# Commercial paper

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Commercial paper, in the global financial market, is an unsecured promissory note with a fixed maturity of not more than 270 days.

In finance, unsecured debt refers to any type of debt or general obligation that is not protected by a guarantor, or collateralized by a lien on specific assets of the borrower in the case of a bankruptcy or liquidation or failure to meet the terms for repayment. That differs from secured debt such as a mortgage, which is backed by a piece of real estate.

A promissory note, sometimes referred to as a note payable, is a legal instrument, in which one party promises in writing to pay a determinate sum of money to the other, either at a fixed or determinable future time or on demand of the payee, under specific terms.

In finance, maturity or maturity date refers to the final payment date of a loan or other financial instrument, at which point the principal is due to be paid.

## Contents

Commercial paper is a money-market security issued (sold) by large corporations to obtain funds to meet short-term debt obligations (for example, payroll), and is backed only by an issuing bank or company promise to pay the face amount on the maturity date specified on the note. Since it is not backed by collateral, only firms with excellent credit ratings from a recognized credit rating agency will be able to sell their commercial paper at a reasonable price. Commercial paper is usually sold at a discount from face value, and generally carries lower interest repayment rates than bonds due to the shorter maturities of commercial paper. Typically, the longer the maturity on a note, the higher the interest rate the issuing institution pays. Interest rates fluctuate with market conditions, but are typically lower than banks' rates.

As money became a commodity, the money market became a component of the financial market for assets involved in short-term borrowing, lending, buying and selling with original maturities of one year or less. Trading in money markets is done over the counter and is wholesale.

A security is a tradable financial asset. The term commonly refers to any form of financial instrument, but its legal definition varies by jurisdiction. In some jurisdictions the term specifically excludes financial instruments other than equities and fixed income instruments. In some jurisdictions it includes some instruments that are close to equities and fixed income, e.g., equity warrants. In some countries and languages the term "security" is commonly used in day-to-day parlance to mean any form of financial instrument, even though the underlying legal and regulatory regime may not have such a broad definition.

A corporation is an organization, usually a group of people or a company, authorized to act as a single entity and recognized as such in law. Early incorporated entities were established by charter. Most jurisdictions now allow the creation of new corporations through registration.

Commercial paper – though a short-term obligation – is issued as part of a continuous rolling program, which is either a number of years long (as in Europe), or open-ended (as in the U.S.). [1]

## Overview

The use of commercial paper has been adopted by every state in the United States except Louisiana. [2]

At the end of 2009, more than 1,700 companies in the United States issued commercial paper. As of October 31, 2008, the U.S. Federal Reserve reported seasonally adjusted figures for the end of 2007: there was $1.7807 trillion in total outstanding commercial paper;$801.3 billion was "asset backed" and $979.4 billion was not;$162.7 billion of the latter was issued by non-financial corporations, and $816.7 billion was issued by financial corporations. [3] Asset-backed commercial paper (ABCP) is a form of commercial paper that is collateralized by other financial assets. Institutional investors usually purchase such instruments in order to diversify their assets and generate short-term gains. Outside of the United States the international Euro-Commercial Paper Market has over$500 billion in outstandings, made up of instruments denominated predominately in euros, dollars and sterling. [4]

## History

Commercial credit, in the form of promissory notes issued by corporations, has existed since at least the 19th century. For instance, Marcus Goldman, founder of Goldman Sachs, got his start trading commercial paper in New York in 1869. [5] [6]

## Issuance

Commercial paper – though a short-term obligation – is issued as part of a continuous significantly longer rolling program, which is either a number of years long (as in Europe), or open-ended (as in the U.S.). [1] [7] Because the continuous commercial paper program is much longer than the individual commercial paper in the program (which cannot be longer than 270 days), as commercial paper matures it is replaced with newly issued commercial paper for the remaining amount of the obligation. [8] If the maturity is less than 270 days, the issuer does not have to file a registrations statement with the SEC, which would mean delay and increased cost. [9]

There are two methods of issuing credit. The issuer can market the securities directly to a buy and hold investor such as most money market funds. Alternatively, it can sell the paper to a dealer, who then sells the paper in the market. The dealer market for commercial paper involves large securities firms and subsidiaries of bank holding companies. Most of these firms also are dealers in US Treasury securities. Direct issuers of commercial paper usually are financial companies that have frequent and sizable borrowing needs and find it more economical to sell paper without the use of an intermediary. In the United States, direct issuers save a dealer fee of approximately 5 basis points, or 0.05% annualized, which translates to $50,000 on every$100 million outstanding. This saving compensates for the cost of maintaining a permanent sales staff to market the paper. Dealer fees tend to be lower outside the United States.

