reserve responded by lending aggressively tolion to $29 billion. The Federal Reserve responded by lending aggressively to

banks through the discount window, which alleviated liquidity constraints andbanks through the discount window, which alleviated liquidity constraints and

stabilized the market.stabilized the market.

Ater the Penn Central ailure, and largely as a result o it, corporate commercial Ater the Penn Central ailure, and largely as a result o it, corporate commercial

paper issuers started purchasing insurance against market-wide liquidity disruptionspaper issuers started purchasing insurance against market-wide liquidity disruptions

in the orm o backup loan commitments. Within a ew years ater the crisis, almostin the orm o backup loan commitments. Within a ew years ater the crisis, almost

all corporate commercial paper issuers held backup loan commitments coveringall corporate commercial paper issuers held backup loan commitments covering

100 percent o outstanding commercial paper. The loan commitments were issued100 percent o outstanding commercial paper. The loan commitments were issued

by banks through which the Federal Reserve had administered its lending duringby banks through which the Federal Reserve had administered its lending during

the crisis. This arrangement improved the saety o the corporate commercial paperthe crisis. This arrangement improved the saety o the corporate commercial paper

market or two reasons: 1) banks have access to the discount window; and 2) banksmarket or two reasons: 1) banks have access to the discount window; and 2) banks

typically experience deposit inows during periods o market-wide liquidity disrup-typically experience deposit inows during periods o market-wide liquidity disrup-

tions (Gatev and Strahan, 2006). However, the backup loan commitments increasetions (Gatev and Strahan, 2006). However, the backup loan commitments increase

the riskiness o the fnancial sector as a whole because the risks o market-wide dis-the riskiness o the fnancial sector as a whole because the risks o market-wide dis-

ruptions are eectively insured by the fnancial sector.ruptions are eectively insured by the fnancial sector.

Similar episodes o declines in the size o commercial paper market haveSimilar episodes o declines in the size o commercial paper market have

occurred since Penn Central. Typically in such cases, a single commercial paperoccurred since Penn Central. Typically in such cases, a single commercial paper

issuer experiences a negative shock which reduces investors’ confdence in otherissuer experiences a negative shock which reduces investors’ confdence in other

commercial paper issuers. The common element o such episodes is that theycommercial paper issuers. The common element o such episodes is that they

appear suddenly and lead to large, usually temporary contractions in the marketappear suddenly and lead to large, usually temporary contractions in the market

size. For example, the ailure o the energy company Enron in 2001 raised concernssize. For example, the ailure o the energy company Enron in 2001 raised concerns

about the quality o fnancial reporting and led to a sharp decline in outstandingabout the quality o fnancial reporting and led to a sharp decline in outstanding

corporate commercial paper. However, an important dierence between all suchcorporate commercial paper. However, an important dierence between all such

episodes and the fnancial crisis o 2007–2009 is that the ormer concerned theepisodes and the fnancial crisis o 2007–2009 is that the ormer concerned the

corporate commercial paper market rather than the fnancial or the asset-backedcorporate commercial paper market rather than the fnancial or the asset-backed

commercial paper market.commercial paper market.

Collapse of the Asset-backed Commercial Paper MarketCollapse of the Asset-backed Commercial Paper Market

The decline in the asset-backed commercial paper market was triggered byThe decline in the asset-backed commercial paper market was triggered by

the crisis in the subprime mortgage market. Although delinquencies on subprimethe crisis in the subprime mortgage market. Although delinquencies on subprime

mortgages had been rising through most o 2006, the fnancial crisis showed itsmortgages had been rising through most o 2006, the fnancial crisis showed its

frst clear signs only in summer 2007. On July 31, 2007, two Bear Stearns’s hedgefrst clear signs only in summer 2007. On July 31, 2007, two Bear Stearns’s hedge

unds that had invested in subprime mortgages fled or bankruptcy. A third Bearunds that had invested in subprime mortgages fled or bankruptcy. A third Bear

Stearns’s hedge und suspended investors’ redemptions. In the ollowing week,Stearns’s hedge und suspended investors’ redemptions. In the ollowing week,

more news about delinquencies in subprime mortgages hit the market. On Augustmore news about delinquencies in subprime mortgages hit the market. On August

7, 2007, BNP Paribas halted withdrawals rom its three investment unds and7, 2007, BNP Paribas halted withdrawals rom its three investment unds and

suspended calculation o their net asset values.suspended calculation o their net asset values.




As a result o these announcements, investors in asset-backed commercial As a result o these announcements, investors in asset-backed commercial

paper became concerned that the collateral backing asset-backed commercialpaper became concerned that the collateral backing asset-backed commercial

paper might be o a lower quality than they initially thought. Consequently, manypaper might be o a lower quality than they initially thought. Consequently, many

investors stopped refnancing maturing commercial paper, and within two daysinvestors stopped refnancing maturing commercial paper, and within two days

the spread on overnight asset-backed commercial paper over the ederal undsthe spread on overnight asset-backed commercial paper over the ederal unds

interest rate increased rom 10 basis points to 150 basis points. Because o theinterest rate increased rom 10 basis points to 150 basis points. Because o the

credit guarantees, sponsoring fnancial institutions had to provide liquidity tocredit guarantees, sponsoring fnancial institutions had to provide liquidity to

pay o maturing asset-backed commercial paper. This obligation raised concernspay o maturing asset-backed commercial paper. This obligation raised concerns

about counterparty risk among banks and caused interbank lending rates to shootabout counterparty risk among banks and caused interbank lending rates to shoot

upwards. The crisis in asset-backed commercial paper quickly spread across theupwards. The crisis in asset-backed commercial paper quickly spread across the

fnancial sector and aected banks worldwide (Acharya and Schnabl, 2009).fnancial sector and aected banks worldwide (Acharya and Schnabl, 2009).

As shown in As shown in FigureFigure 1, rom August 2007 to August 2008, the value o asset-1, rom August 2007 to August 2008, the value o asset-

backed commercial paper outstanding ell by 33.1 percent, rom $1.18 trillion tobacked commercial paper outstanding ell by 33.1 percent, rom $1.18 trillion to

$789 billion. These numbers likely understate the actual decline in demand or$789 billion. These numbers likely understate the actual decline in demand or

asset-backed commercial paper because credit guarantees oten required sponsor-asset-backed commercial paper because credit guarantees oten required sponsor-

ing banks to purchase asset-backed commercial paper directly.ing banks to purchase asset-backed commercial paper directly.

Even though asset-backed commercial paper outstanding decreased, issuanceEven though asset-backed commercial paper outstanding decreased, issuance

o asset-backed commercial paper actually increased in late August 2007, as showno asset-backed commercial paper actually increased in late August 2007, as shown

inin FigureFigure 2. Average daily issuance o asset-backed commercial paper increased2. Average daily issuance o asset-backed commercial paper increased

rom $71 billion in early August 2007 to $106 billion in early September 2007.rom $71 billion in early August 2007 to $106 billion in early September 2007.

