commercial paper

commercial paper

commercial paper, type of short-term negotiable instrument, usually an unsecured promissory note, that calls for the payment of money at a specified date. Because it is not backed by collateral, commercial paper is usually issued by major firms whose credit-rating is so good that their notes are immediately accepted for trading. The notes are sold at a discount and mature in from three to six months. Commercial paper is an important source of cash for the issuing firm; it supplements bank loans and is usually payable at a lower rate of interest than the prime discount rate. Strictly speaking, it includes only those instruments that are used in commerce in place of money, as distinguished from paper used in investment, personal, estate, speculative, and public transactions. In addition to promissory notes, commercial paper may include drafts, bills of exchange and checks, acceptances, bills of lading, warehouse receipts, orders for delivery of goods, and express orders. See. N. D. Baxter, The Commercial Paper Market (1969); Steve H. Nickles, Commercial Paper (1988).
Commercial paper is an unsecured promissory note with a fixed maturity of one to 270 days. It is usually sold at a discount from face value. It is a money-market security issued by large banks and corporations backed only by their promise to pay the face amount on the date specified on the note. Since it is not backed by collateral, only firms with excellent credit ratings will be able to sell their commercial paper at a reasonable price.

In the money market, commercial paper is a financial instrument that matures before nine months (270 days), and is only used to fund operating expenses or current assets (e.g., inventories and receivables) and not used for fixed assets, such as land, buildings, or machinery. By meeting these qualifications it may be issued without U.S. federal government regulation, that is, it need not be registered with the U.S. Securities and Exchange Commission. Commercial paper is a type of negotiable instrument, where the legal rights and obligations of involved parties are governed by Articles Three and Four of the Uniform Commercial Code, a set of non-federal business laws adopted by each of the 50 U.S. States.

Commercial paper is defined in Canada as having a maturity of not more than one year and is exempt from dealer registration and prospectus requirements.

Commercial paper is an alternative to a line of credit with a bank. Once a business becomes large enough, and maintains a high enough credit rating, then using commercial paper is always cheaper than using a bank line of credit. Nevertheless, many companies still maintain bank lines of credit to act as a "backup" to the commercial paper. In this situation, banks often charge fees for the amount of the line of the credit that does not have a balance. While these fees may seem like pure profit for banks, if the company ever actually needs to use the line of credit it would likely be in serious trouble and have difficulty repaying its liabilities.

Currently, more than 1,700 companies in the United States issue commercial paper. At the end of 2007 there was $1.788 trillion in total outstanding commercial paper. Of which $839 billion was "asset backed" and $846 billion was not ($153 billion of this was issued by non-financial corporations, and $797 billion was issued by financial corporations).

History

Commercial paper, in the form of promissory notes issued by corporations, have 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.

Issuing commercial paper

There are two methods of issuing paper. The issuer can market the securities directly to a buy and hold investor such as most money 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.

Defaults

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

  • June 1970: Penn Central, $82 million
  • :This led to Fed intervention.
  • January 31, 1997: Mercury Finance (a major automotive lender), $17 million, rising to $315 million
  • :Effects were small, partly because default occurred during a robust economy.
  • September 15, 2008: Lehman Brothers
  • :This caused two money funds to break the buck, and led to Fed intervention in money market funds.

See also

Notes and References

External links

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