What’s wrong with commercial paper?

The credit crunch isn’t over and it’s the commercial paper sector that’s prolonging the misery. John Stepek finds out exactly what the problem is.

Is the credit crunch over?

Far from it. Equity markets have rallied a little since mid-August. This rebound was fuelled partly by the Federal Reserve making it cheaper for banks to secure emergency funding by cutting its discount rate (which, despite the name, is usually 1% above the base rate) from 6.25% to 5.75%. As a result, investors are more confident that the Fed will be forced to cut US interest rates as early as its next meeting on 18 September.

However, the Fed's move has still done little to improve the situation in the area of the market causing the main problems: the commercial paper market.

What is commercial paper?

Basically a system of IOUs used by banks and big companies to borrow money for short periods. These loans usually mature within around 60 to 90 days. This market has grown massively over the past five to ten years. Credit ratings agency Moody's reckons that there was $25.8bn of commercial paper loans outstanding in Europe alone in December 1997; by May of this year, $510.9bn was outstanding.

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One of the main benefits for borrowers is that issuing commercial paper is usually cheaper than borrowing from a bank, as the loans are regarded as extremely safe. Those who buy commercial paper include money-market funds, which are generally seen as near-cash investments in terms of their risk profile. The loans are usually rolled over automatically when they reach maturity.

Sounds great. What's the problem?

The main problems are in a sub-sector of the commercial paper market known as asset-backed commercial paper (ABCP), loans backed by assets such as mortgages or credit-card debt. ABCP is mainly held in special investment vehicles (SIVs) or conduits, which are set up by banks, but crucially, are kept off the bank's balance sheet. These SIVs issue short-term commercial paper and use the funds raised to buy assets such as mortgage-backed securities and other debt that matures over a longer period of time. The profits come from the fact that the long-term debt it buys pays a higher yield than it pays out on its commercial paper.

As these vehicles are off balance sheet, they can borrow and invest as much as they want without affecting the sponsoring bank's ability to lend money for other reasons. This area of the market has been booming, now accounting for around $2trn of all the commercial paper outstanding, according to The Economist.

So what's gone wrong?

Subprime mortgages. As markets belatedly realised that giving home loans to people with no incomes, job or assets (Ninja' loans) was a terrible idea for anyone who cares about getting their money back, so investors in ABCP began to panic. The idea that some of the assets backing commercial paper were unsound meant that investors began to demand their money back and refused to keep rolling over the loans. This left SIVs scrabbling to find the money to repay investors.

Why is this bad news for banks?

Even though SIVs and conduits are off-balance sheet, banks are still ultimately responsible for them. One reason why investors had such confidence in these vehicles is that they are sponsored by banks, which are bound to bail them out with emergency credit lines if necessary (although under certain conditions banks can wriggle out of this obligation).

The trouble is, the banks never thought they would be called upon to bail these vehicles out. Now they have, some have been found wanting. German bank IKB (IKB), for example, set up a conduit called Rhineland Funding, which issued $19bn of commercial paper to invest in asset-backed securities. When investors pulled out, it didn't have the money to pay them back and so had to go to IKB for emergency funding. Unfortunately, IKB didn't have the money either, and it fell to its majority shareholder, state-owned bank KfW, to extend an emergency $10.8bn credit line.

More recently, another regional German bank, Sachsen, had to be bailed out under similar circumstances amid losses in vehicles designed for it by Barclays. And it's not just German banks. HBOS (HBOS) recently had to refinance its Grampian ABCP vehicle; HSBC (HSBA) has $40bn in conduits around the world; Lloyds TSB (LLOY) has $25bn; and RBS (RBS) has about $14bn.

When will things return to normal?

It will take a while. Even when investors are prepared to renew loans, it is over shorter periods. The Daily Telegraph suggests that as much as 25% of ABCP in Europe now trades in the overnight markets. In other words, lenders will only lend for a day at a time. A backlog of about $25bn has built up in the system. And as The Economist points out, even if the Fed does cut interest rates, "risky assets are likely to hold much less appeal than they did". So there will be no return to the days of easy money.

How does all this affect me?

The crisis is putting more pressure on banks' balance sheets. According to The Daily Telegraph, Standard & Poor's reckon HBOSs refinancing of Grampian ABCP "knocked 40 basis points from its Tier 1 capital ratio the core measure of a bank's financial strength, which dictates how much money it is allowed to lend". Another problem is that firms that once would have borrowed money on the money markets are having to draw on banking credit lines.

Combined with the funding banks have committed to private-equity deals, which they are having difficulty selling on, the amount of money available to lend elsewhere is being squeezed. That means more costly loans for the rest of us, on everything from mortgages to credit cards.

John Stepek

John is the executive editor of MoneyWeek and writes our daily investment email, Money Morning. John graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news. John joined MoneyWeek in 2005.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.