At the same time, however, average maturity o asset-backed commercial paper At the same time, however, average maturity o asset-backed commercial paper

Figure 1

Commercial Paper Outstanding, January 2004–October 2009

Source: Authors’ analysis based on Federal Reserve Board data.Note: Figure 1 shows the weekly commercial paper outstanding. The asset-backed commercial paper ( ABCP) market collapse was August 9, 2007. Lehman’s bankruptcy was September 15, 2008.

P a p e r o u t s t a n d i n g ( i n $ b i l l i o n s )

0

200

400

600

800

1,000

1,200

1 / 7 / 2 0 0 4

7 / 7 / 2 0 0 4

1 / 7 / 2 0 0 5

7 / 7 / 2 0 0 5

1 / 7 / 2 0 0 6

7 / 7 / 2 0 0 6

1 / 7 / 2 0 0 7

7 / 7 / 2 0 0 7

1 / 7 / 2 0 0 8

7 / 7 / 2 0 0 8

1 / 7 / 2 0 0 9

7 / 7 / 2 0 0 9

ABCP market collapse

Lehman’sbankruptcy

Asset-backed

Financial

Corporate

4 / 7 / 2 0 0 4

1 0 / 7 / 2 0 0 4

4 / 7 / 2 0 0 5

1 0 / 7 / 2 0 0 5

4 / 7 / 2 0 0 6

1 0 / 7 / 2 0 0 6

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1 0 / 7 / 2 0 0 7

4 / 7 / 2 0 0 8

1 0 / 7 / 2 0 0 8

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1 0 / 7 / 2 0 0 9




decreased sufciently to more than oset the increase in issuance, thus resulting indecreased sufciently to more than oset the increase in issuance, thus resulting in

an overall decline in commercial paper market size.an overall decline in commercial paper market size. FigureFigure 3 urther shows that the3 urther shows that the

spread between overnight asset-backed commercial paper and the ederal undsspread between overnight asset-backed commercial paper and the ederal unds

interest rate spiked up shortly ater the crisis started. While in the year beore theinterest rate spiked up shortly ater the crisis started. While in the year beore the

crisis the average spread equaled 3 basis points, in the year ater the crisis the aver-crisis the average spread equaled 3 basis points, in the year ater the crisis the aver-

age spread rose to 46 basis points.age spread rose to 46 basis points.

The decrease in outstanding asset-backed commercial paper, combined withThe decrease in outstanding asset-backed commercial paper, combined with

the increase in its spread, suggests that the decline was likely caused by a drop inthe increase in its spread, suggests that the decline was likely caused by a drop in

demand or, rather than supply o, asset-backed commercial paper. In line with thisdemand or, rather than supply o, asset-backed commercial paper. In line with this

interpretation, several money market unds reported that they had reduced theirinterpretation, several money market unds reported that they had reduced their

holdings o asset-backed commercial paper to mitigate the risk o negative public-holdings o asset-backed commercial paper to mitigate the risk o negative public-

ity, which could trigger withdrawals by investors (Moody’s Investor Service, 2007b).ity, which could trigger withdrawals by investors (Moody’s Investor Service, 2007b).

Covitz, Liang, and Suarez (2009) show that conduits with the weakest creditCovitz, Liang, and Suarez (2009) show that conduits with the weakest credit

guarantees had the largest difculties in rolling over their maturing asset-backedguarantees had the largest difculties in rolling over their maturing asset-backed

commercial paper. For example, rom July to December 2007, total asset-backedcommercial paper. For example, rom July to December 2007, total asset-backed

commercial paper issued by structured investment vehicles ell rom $84 billion tocommercial paper issued by structured investment vehicles ell rom $84 billion to

$15 billion. Acharya, Schnabl, and Suarez (2009) urther demonstrate that credit$15 billion. Acharya, Schnabl, and Suarez (2009) urther demonstrate that credit

guarantees covered almost all o the maturing asset-backed commercial paper andguarantees covered almost all o the maturing asset-backed commercial paper and

97 percent o asset-backed commercial paper was repaid at maturity or shortly97 percent o asset-backed commercial paper was repaid at maturity or shortly

thereater. Issuers deaulted only on 3 percent o asset-backed commercial paperthereater. Issuers deaulted only on 3 percent o asset-backed commercial paper

Figure 2

Commercial Paper Issuances, January 2004–October 2009

Source: Authors’ analysis based on Federal Reserve Board data.Note: Figure 2 shows a fve-day rolling-window average o commercial paper issuances. The asset-backed commercial paper ( ABCP) market collapse was August 9, 2007. Lehman’s bankruptcy wasSeptember 15, 2008.

P a p e r i s s u e d ( i n

b i l l i o n s )

0

20

40

60

80

100

120

1 / 2 / 2 0 0 4

7 / 2 / 2 0 0 4

1 / 2 / 2 0 0 5

7 / 2 / 2 0 0 5

1 / 2 / 2 0 0 6

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1 / 2 / 2 0 0 7

7 / 2 / 2 0 0 7

1 / 2 / 2 0 0 8

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7 / 2 / 2 0 0 9



Asset-backed

Financial

Corporate

4 / 2 / 2 0 0 4

1 0 / 2 / 2 0 0 4

4 / 2 / 2 0 0 5

1 0 / 2 / 2 0 0 5

4 / 2 / 2 0 0 6

1 0 / 2 / 2 0 0 6

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1 0 / 2 / 2 0 0 7

4 / 2 / 2 0 0 8

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4 / 2 / 2 0 0 9

1 0 / 2 / 2 0 0 9




outstanding. Hence, most o the investment losses due to the all in asset pricesoutstanding. Hence, most o the investment losses due to the all in asset prices

eectively remained contained with the sponsoring fnancial institutions, not theeectively remained contained with the sponsoring fnancial institutions, not the

investors in asset-backed commercial paper.investors in asset-backed commercial paper.

Figures 1, 2, and 3 also illustrate that the events o August 2007 had littleFigures 1, 2, and 3 also illustrate that the events o August 2007 had little

eect on issuers o fnancial and corporate commercial paper. Those issuers con-eect on issuers o fnancial and corporate commercial paper. Those issuers con-

tinued rolling over commercial paper at customary rates. For example, the spreadtinued rolling over commercial paper at customary rates. For example, the spread

o fnancial commercial paper over the ederal unds rate remained at negative oneo fnancial commercial paper over the ederal unds rate remained at negative one

basis point in the year beore and the year ater the crisis. The amount o non-asset-basis point in the year beore and the year ater the crisis. The amount o non-asset-

backed commercial paper outstanding remained stable at $980 billion in the yearbacked commercial paper outstanding remained stable at $980 billion in the year

ater the crisis.ater the crisis.

