Meltdown 101: What Is Commercial Paper, And Why Does It Matter?

By MARK JEWELL, AP Business Writer

BOSTON (AP) – Why is the commercial paper market so pivotal to easing the credit crunch that the Federal Reserve announced Tuesday it will intervene to prop up the market? The Associated Press offers some insight based on interviews with experts:

A: It’s a low-cost source of cash for companies to meet short-term financial needs. A key advantage is that it’s cheaper than tapping a line of credit from a bank. The market really began to grow in the 1970s with the emergence of money-market mutual funds that became large buyers of commercial paper.

A: The big and financially sound firms that typically issue commercial paper have plenty of revenue to fund long-term needs. But they also sometimes need short-term cash to cover everything from buying supplies, paying vendors and making payroll, so they turn to the commercial paper market.

When such a firm temporarily has extra cash and wants to get a decent return to offset inflation, it can switch roles and serve as a buyer of commercial paper to make cash available to other companies.

Such borrowing is often unsecured, with no assets serving as collateral. Such transactions are backed by the borrowing company’s high credit ratings and regular cash flow, and expectation that it can make repayment once it receives money due from its own customers. It’s less common, but asset-backed commercial paper can be secured by assets such as consumer loans.

Companies with low credit ratings generally raise cash through bond offerings rather than short-term commercial paper.

A: Commercial paper carries shorter repayment dates than bonds, with maturities running anywhere from overnight to as long as nine months. The longer the maturity, the higher the interest rate. Because of their short maturities, commercial paper is exempt from registering with the Securities and Exchange Commission, which helps keep borrowing costs low. Interest rates fluctuate with market conditions, but are typically lower than banks’ rates.

A: Money-market mutual funds and other funds open primarily to institutional investors buy about 60 percent of the commercial paper in the market, according to Peter Crane, president of fund-tracking firm Crane Data. “Money-market funds are the 800-pound gorilla in the commercial paper market,” Crane said. By participating, money funds typically generate a higher yield than from investing in safer government debt such as Treasury bills.

A: While commercial paper is still generally a safe investment, its risks were highlighted last month as a large money-market fund called the Reserve Primary Fund “broke the buck” – meaning the value of its underlying assets fell below $1 for each investor dollar put in. Investors were exposed to losses after the fund conceded that $785 million it had invested in debt of Lehman Brothers became worthless after the investment bank’s bankruptcy. That instance, and the broad turmoil in markets, have made investors wary of even the smallest risk that a borrower may default.

The commercial paper market has shrunk to about $1.6 trillion in outstanding borrowing, down from $2.2 trillion in July 2007. Institutional investors in money-market funds, such as pension funds, have led the pullout. Over the four-week period ended Friday, assets in so-called “prime” money-market funds investing in commercial paper dropped by more than $514 billion, or about 25 percent, according to fund-tracking firm iMoneyNet. Meanwhile, reflecting a shift to security, assets in money-market funds investing in government debt gained $380 billion during the same four weeks.

A: The flight of money funds and other participants from commercial paper has left companies facing higher interest rates to raise short-term cash, especially for borrowing with repayment periods of weeks or months rather than days. That means they must rely on higher-cost credit from banks, or forgo borrowing at all.

Consequently, as the freeze persists, companies could have to scramble to find cash for short-term needs. The Federal Reserve’s move Tuesday to begin buying three-month unsecured and asset-backed commercial paper directly from eligible companies is intended to head off such problems.

“Until last week, the word of a company like Chevron or Toyota was good enough for the commercial paper market,” said Crane, of Crane Data. “It still is, but investors are demanding a premium, and the money-market funds are having to deal with forced liquidations, and panic outflows.”

Crane and Ben Garber, an economist with Moody’s Investors Service, said they have not yet heard of instances of major companies being unable to meet short-term obligations because of the freeze in the market. But such instances would likely begin to crop up in coming weeks, absent any catalyst to thaw the market, they said.

“The odds of a company like Chevron or IBM not being able to meet payroll is ridiculously low, but after a while it might become an issue,” Crane said. “It’s like you’re an ocean liner approaching an iceberg. You have to adjust your course from a long way off to avoid hitting it.”

On the Net:

Information about the commercial backed paper market:

U.S. Federal Reserve: http://www.federalreserve.gov/releases/cp/about.htm

Commercial Paper Issuers Working Group: http://www.cpiwg.org

(Copyright 2008 by The Associated Press. All Rights Reserved.)