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Prime Rate
Return on
Commercial
Paper
2000 2001
2003 2004
2002
2005
2007
2006
2008
2010
2009
F I G U R E 1 1 . 5
Return on Commercial Paper and the Prime Rate, 1990–2010
Source:
http://www.federalreserve.gov/releases
.
to banks of using commercial paper. Bank holding companies still use commercial
paper to fund leasing and consumer finance.
The use of commercial paper increased substantially in the early 1980s because
of the rising cost of bank loans. Figure 11.5 graphs the interest rate on commercial
paper against the bank prime rate for the period January 1990–February 2010.
Commercial paper has become an important alternative to bank loans primarily
because of its lower cost.
Market for Commercial Paper
Nonbank corporations use commercial paper exten-
sively to finance the loans that they extend to their customers. For example, General
Motors Acceptance Corporation (GMAC) borrows money by issuing commercial
paper and uses the money to make loans to consumers. Similarly, GE Capital and
Chrysler Credit use commercial paper to fund loans made to consumers. The total
number of firms issuing commercial paper varies between 600 to 800, depending
on the level of interest rates. Most of these firms use one of about 30 commercial
paper dealers who match up buyers and sellers. The large New York City money
center banks are very active in this market. Some of the larger issuers of commer-
cial paper choose to distribute their securities with direct placements. In a direct
placement, the issuer bypasses the dealer and sells directly to the end investor. The
advantage of this method is that the issuer saves the 0.125% commission that the
dealer charges.
Most issuers of commercial paper back up their paper with a line of credit at a
bank. This means that in the event the issuer cannot pay off or roll over the matur-
ing paper, the bank will lend the firm funds for this purpose. The line of credit reduces
270
Part 5 Financial Markets
the risk to the purchasers of the paper and so lowers the interest rate. The bank
that provides the backup line of credit agrees in advance to make a loan to the issuer
if needed to pay off the outstanding paper. The bank charges a fee of 0.5% to 1%
for this commitment. Issuers pay this fee because they are able to save more than this
in lowered interest costs by having the line of credit.
Commercial banks were the original purchasers of commercial paper. Today the mar-
ket has greatly expanded to include large insurance companies, nonfinancial businesses,
bank trust departments, and government pension funds. These firms are attracted by the
relatively low default risk, short maturity, and high yields these securities offer. Currently,
about $1.25 trillion in commercial paper is outstanding (see Figure 11.6).
The Role of Asset-Backed Commercial Paper in the Financial Crisis
A special
type of commercial paper known as asset-backed commercial paper (ABCP)
played a role in the subprime mortgage crisis in 2008. ABCPs are short-term secu-
rities with more than half having maturities of 1 to 4 days. The average maturity is
30 days. ABCPs differ from conventional commercial paper in that it is backed
(secured) by some bundle of assets. In 2004–2007 these assets were mostly securi-
tized mortgages. The majority of the sponsors of the ABCP programs had credit rat-
ings from major rating agencies; however, the quality of the pledged assets was
usually poorly understood. The size of the ABCP market nearly doubled between
2004 and 2007 to about $1 trillion as the securitized mortgage market exploded.
When the quality of the subprime mortgages used to secure ABCP was
exposed in 2007–2008, a run on ABCPs began. Unlike commercial bank deposits,
there was no deposit insurance backing these investments. Investors attempted to
sell them into a saturated market. The problems extended to money market mutual
funds, which found the issuers of ABCP had exercised their option to extend the
maturities at low rates. Withdrawals from money market mutual funds threat-
ened to cause them to “break the buck,” where a dollar held in the fund can only
0.5
1.0
1.5
2000
2002
1998
1996
1994
1992
1990
Amount
Outstanding
($ billions)
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