Lehman’s BankruptcyLehman’s Bankruptcy

The second major negative shock in the commercial paper market was theThe second major negative shock in the commercial paper market was the

deault o Lehman Brothers. In September 2008, many investors were surpriseddeault o Lehman Brothers. In September 2008, many investors were surprised

to learn that the Reserve Primary Fund—one o the largest money market undsto learn that the Reserve Primary Fund—one o the largest money market unds

with more than $65 billion o assets under management—owned more than with more than $65 billion o assets under management—owned more than

$785 million o Lehman’s commercial paper. The ounder o the Reserve Primary$785 million o Lehman’s commercial paper. The ounder o the Reserve Primary

Fund—Bruce Bent—who had been one o the pioneers o the money marketFund—Bruce Bent—who had been one o the pioneers o the money market

industry, had publicly expressed the view that money market unds should notindustry, had publicly expressed the view that money market unds should not

invest in commercial paper because it was too risky. In line with this view, untilinvest in commercial paper because it was too risky. In line with this view, until

September 2005, the Reserve Primary Fund stated in its flings with the SecuritiesSeptember 2005, the Reserve Primary Fund stated in its flings with the Securities

Figure 3

Overnight Commercial Paper Spreads (Net of Fed Funds Rate),

January 2004–October 2009

Source: Authors’ analysis based on Federal Reserve Board and New York Federal Reserve data.Note: Figure 3 urther shows a fve-day rolling-window average or the spread between overnight asset-backed commercial paper and the ederal unds rate. The asset-backed commercial paper ( ABCP)market collapse was August 9, 2007. Lehman’s bankruptcy was September 15, 2008.

S p r e a d ( i n b a s i s p o i n t s )

–50

0

50

150

200

250

350

1 / 8 / 2 0 0 4

7 / 8 / 2 0 0 4

1 / 8 / 2 0 0 5

7 / 8 / 2 0 0 5

1 / 8 / 2 0 0 6

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7 / 8 / 2 0 0 9



Asset-backed

Financial

Corporate

100

300

4 / 8 / 2 0 0 4

1 0 / 8 / 2 0 0 4

4 / 8 / 2 0 0 5

1 0 / 8 / 2 0 0 5

4 / 8 / 2 0 0 6

1 0 / 8 / 2 0 0 6

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1 0 / 8 / 2 0 0 7

4 / 8 / 2 0 0 8

1 0 / 8 / 2 0 0 8

4 / 8 / 2 0 0 9

1 0 / 8 / 2 0 0 9




and Exchange Commission that the und did not invest in commercial paper. Thisand Exchange Commission that the und did not invest in commercial paper. This

commitment was abandoned in later flings and, rom 2006 onwards, the Reservecommitment was abandoned in later flings and, rom 2006 onwards, the Reserve

Primary Fund began acquiring signifcant amounts o commercial paper to boostPrimary Fund began acquiring signifcant amounts o commercial paper to boost

its perormance (Stecklow and Gullappalli, 2008).its perormance (Stecklow and Gullappalli, 2008).

The revelation o the Reserve Fund’s exposure to Lehman’s bankruptcyThe revelation o the Reserve Fund’s exposure to Lehman’s bankruptcy

triggered an immediate run on the und. On September 16, 2008, the Reservetriggered an immediate run on the und. On September 16, 2008, the Reserve

Primary Fund was orced to pay out $10.8 billion in redemptions and aced aboutPrimary Fund was orced to pay out $10.8 billion in redemptions and aced about

$28 billion o urther withdrawal requests. The run quickly spread to other money$28 billion o urther withdrawal requests. The run quickly spread to other money

market unds with commercial paper holdings. Our analysis based on iMoneyNetmarket unds with commercial paper holdings. Our analysis based on iMoneyNet

data shows that, within a week, institutional investors reduced their investments indata shows that, within a week, institutional investors reduced their investments in

money market unds by more than $172 billion. To stop the run on money marketmoney market unds by more than $172 billion. To stop the run on money market

unds, on September 19, 2008, the U.S. Department o the Treasury announcedunds, on September 19, 2008, the U.S. Department o the Treasury announced

a temporary deposit insurance covering all money market investments. Thisa temporary deposit insurance covering all money market investments. This

announcement stopped the run on money market unds, and redemption requestsannouncement stopped the run on money market unds, and redemption requests

promptly receded.promptly receded.

Nonetheless, investors interpreted the Lehman’s bankruptcy as a signal thatNonetheless, investors interpreted the Lehman’s bankruptcy as a signal that

commercial paper, issued and sponsored by fnancial institutions, was ar riskier thancommercial paper, issued and sponsored by fnancial institutions, was ar riskier than

investors had previously thought. As Figure 1 indicates, fnancial commercial paperinvestors had previously thought. As Figure 1 indicates, fnancial commercial paper

outstanding dropped by 29.5 percent, rom $806 billion on September 10, 2008, tooutstanding dropped by 29.5 percent, rom $806 billion on September 10, 2008, to

$568 billion on October 22, 2008. Over the same time period, asset-backed$568 billion on October 22, 2008. Over the same time period, asset-backed

commercial paper outstanding dropped by 9.8 percent, rom $741 billion to $668commercial paper outstanding dropped by 9.8 percent, rom $741 billion to $668

billion. Somewhat surprisingly, however, issuances o commercial paper doubled,billion. Somewhat surprisingly, however, issuances o commercial paper doubled,

rom $62 billion to $123 billion, as shown in Figure 2. Despite that, commercialrom $62 billion to $123 billion, as shown in Figure 2. Despite that, commercial

paper outstanding decreased because the average maturity o commercial paperpaper outstanding decreased because the average maturity o commercial paper

dropped ater Lehman’s bankruptcy. Finally, Figure 3 shows that the spreads ondropped ater Lehman’s bankruptcy. Finally, Figure 3 shows that the spreads on

commercial paper increased, though the eect or fnancial commercial paper andcommercial paper increased, though the eect or fnancial commercial paper and

corporate commercial paper was shorter than that or asset-backed commercialcorporate commercial paper was shorter than that or asset-backed commercial

paper.paper.

Money market unds were a leading orce in the decline o the commercialMoney market unds were a leading orce in the decline o the commercial

paper market. Even though money market und investments were considered saepaper market. Even though money market und investments were considered sae

because o the newly introduced deposit insurance, money market unds them-because o the newly introduced deposit insurance, money market unds them-

selves decided to reduce their holdings o commercial paper. As shown inselves decided to reduce their holdings o commercial paper. As shown in FigureFigure 4,4,

within one month ater Lehman’s bankruptcy, commercial paper holdings ell within one month ater Lehman’s bankruptcy, commercial paper holdings ell

rom 24.2 to 16.9 percent o money market unds’ assets. To oset the decreaserom 24.2 to 16.9 percent o money market unds’ assets. To oset the decrease

in commercial paper holdings, money market unds expanded their holdings oin commercial paper holdings, money market unds expanded their holdings o

Treasuries and agency debt rom 36.7 to 44.5 percent o asset holdings. This drasticTreasuries and agency debt rom 36.7 to 44.5 percent o asset holdings. This drastic

change in asset holdings is oten described as ight-to-quality—that is, an episodechange in asset holdings is oten described as ight-to-quality—that is, an episode

during which risk-averse investors, such as money market unds, only want to holdduring which risk-averse investors, such as money market unds, only want to hold

assets o highest quality, such as government debt.assets o highest quality, such as government debt.