## Line of credit

Commercial paper is a lower-cost alternative to a line of credit with a bank. Once a business becomes established, and builds a high credit rating, it is often cheaper to draw on a commercial paper than on a bank line of credit. Nevertheless, many companies still maintain bank lines of credit as a "backup". Banks often charge fees for the amount of the line of the credit that does not have a balance, because under the capital regulatory regimes set out by the Basel Accords, banks must anticipate that such unused lines of credit will be drawn upon if a company gets into financial distress. They must therefore put aside equity capital to account for potential loan losses also on the currently unused part of lines of credit, and will usually charge a fee for the cost of this equity capital.

• High credit ratings fetch a lower cost of capital.
• Wide range of maturity provide more flexibility.
• It does not create any lien on asset of the company.
• Tradability of Commercial Paper provides investors with exit options.

• Its usage is limited to only blue chip companies.
• Issuances of commercial paper bring down the bank credit limits.
• A high degree of control is exercised on issue of Commercial Paper.
• Stand-by credit may become necessary

## Commercial paper yields

Like treasury bills, yields on commercial paper are quoted on a discount basis—the discount return to commercial paper holders is the annualized percentage difference between the price paid for the paper and the face value using a 360-day year. Specifically, where ${\displaystyle dy_{CP}}$ is the discount yield, ${\displaystyle P_{f}}$ is the face value, ${\displaystyle P_{0}}$ is the price paid, and ${\displaystyle t}$ is the term length of the paper in days:

${\displaystyle dy_{CP}=({\frac {P_{f}-P_{0}}{P_{f}}}).{\frac {360}{t}}}$

and when converted to a bond equivalent yield (${\displaystyle bey_{CP}}$):

${\displaystyle bey_{CP}=({\frac {P_{f}-P_{0}}{P_{0}}}).{\frac {365}{t}}}$ [10]

## Defaults

Defaults on high quality commercial paper are rare, and cause concern when they occur. [11] Notable examples include:

• On June 21, 1970, Penn Central filed for bankruptcy under Chapter 7 of the U.S. Bankruptcy Code and defaulted on approximately $77.1 million of commercial paper. This sparked a runoff in the commercial paper market of approximately$3 billion, causing the Federal Reserve to intervene by permitting commercial banks to borrow at the discount window. [12] This placed a substantial burden on clients of the issuing dealer for Penn Central’s commercial paper, Goldman Sachs. [13]
• On January 31, 1997, Mercury Finance, a major automotive lender, defaulted on a debt of $17 million, rising to$315 million. Effects were small, partly because default occurred during a robust economy. [11]
• On September 15, 2008, Lehman Brothers caused two money funds to break the buck, and led to Fed intervention in money market funds.
• In case of default, the issuer of commercial paper (large corporate) would be debarred for 6 months and credit ratings would be dropped down from existing to "Default".

## Related Research Articles

Discounting is a financial mechanism in which a debtor obtains the right to delay payments to a creditor, for a defined period of time, in exchange for a charge or fee. Essentially, the party that owes money in the present purchases the right to delay the payment until some future date. The discount, or charge, is the difference between the original amount owed in the present and the amount that has to be paid in the future to settle the debt.

In finance, a bond is an instrument of indebtedness of the bond issuer to the holders. The most common types of bonds include municipal bonds and corporate bonds.

In finance, a credit derivative refers to any one of "various instruments and techniques designed to separate and then transfer the credit risk" or the risk of an event of default of a corporate or sovereign borrower, transferring it to an entity other than the lender or debtholder.

A credit default swap (CDS) is a financial swap agreement that the seller of the CDS will compensate the buyer in the event of a debt default or other credit event. That is, the seller of the CDS insures the buyer against some reference asset defaulting. The buyer of the CDS makes a series of payments to the seller and, in exchange, may expect to receive a payoff if the asset defaults.

A repurchase agreement, also known as a repo, is a form of short-term borrowing, mainly in government securities. The dealer sells the underlying security to investors and buys them back shortly afterwards, usually the following day, at a slightly higher price.

Bond valuation is the determination of the fair price of a bond. As with any security or capital investment, the theoretical fair value of a bond is the present value of the stream of cash flows it is expected to generate. Hence, the value of a bond is obtained by discounting the bond's expected cash flows to the present using an appropriate discount rate.