To the Rescue: Federal Reserve InterventionsTo the Rescue: Federal Reserve Interventions

Both the collapse o the asset-backed commercial paper market and Lehman’sBoth the collapse o the asset-backed commercial paper market and Lehman’s

bankruptcy triggered immediate responses by policymakers. The responses werebankruptcy triggered immediate responses by policymakers. The responses were

largely motivated by concerns about the eect o the commercial paper market onlargely motivated by concerns about the eect o the commercial paper market on




the real economy. In particular, many fnancial intermediaries used commercialthe real economy. In particular, many fnancial intermediaries used commercial

paper to fnance their lending activities and so the increased difculty in issu-paper to fnance their lending activities and so the increased difculty in issu-

ing commercial paper sharply reduced their abilities to provide loans to frmsing commercial paper sharply reduced their abilities to provide loans to frms

and individuals. The difculties in the commercial paper market also promptedand individuals. The difculties in the commercial paper market also prompted

nonfnancial corporations to draw on their back-up credit lines, which urther neg-nonfnancial corporations to draw on their back-up credit lines, which urther neg-

atively aected fnancial intermediaries. Since the nonfnancial sector accountedatively aected fnancial intermediaries. Since the nonfnancial sector accounted

only or 12 percent o the commercial paper outstanding, the policy ocus was pri-only or 12 percent o the commercial paper outstanding, the policy ocus was pri-

marily on stabilizing the market or fnancial and asset-backed commercial paper.marily on stabilizing the market or fnancial and asset-backed commercial paper.

The policy interventions ater the collapse o the asset-backed commercialThe policy interventions ater the collapse o the asset-backed commercial

market had been smaller in scale and scope than those ater Lehman’s bankruptcy.market had been smaller in scale and scope than those ater Lehman’s bankruptcy.

The reason is that the collapse o the asset-backed commercial market was viewedThe reason is that the collapse o the asset-backed commercial market was viewed

as a lack o liquidity—that is, a lack o short-term fnancing—which could beas a lack o liquidity—that is, a lack o short-term fnancing—which could be

remedied using conventional tools o monetary policy such as providing collateral-remedied using conventional tools o monetary policy such as providing collateral-

ized loans via the discount window. In contrast, Lehman’s bankruptcy was viewedized loans via the discount window. In contrast, Lehman’s bankruptcy was viewed

as a lack o solvency—that is, a lack o sufcient capital within the fnancial systemas a lack o solvency—that is, a lack o sufcient capital within the fnancial system

to cover losses resulting rom declines in asset values—which required broaderto cover losses resulting rom declines in asset values—which required broader

policy interventions such as setting up deposit insurance or money market unds,policy interventions such as setting up deposit insurance or money market unds,

direct purchase o commercial paper, and capital injections or fnancial institu-direct purchase o commercial paper, and capital injections or fnancial institu-

tions (as discussed in Philippon and Schnabl, 2009).tions (as discussed in Philippon and Schnabl, 2009).

The Federal Reserve’s eorts to assure liquidity to banks, partly because oThe Federal Reserve’s eorts to assure liquidity to banks, partly because o

their exposure to problems o the asset-backed commercial paper market, startedtheir exposure to problems o the asset-backed commercial paper market, started

Figure 4

Money Market Funds’ Asset Shares in Total Holdings, January 2004–December

2008

Source: Authors’ analysis using iMoneyNet data on money market unds’ holdings.Note: The asset-backed commercial paper ( ABCP) market collapse was August 9, 2007. Lehman’sbankruptcy was September 15, 2008.

S h a r e s ( i n

p e r c e n t )

15

20

25

30

40

45

50

2 - J a n - 0 4

2 - M a r - 0 4

2 - N o v - 0 4

2 - M a y - 0 5

2 - N o v - 0 5

2 - M a r - 0 6

2 - S e p - 0 6

2 - M a r - 0 7

2 - J u l - 0 7

2 - J a n - 0 8

2 - M a y - 0 8

2 - N o v - 0 8



Government debt

Commercial paper

Other

35

2 - M a y - 0 4

2 - J u l - 0 4

2 - S e p - 0 4

2 - J a n - 0 5

2 - M a r - 0 5

2 - J u l - 0 5

2 - S e p - 0 5

2 - J a n - 0 6

2 - M a y - 0 6

2 - J u l - 0 6

2 - N o v - 0 6

2 - J a n - 0 7

2 - M a y - 0 7

2 - S e p - 0 7

2 - N o v - 0 7

2 - M a r - 0 8

2 - J u l - 0 8

2 - S e p - 0 8




on August 9, 2007. Over the ollowing two days, the Federal Reserve used overnighton August 9, 2007. Over the ollowing two days, the Federal Reserve used overnight

repurchase agreements worth a total o $62 billion to inject liquidity into the mar-repurchase agreements worth a total o $62 billion to inject liquidity into the mar-

ket so that banks could cover their short-term fnancing needs (Cecchetti, 2008;ket so that banks could cover their short-term fnancing needs (Cecchetti, 2008;

Brunnermeier, 2009).Brunnermeier, 2009).22 (Repurchase agreements are collateralized loans used or(Repurchase agreements are collateralized loans used or

bank borrowing.) The next week, with conditions having deteriorated even urther,bank borrowing.) The next week, with conditions having deteriorated even urther,

the Federal Reserve reduced the discount rate by 50 basis points and extended thethe Federal Reserve reduced the discount rate by 50 basis points and extended the

maximum term or discount-window loans to 30 days. On September 18, 2007,maximum term or discount-window loans to 30 days. On September 18, 2007,

the Federal Reserve announced a new initiative called the Term Auction Facilitythe Federal Reserve announced a new initiative called the Term Auction Facility

(TAF)—a lending program that provided loans or a term o 28 to 35 days—longer(TAF)—a lending program that provided loans or a term o 28 to 35 days—longer

than the usual discount-window practice. Over the ollowing months, the Federalthan the usual discount-window practice. Over the ollowing months, the Federal

Reserve lowered its target interest rate seven times, totaling 325 basis points. InReserve lowered its target interest rate seven times, totaling 325 basis points. In

March 2008, the Fed increased the size o the Term Auction Facility and announcedMarch 2008, the Fed increased the size o the Term Auction Facility and announced

its intention to conduct a series o term repurchase transactions totaling $100 bil-its intention to conduct a series o term repurchase transactions totaling $100 bil-

lion. These transactions could be collateralized by a variety o securities, includinglion. These transactions could be collateralized by a variety o securities, including

Treasury debt, agency debt, and agency mortgage-backed securities. The FederalTreasury debt, agency debt, and agency mortgage-backed securities. The Federal

Reserve also extended liquidity provision to other fnancial institutions, or exam-Reserve also extended liquidity provision to other fnancial institutions, or exam-

ple, allowing primary dealers (banks and securities broker-dealers that are allowedple, allowing primary dealers (banks and securities broker-dealers that are allowed

to trade directly with the Federal Reserve System) to use mortgage-backed assets toto trade directly with the Federal Reserve System) to use mortgage-backed assets to

borrow overnight or or 28 days.borrow overnight or or 28 days.

These interventions seemed successul in improving fnancing conditionsThese interventions seemed successul in improving fnancing conditions

or large fnancial frms. Even though the investment bank Bear Stearns ailed inor large fnancial frms. Even though the investment bank Bear Stearns ailed in

March 2008, its ailure had little impact on the commercial paper market. By midMarch 2008, its ailure had little impact on the commercial paper market. By mid

2008, the asset-backed commercial paper market had stabilized and larger con-2008, the asset-backed commercial paper market had stabilized and larger con-

duits managed to issue asset-backed commercial paper. Also, fnancial companiesduits managed to issue asset-backed commercial paper. Also, fnancial companies

and corporations were still able to issue fnancial and corporate commercial paper.and corporations were still able to issue fnancial and corporate commercial paper.

However, with the bankruptcy o Lehman Brothers and the subsequent runHowever, with the bankruptcy o Lehman Brothers and the subsequent run

on money market unds, the situation in the commercial paper market worsenedon money market unds, the situation in the commercial paper market worsened

again. Policymakers decided to roll out new policy initiatives to contain the situa-again. Policymakers decided to roll out new policy initiatives to contain the situa-

tion. As mentioned above, the U.S. Treasury announced on September 19, 2008,tion. As mentioned above, the U.S. Treasury announced on September 19, 2008,

that the U.S. government would temporarily guarantee assets o money marketthat the U.S. government would temporarily guarantee assets o money market

unds. When that guarantee did not stop the decline in the commercial paperunds. When that guarantee did not stop the decline in the commercial paper

market, the Federal Reserve announced several other initiatives to support themarket, the Federal Reserve announced several other initiatives to support the

commercial paper market directly. On September 18, 2008, it announced a newcommercial paper market directly. On September 18, 2008, it announced a new

lending program called the Asset-Backed Commercial Paper Money Marketlending program called the Asset-Backed Commercial Paper Money Market

Mutual Fund Liquidity Facility (AMLF). The AMLF, administered by the FederalMutual Fund Liquidity Facility (AMLF). The AMLF, administered by the Federal

Reserve Bank o Boston, was supposed to provide loans to commercial banks soReserve Bank o Boston, was supposed to provide loans to commercial banks so

that they could purchase high-quality asset-backed commercial paper rom moneythat they could purchase high-quality asset-backed commercial paper rom money

market unds. These are non-recourse loans—that is, i the asset-backed commer-market unds. These are non-recourse loans—that is, i the asset-backed commer-

cial paper deaults, the Federal Reserve takes over the commercial paper insteadcial paper deaults, the Federal Reserve takes over the commercial paper instead

o requiring repayment o the loan. As shown ino requiring repayment o the loan. As shown in FigureFigure 5, AMLF started buying5, AMLF started buying

commercial paper on September 24, and its frst two weeks o activity amounted tocommercial paper on September 24, and its frst two weeks o activity amounted to

2

On the same day, the European Central Bank also pumped 95 billion euros in overnight lending intothe market—the largest loan in the bank’s history.




approximately $150 billion worth o purchases. Over time, AMLF lowered its pur-approximately $150 billion worth o purchases. Over time, AMLF lowered its pur-

chases and reduced its holdings almost to zero by October 2009.chases and reduced its holdings almost to zero by October 2009.

On October 7, 2008, the Federal Reserve announced that, in addition to buy-On October 7, 2008, the Federal Reserve announced that, in addition to buy-

ing through AMLF, it would purchase three-month commercial paper directlying through AMLF, it would purchase three-month commercial paper directly

rom eligible issuers through the Commercial Paper Funding Facility (CPFF). Onlyrom eligible issuers through the Commercial Paper Funding Facility (CPFF). Only

U.S. issuers o commercial paper, including U.S. issuers with a oreign parent, wereU.S. issuers o commercial paper, including U.S. issuers with a oreign parent, were

eligible to sell commercial paper to this acility. The interest rate on corporate andeligible to sell commercial paper to this acility. The interest rate on corporate and

fnancial commercial paper was the three-month overnight indexed swap rate—afnancial commercial paper was the three-month overnight indexed swap rate—a

standard measure o borrowing costs in money markets—plus 200 basis points.standard measure o borrowing costs in money markets—plus 200 basis points.

Likewise, the interest rate on asset-backed commercial paper was the overnightLikewise, the interest rate on asset-backed commercial paper was the overnight

indexed swap rate plus 300 basis points.indexed swap rate plus 300 basis points.

As shown in Figure 5, CPFF started purchasing commercial paper on October As shown in Figure 5, CPFF started purchasing commercial paper on October

26, 2008. The impact o these purchases on the size and spreads o the commer-26, 2008. The impact o these purchases on the size and spreads o the commer-

cial paper market is immediately apparent in Figure 1 and Figure 3. The value ocial paper market is immediately apparent in Figure 1 and Figure 3. The value o

fnancial commercial paper outstanding came back to its pre-crisis level. Also, thefnancial commercial paper outstanding came back to its pre-crisis level. Also, the

spreads on all types o commercial paper signifcantly decreased. By the end ospreads on all types o commercial paper signifcantly decreased. By the end o

2008, the total value o commercial paper purchased under the CPFF program2008, the total value o commercial paper purchased under the CPFF program

equaled $335 billion dollars, out o which one-third was asset-backed commercialequaled $335 billion dollars, out o which one-third was asset-backed commercial

paper. As a result, the Federal Reserve was the single largest buyer o commer-paper. As a result, the Federal Reserve was the single largest buyer o commer-

cial paper (Federal Reserve Bank o New York, 2008). Initially, the program onlycial paper (Federal Reserve Bank o New York, 2008). Initially, the program only

Figure 5

Holdings of Commercial Paper by Fed Funding Facilities: September 2008–October 2009

Source: Based on Federal Reserve Board and New York Federal Reserve data.Note: The CPFF the Commercial Paper Funding Facility. The AMLF is the Asset-Backed CommercialPaper Money Market Mutual Fund Liquidity Facility.

F e d e r a l R

e s e r v e h o l d i n g s ( i n

b i l l i o n s $ )

0

50

100

150

250

300

400

9 / 2 4 / 2 0 0 8

1 0 / 2 4 / 2 0 0 8

1 1 / 2 4 / 2 0 0 8

1 2 / 2 4 / 2 0 0 8

1 / 2 4 / 2 0 0 9

2 / 2 4 / 2 0 0 9

3 / 2 4 / 2 0 0 9

4 / 2 4 / 2 0 0 9

5 / 2 4 / 2 0 0 9

6 / 2 4 / 2 0 0 9

7 / 2 4 / 2 0 0 9

CPFF (left axis) AMLF (left axis)

Fed share (right axis)

F e d e r a l R e s e r v e s h a r e o f m a r k e t t o t a l

200

350

25.0%

20.0%

15.0%

10.0%

5.0%

0.0%8 / 2 4 / 2 0 0 9

9 / 2 4 / 2 0 0 9




purchased assets with maturities over 15 days; then ater January 2009, it expandedpurchased assets with maturities over 15 days; then ater January 2009, it expanded

to shorter-maturity assets. Also, like with AMLF, the value o assets purchasedto shorter-maturity assets. Also, like with AMLF, the value o assets purchased

under CPFF has been gradually declining and reached about $40 billion dollars inunder CPFF has been gradually declining and reached about $40 billion dollars in

October 2009, as shown in Figure 5.October 2009, as shown in Figure 5.