Floating rate notes (FRNs) are bonds that have a variable coupon, equal to a money market reference rate, like LIBOR or federal funds rate, plus a quoted spread. The spread is a rate that remains constant. Almost all FRNs have quarterly coupons, i.e. they pay out interest every three months. At the beginning of each coupon period, the coupon is calculated by taking the fixing of the reference rate for that day and adding the spread. A typical coupon would look like 3 months USD LIBOR +0.20%.

A mortgage-backed security (MBS) is a type of asset-backed security which is secured by a mortgage or collection of mortgages. The mortgages are sold to a group of individuals that securitizes, or packages, the loans together into a security that investors can buy. The mortgages of a MBS may be residential or commercial, depending on whether it is an Agency MBS or a Non-Agency MBS; in the United States they may be issued by structures set up by government-sponsored enterprises like Fannie Mae or Freddie Mac, or they can be "private-label", issued by structures set up by investment banks. The structure of the MBS may be known as "pass-through", where the interest and principal payments from the borrower or homebuyer pass through it to the MBS holder, or it may be more complex, made up of a pool of other MBSs. Other types of MBS include collateralized mortgage obligations and collateralized debt obligations (CDOs).

A collateralized debt obligation (CDO) is a type of structured asset-backed security (ABS). Originally developed as instruments for the corporate debt markets, after 2002 CDOs became vehicles for refinancing mortgage-backed securities (MBS). Like other private label securities backed by assets, a CDO can be thought of as a promise to pay investors in a prescribed sequence, based on the cash flow the CDO collects from the pool of bonds or other assets it owns. Distinctively, CDO credit risk is typically assessed based on a PD derived from ratings on those bonds or assets. The CDO is "sliced" into "tranches", which "catch" the cash flow of interest and principal payments in sequence based on seniority. If some loans default and the cash collected by the CDO is insufficient to pay all of its investors, those in the lowest, most "junior" tranches suffer losses first. The last to lose payment from default are the safest, most senior tranches. Consequently, coupon payments vary by tranche with the safest/most senior tranches receiving the lowest rates and the lowest tranches receiving the highest rates to compensate for higher default risk. As an example, a CDO might issue the following tranches in order of safeness: Senior AAA ; Junior AAA; AA; A; BBB; Residual.

The bond market is a financial market where participants can issue new debt, known as the primary market, or buy and sell debt securities, known as the secondary market. This is usually in the form of bonds, but it may include notes, bills, and so on.

A structured investment vehicle (SIV) is a non-bank financial institution established to earn a credit spread between the longer-term assets held in its portfolio and the shorter-term liabilities it issues. They are simple credit spread lenders, frequently "lending" by investing in securitizations, but also by investing in corporate bonds and funding by issuing commercial paper and medium term notes, which were usually rated AAA until the onset of the financial crisis. They did not expose themselves to either interest rate or currency risk and typically held asset to maturity. SIVs differ from asset-backed securities and collateralized debt obligations (CDOs) in that they are permanently capitalized and have an active management team.

This article provides background information regarding the subprime mortgage crisis. It discusses subprime lending, foreclosures, risk types, and mechanisms through which various entities involved were affected by the crisis.

The U.S. central banking system, the Federal Reserve, in partnership with central banks around the world, took several steps to address the subprime mortgage crisis. Federal Reserve Chairman Ben Bernanke stated in early 2008: "Broadly, the Federal Reserve’s response has followed two tracks: efforts to support market liquidity and functioning and the pursuit of our macroeconomic objectives through monetary policy." A 2011 study by the Government Accountability Office found that "on numerous occasions in 2008 and 2009, the Federal Reserve Board invoked emergency authority under the Federal Reserve Act of 1913 to authorize new broad-based programs and financial assistance to individual institutions to stabilize financial markets. Loans outstanding for the emergency programs peaked at more than $1 trillion in late 2008." Credit rating agencies (CRAs)—firms which rate debt instruments/securities according to the debtor's ability to pay lenders back—played a significant role at various stages in the American subprime mortgage crisis of 2007–2008 that led to the great recession of 2008–2009. The new, complex securities of "structured finance" used to finance subprime mortgages could not have been sold without ratings by the "Big Three" rating agencies—Moody's Investors Service, Standard & Poor's, and Fitch Ratings. A large section of the debt securities market—many money markets and pension funds—were restricted in their bylaws to holding only the safest securities—i.e. securities the rating agencies designated "triple-A". The pools of debt the agencies gave their highest ratings to included over three trillion dollars of loans to homebuyers with bad credit and undocumented incomes through 2007. Hundreds of billions of dollars' worth of these triple-A securities were downgraded to "junk" status by 2010, and the writedowns and losses came to over half a trillion dollars. This led "to the collapse or disappearance" in 2008–09 of three major investment banks, and the federal governments buying of$700 billion of bad debt from distressed financial institutions.