On October 21, 2008, the Federal Reserve announced another lending programOn October 21, 2008, the Federal Reserve announced another lending program

—the Money Market Investor Funding Facility (MMIFF)—intended to complement—the Money Market Investor Funding Facility (MMIFF)—intended to complement

AMLF. Similar to AMLF, the new program was supposed to provide non-recourse AMLF. Similar to AMLF, the new program was supposed to provide non-recourse

loans to money market unds. The main dierence was that it was restricted toloans to money market unds. The main dierence was that it was restricted to

money market instruments other than asset-backed commercial paper, such asmoney market instruments other than asset-backed commercial paper, such as

certifcates o deposit, bank notes, and fnancial and corporate commercial paper.certifcates o deposit, bank notes, and fnancial and corporate commercial paper.

The New York Fed began unding eligible money market instruments under thisThe New York Fed began unding eligible money market instruments under this

program on November 24, 2008. However, the acility never took o and, as oprogram on November 24, 2008. However, the acility never took o and, as o

October 2009, it had not provided a single loan to money market unds.October 2009, it had not provided a single loan to money market unds.

Why Did the Commercial Paper Market Collapse? Why Did the Commercial Paper Market Collapse?

We discuss three possible explanations or the collapse o the commercial We discuss three possible explanations or the collapse o the commercial

paper market: substitution to other sources o fnancing, adverse selection, andpaper market: substitution to other sources o fnancing, adverse selection, and

institutional constraints aced by money market unds. These explanations are notinstitutional constraints aced by money market unds. These explanations are not

mutually exclusive, and we present evidence in avor o each o the explanations.mutually exclusive, and we present evidence in avor o each o the explanations.

Substitution to Other Sources of FinancingSubstitution to Other Sources of Financing

One possible reason or the decline in commercial paper is that buyers oOne possible reason or the decline in commercial paper is that buyers o

commercial paper, such as money market unds, learned during the fnancial crisiscommercial paper, such as money market unds, learned during the fnancial crisis

that commercial paper was riskier than they initially thought and thereore theythat commercial paper was riskier than they initially thought and thereore they

revised upwards their expectations about the likelihood o commercial paper’srevised upwards their expectations about the likelihood o commercial paper’s

deault. For example, investors learned that asset-backed commercial paper wasdeault. For example, investors learned that asset-backed commercial paper was

collateralized by assets or which liquidity in the secondary market could suddenlycollateralized by assets or which liquidity in the secondary market could suddenly

disappear. With Lehman’s bankruptcy, investors in commercial paper learned thatdisappear. With Lehman’s bankruptcy, investors in commercial paper learned that

even large fnancial institutions could collapse overnight, causing the deault oeven large fnancial institutions could collapse overnight, causing the deault o

supposedly sae commercial paper. As a result, investors required higher returnsupposedly sae commercial paper. As a result, investors required higher return

to compensate them or bearing more risk, which substantially raised the cost oto compensate them or bearing more risk, which substantially raised the cost o

commercial paper unding.commercial paper unding.

Also, beore the fnancial crisis, most investors believed that commercial paper Also, beore the fnancial crisis, most investors believed that commercial paper

almost never deaults and thereore had little incentive to invest in inormationalmost never deaults and thereore had little incentive to invest in inormation

gathering about issuers o commercial paper. Such poor inormation-gatheringgathering about issuers o commercial paper. Such poor inormation-gathering

incentives can maniest themselves, or example, in taking portolio positions thatincentives can maniest themselves, or example, in taking portolio positions that

more closely resemble the market (Kacperczyk, Sialm, and Zheng, 2005; Kacperc-more closely resemble the market (Kacperczyk, Sialm, and Zheng, 2005; Kacperc-

zyk, van Nieuwerburgh, and Veldkamp, 2009). This behavior seemed to have takenzyk, van Nieuwerburgh, and Veldkamp, 2009). This behavior seemed to have taken

place among money market unds as most o them held commercial paper rom 50place among money market unds as most o them held commercial paper rom 50

or more issuers, in addition to holding other money market instruments. However,or more issuers, in addition to holding other money market instruments. However,

during the crisis, investors decided to invest more resources in inormation-during the crisis, investors decided to invest more resources in inormation-

gathering activities because the value o commercial paper was more sensitive togathering activities because the value o commercial paper was more sensitive to




new inormation. As a result, the spread on commercial paper increased to com-new inormation. As a result, the spread on commercial paper increased to com-

pensate investors or the increase in costs o inormation gathering. This eectpensate investors or the increase in costs o inormation gathering. This eect

is likely to be particularly strong in the short run as investors need some time tois likely to be particularly strong in the short run as investors need some time to

adjust to the new market environment.adjust to the new market environment.

As a result o the higher costs o commercial paper, some issuers o commercial As a result o the higher costs o commercial paper, some issuers o commercial

paper were orced to consider substitution to other sources o fnancing. In the casepaper were orced to consider substitution to other sources o fnancing. In the case

o the collapse o the asset-backed commercial paper market, the primary sourceso the collapse o the asset-backed commercial paper market, the primary sources

o alternative fnancing were the sponsoring fnancial institutions. The sponsor-o alternative fnancing were the sponsoring fnancial institutions. The sponsor-

ing fnancial institutions were required to repurchase the assets rom conduitsing fnancial institutions were required to repurchase the assets rom conduits

in case investors were unwilling to refnance maturing asset-backed commercialin case investors were unwilling to refnance maturing asset-backed commercial

paper. Hence, sponsoring fnancial institutions used other sources o fnancing,paper. Hence, sponsoring fnancial institutions used other sources o fnancing,

such as bank deposits, certifcates o deposits, or even fnancial commercial papersuch as bank deposits, certifcates o deposits, or even fnancial commercial paper

to replace fnancing rom the asset-backed commercial paper market.to replace fnancing rom the asset-backed commercial paper market.

In the period ollowing Lehman’s bankruptcy in September 2008, the situa-In the period ollowing Lehman’s bankruptcy in September 2008, the situa-

tion was dierent. In this episode, the decline in asset-backed commercial papertion was dierent. In this episode, the decline in asset-backed commercial paper

looked much as it had in all o 2007. However, the impact on fnancial institutionslooked much as it had in all o 2007. However, the impact on fnancial institutions

was stronger because—in addition to the fnancing requirements rom asset- was stronger because—in addition to the fnancing requirements rom asset-

backed commercial conduits—fnancial institutions themselves lost access to thebacked commercial conduits—fnancial institutions themselves lost access to the

commercial paper market as a direct unding source. Other short-term unding,commercial paper market as a direct unding source. Other short-term unding,

such as repurchase agreements, also became unavailable at that time. Hence, manysuch as repurchase agreements, also became unavailable at that time. Hence, many

fnancial institutions aced severe liquidity problems, which eventually promptedfnancial institutions aced severe liquidity problems, which eventually prompted

the large-scale interventions by the Federal Reserve.the large-scale interventions by the Federal Reserve.

The eect on corporate commercial paper was less severe. Still some issuersThe eect on corporate commercial paper was less severe. Still some issuers

switched to alternative long-term fnancing, mostly as a response to growing uncer-switched to alternative long-term fnancing, mostly as a response to growing uncer-

tainty regarding the commercial paper market. For example, on March 3, 2009,tainty regarding the commercial paper market. For example, on March 3, 2009,

Coca Cola announced that it had sold $0.9 billion o fve-year and $1.35 billion oCoca Cola announced that it had sold $0.9 billion o fve-year and $1.35 billion o

ten-year notes to repay its maturing commercial paper. In the process, it agreed toten-year notes to repay its maturing commercial paper. In the process, it agreed to

pay 4.875 percent to replace short-term debt with an average yield o 0.41 percent.pay 4.875 percent to replace short-term debt with an average yield o 0.41 percent.

This swap amounted to about $48 million in extra annual interest on every $1 bil-This swap amounted to about $48 million in extra annual interest on every $1 bil-

lion borrowed and used to replace commercial paper. Similarly, in February 2009,lion borrowed and used to replace commercial paper. Similarly, in February 2009,

the largest U.S. health insurer by enrollment—WellPoint—sold $1 billion o fve-the largest U.S. health insurer by enrollment—WellPoint—sold $1 billion o fve-

year and ten-year notes at rates as high as 7 percent to repay its commercial paper year and ten-year notes at rates as high as 7 percent to repay its commercial paper

with an average yield o about 2 percent. Also, General Electric Co. cut its fnancing with an average yield o about 2 percent. Also, General Electric Co. cut its fnancing

arm’s commercial paper borrowing by about a third, to $60 billion, as part o a planarm’s commercial paper borrowing by about a third, to $60 billion, as part o a plan

to reduce its overall debt (Keogh, Detrixhe, and Coppola, 2009). Overall, the sub-to reduce its overall debt (Keogh, Detrixhe, and Coppola, 2009). Overall, the sub-

stitution to other debt market instruments can explain a air share o the declinestitution to other debt market instruments can explain a air share o the decline

in commercial paper unding, but probably not all o it.in commercial paper unding, but probably not all o it.

Adverse Selection Adverse Selection

During the fnancial crisis, many issuers ound themselves unable to issueDuring the fnancial crisis, many issuers ound themselves unable to issue

any commercial paper at all, regardless o the interest rate oered. For example,any commercial paper at all, regardless o the interest rate oered. For example,

during the decline in asset-backed commercial paper, Moody’s Investor Servicesduring the decline in asset-backed commercial paper, Moody’s Investor Services

(2007b) reported that “programs [conduits] ound it difcult or impossible to issue(2007b) reported that “programs [conduits] ound it difcult or impossible to issue

commercial paper” and that “issuing paper at longer maturities was unavailable.”commercial paper” and that “issuing paper at longer maturities was unavailable.”




Similarly, ater the Lehman’s bankruptcy, theSimilarly, ater the Lehman’s bankruptcy, the Wall Street JournalWall Street Journal reported that “thereported that “the

[commercial paper] market all but roze” (Mollenkamp, Whitehouse, Hilsenrath,[commercial paper] market all but roze” (Mollenkamp, Whitehouse, Hilsenrath,

and Dugan, 2009).and Dugan, 2009).

One possible explanation or the sharp decline in the market size is adverseOne possible explanation or the sharp decline in the market size is adverse

selection between commercial paper’s issuers and investors. Suppose that theselection between commercial paper’s issuers and investors. Suppose that the

highest-quality issuers leave the commercial paper market because commercialhighest-quality issuers leave the commercial paper market because commercial

paper spreads rise. This may happen i such issuers could obtain fnancing mostpaper spreads rise. This may happen i such issuers could obtain fnancing most

easily and cheaply elsewhere. As a result, the average quality o the remaining issu-easily and cheaply elsewhere. As a result, the average quality o the remaining issu-

ers o commercial paper would decrease, and assuming that investors could noters o commercial paper would decrease, and assuming that investors could not

tell quality dierences between the remaining issuers, they would urther increasetell quality dierences between the remaining issuers, they would urther increase

their required commercial paper spreads, which would then prompt even moretheir required commercial paper spreads, which would then prompt even more

issuers to drop out. I this cycle continued, it could lead to a complete market reezeissuers to drop out. I this cycle continued, it could lead to a complete market reeze

(Akerlo, 1970).(Akerlo, 1970).

It is surely plausible that adverse selection can explain some o the decline inIt is surely plausible that adverse selection can explain some o the decline in

the commercial paper market; nonetheless, it is difcult to test or its presence inthe commercial paper market; nonetheless, it is difcult to test or its presence in

this context because adverse selection primarily amplifes existing substitution tothis context because adverse selection primarily amplifes existing substitution to

other sources o fnancing. Notably, Covitz, Liang, and Suarez (2009) analyze theother sources o fnancing. Notably, Covitz, Liang, and Suarez (2009) analyze the

type o asset-backed commercial paper issuers that were leaving the commercialtype o asset-backed commercial paper issuers that were leaving the commercial

paper market. They fnd that in the frst weeks o the 2007 crisis, almost all issuerspaper market. They fnd that in the frst weeks o the 2007 crisis, almost all issuers

were aected by the difculties in issuing such paper. Over time, however, it was were aected by the difculties in issuing such paper. Over time, however, it was

mostly the weaker conduits (as measured by the strength o the credit guaranteesmostly the weaker conduits (as measured by the strength o the credit guarantees

provided by their sponsors) that let the market. Assuming that unobservable qual-provided by their sponsors) that let the market. Assuming that unobservable qual-

ity measures are positively correlated with observable quality measures, this fndingity measures are positively correlated with observable quality measures, this fnding

would suggest that adverse selection was less important, especially during the later would suggest that adverse selection was less important, especially during the later

weeks o the crisis in 2007. weeks o the crisis in 2007.

In comparison, preliminary results using data on commercial paper out-In comparison, preliminary results using data on commercial paper out-

standing around Lehman’s bankruptcy suggest that adverse selection was morestanding around Lehman’s bankruptcy suggest that adverse selection was more

important in 2008. In our own work, we fnd that fnancial institutions with largeimportant in 2008. In our own work, we fnd that fnancial institutions with large

drops in their share prices continued to issue commercial paper ater Lehman’sdrops in their share prices continued to issue commercial paper ater Lehman’s

bankruptcy, while fnancial institutions with stable share prices reduced orbankruptcy, while fnancial institutions with stable share prices reduced or

stopped issuing commercial paper. Assuming that the decline in share pricesstopped issuing commercial paper. Assuming that the decline in share prices

is a good proxy or a fnancial institution’s unobserved quality, this fndingis a good proxy or a fnancial institution’s unobserved quality, this fnding

suggests that adverse selection may have amplifed the decline in commercialsuggests that adverse selection may have amplifed the decline in commercial

paper outstanding in 2008.paper outstanding in 2008.