Commercial Paper Funding Facility (CPFF) was a system created by the United States Federal Reserve Board during the Global financial crisis of 2008 to improve liquidity in the short-term funding markets. The CPFF was created on October 27, 2008 and funded a special purpose vehicle (SPV) that purchased three-month unsecured and asset-backed commercial paper (CP) from eligible issuers. This resulted in greater availability of credit for firms doing business. It worked under the aegis of the Federal Reserve Bank of New York where the NY Fed finances the purchase of highly rated unsecured and asset-backed commercial paper from eligible issuers via eligible primary dealers. The facility expired February 1, 2010. The final CP purchased matured on April 26, 2010. All CP notes purchased were repaid in full.

Commercial Paper Funding Facility (CPFF) was a system created by the United States Federal Reserve Board during the Global financial crisis of 2008 to improve liquidity in the short-term funding markets. The CPFF was created on 27 October 2008 and funded a special purpose vehicle (SPV) that purchased three-month unsecured and asset-backed commercial paper (CP) from eligible issuers. This resulted in greater availability of credit for firms doing business. It worked under the aegis of the Federal Reserve Bank of New York where the NY Fed finances the purchase of highly rated unsecured and asset-backed commercial paper from eligible issuers via eligible primary dealers. The facility expired February 1, 2010. The final CP purchased matured on April 26, 2010. All CP notes purchased were repaid in full.

Securitization is the financial practice of pooling various types of contractual debt such as residential mortgages, commercial mortgages, auto loans or credit card debt obligations and selling their related cash flows to third party investors as securities, which may be described as bonds, pass-through securities, or collateralized debt obligations (CDOs). Investors are repaid from the principal and interest cash flows collected from the underlying debt and redistributed through the capital structure of the new financing. Securities backed by mortgage receivables are called mortgage-backed securities (MBS), while those backed by other types of receivables are asset-backed securities (ABS).

Commercial Paper in India is a new addition to short-term instruments in Indian Money market since 1990 onward. The introduction of Commercial paper as the short-term monetary instrument was the beginning of a reform in Indian Money market on the background of trend of Liberalization which began in the world economy during 1985 to 1990. A commercial paper in India is the monetary instrument issued in the form of promissory note. It acts as the debt instrument to be used by large corporate companies for borrowing short-term monetary funds in the money market. An introduction of Commercial Paper in Indian money market is an innovation in the Financial system of India. Prior to injection of Commercial Paper in Indian money market i.e. before 1990, the corporate companies had to depend upon the crude and traditional method of borrowing working capital from the commercial banks by pledging the inventory of raw materials as Collateral security. It involved more loss of time for the borrowing companies in availing the short-term funds for day-to-day production activities. The commercial paper has become effective instrument for these corporate companies to avail the short-term funds from the money market within shortest possible time limit by avoiding the hassles of direct negotiation with the commercial banks for availing the short-term loans.

An asset-backed commercial paper program is a non-bank financial institution that issues short-term liabilities, commercial paper called asset-backed commercial paper (ABCPs), to finance medium- to long-term assets.

## References

1. Corporate Bonds and Commercial Paper . Retrieved November 21, 2013.
2. Ontario Securities Commission National Instrument 45–106 Archived December 10, 2006, at the Wayback Machine (Section 2.35) Accessed January 30, 2007
3. Federal Reserve. "FRB: Commercial Paper Outstanding" . Retrieved October 31, 2008. Data as of October 29, 2008
4. Moorad Choudhry (December 14, 2011). Corporate Bond Markets: Instruments and Applications . Retrieved November 22, 2013.
5. Recent Events in the Credit and Mortgage Markets and Possible Implications ... Retrieved November 22, 2013.
6. Frank J. Fabozzi, CFA; Pamela Peterson Drake; Ralph S. Polimeni. The Complete CFO Handbook: From Accounting to Accountability . Retrieved November 22, 2013.
7. Stojanovic, Dusan; Vaughan, Mark D. "The Commercial Paper Market: Who's Minding the Shop?" . Retrieved September 23, 2008.
8. U.S. Securities and Exchange Commission, The Financial Collapse of the Penn Central Company, Staff Report of the Securities and Exchange Commission to the Special Subcommittee on Investigations, U.S. Government Printing Office Washington DC 1972, page 272.
9. Ellis, Charles D. The Partnership: The Making of Goldman Sachs. Rev. ed. London: Penguin, 2009. 98. Print.