Institutional ConstraintsInstitutional Constraints

Money market unds are supposed to invest only in low-risk securities, andMoney market unds are supposed to invest only in low-risk securities, and

once a security no longer fts into that category, money market unds stop buy-once a security no longer fts into that category, money market unds stop buy-

ing that security. This kind o constraint oers an alternative explanation or theing that security. This kind o constraint oers an alternative explanation or the

decline in commercial paper holdings by a group o institutional investors. More-decline in commercial paper holdings by a group o institutional investors. More-

over, i other investors ace fxed costs o entry into a given market—or example,over, i other investors ace fxed costs o entry into a given market—or example,

because they have to invest in technology and personnel to manage commercialbecause they have to invest in technology and personnel to manage commercial

paper investments—then a decrease in demand by money market unds may not bepaper investments—then a decrease in demand by money market unds may not be

oset by demand rom other investors.oset by demand rom other investors.




Beore the fnancial crisis, many investors in money market unds paid littleBeore the fnancial crisis, many investors in money market unds paid little

attention to the holdings o their unds and instead relied on credit ratings toattention to the holdings o their unds and instead relied on credit ratings to

ensure that money market unds invested in sae assts. Over time, as money marketensure that money market unds invested in sae assts. Over time, as money market

investors searched or higher yields, money market unds responded by increas-investors searched or higher yields, money market unds responded by increas-

ing their holdings o commercial paper because commercial paper oered highering their holdings o commercial paper because commercial paper oered higher

yields than Treasuries. Ater the contraction o the asset-backed commercial paper yields than Treasuries. Ater the contraction o the asset-backed commercial paper

market in 2007, money market unds stopped rolling over asset-backed commer-market in 2007, money market unds stopped rolling over asset-backed commer-

cial paper because it became too risky. For the same reason, money market undscial paper because it became too risky. For the same reason, money market unds

stopped rolling over both asset-backed and fnancial commercial paper aterstopped rolling over both asset-backed and fnancial commercial paper ater

Lehman’s bankruptcy. This decrease in demand by money market unds surelyLehman’s bankruptcy. This decrease in demand by money market unds surely

contributed to the decline in commercial paper.contributed to the decline in commercial paper.

Overall, the decline in commercial paper rom 2007 to 2009 probably aroseOverall, the decline in commercial paper rom 2007 to 2009 probably arose

because the fnancial crisis triggered a reassessment o the riskiness o commer-because the fnancial crisis triggered a reassessment o the riskiness o commer-

cial paper, which then prompted issuers to substitute to other sources o fnancing.cial paper, which then prompted issuers to substitute to other sources o fnancing.

Adverse selection and institutional constraints probably amplifed this eect. Adverse selection and institutional constraints probably amplifed this eect.

More research needs to be done to quantiy the importance and the interactionsMore research needs to be done to quantiy the importance and the interactions

o these explanations.o these explanations.

ConclusionConclusion

The commercial paper market has long been viewed as a bastion o highThe commercial paper market has long been viewed as a bastion o high

liquidity and low risk. But twice during the fnancial crisis o 2007–2009, the com-liquidity and low risk. But twice during the fnancial crisis o 2007–2009, the com-

mercial paper market nearly dried up and ceased being perceived as a sae haven.mercial paper market nearly dried up and ceased being perceived as a sae haven.

Major interventions by the Federal Reserve, including large outright purchases oMajor interventions by the Federal Reserve, including large outright purchases o

commercial paper, were eventually used to support both issuers o and investors incommercial paper, were eventually used to support both issuers o and investors in

commercial paper.commercial paper.

Even though the commercial paper market has experienced disruptions in theEven though the commercial paper market has experienced disruptions in the

past, the fnancial crisis o 2007–2009 was by ar the largest decline in the commer-past, the fnancial crisis o 2007–2009 was by ar the largest decline in the commer-

cial paper market, and in contrast to previous turbulent episodes, it mostly aectedcial paper market, and in contrast to previous turbulent episodes, it mostly aected

commercial paper issued by fnancial institutions. This crisis has also shown thatcommercial paper issued by fnancial institutions. This crisis has also shown that

the Federal Reserve is likely to respond aggressively to such a sudden decline othe Federal Reserve is likely to respond aggressively to such a sudden decline o

the commercial paper market. In act, the scale o the Federal Reserve’s responsethe commercial paper market. In act, the scale o the Federal Reserve’s response

was unprecedented—including a blanket guarantee o money market investment was unprecedented—including a blanket guarantee o money market investment

worth $3 trillion and direct purchases o commercial paper o up to $370 billion. worth $3 trillion and direct purchases o commercial paper o up to $370 billion.

Such large-scale market interventions raise concerns about uture moral hazard oSuch large-scale market interventions raise concerns about uture moral hazard o

commercial paper issuers, independent o whether these guarantees will remaincommercial paper issuers, independent o whether these guarantees will remain

implicit or not. Financial regulation will need to address the negative incentivesimplicit or not. Financial regulation will need to address the negative incentives

generated by the expectation o uture government interventions, either by directlygenerated by the expectation o uture government interventions, either by directly

regulating the risk o commercial paper issuers or by charging issuers or investorsregulating the risk o commercial paper issuers or by charging issuers or investors

or the insurance provided by the government.or the insurance provided by the government.

The commercial paper market is ar rom being ully restored. In all 2009,The commercial paper market is ar rom being ully restored. In all 2009,

the Federal Reserve is still in the process o unwinding its purchases o commercialthe Federal Reserve is still in the process o unwinding its purchases o commercial

paper, the amount o commercial paper outstanding is still quite low, and interestpaper, the amount o commercial paper outstanding is still quite low, and interest




rate spreads on asset-backed commercial paper are still at their historical highs.rate spreads on asset-backed commercial paper are still at their historical highs.

Issuers o commercial paper will remember or some time that commercial paperIssuers o commercial paper will remember or some time that commercial paper

was much riskier than they had originally believed. And investors in commercial was much riskier than they had originally believed. And investors in commercial

paper will remember or some time that commercial paper turned out to be muchpaper will remember or some time that commercial paper turned out to be much

riskier than they had thought. The high level o skepticism on both sides o theriskier than they had thought. The high level o skepticism on both sides o the

market or commercial paper suggests that the market will probably diminishmarket or commercial paper suggests that the market will probably diminish

relative to its size beore the fnancial crisis.relative to its size beore the fnancial crisis.

■ We would like to thank David Autor, Charles Jones, Andrei Shleifer, Timothy Taylor, and

especially Jeremy Stein for helpful discussions and suggestions.

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