An Example – Commercial Paper

Over the last 2 weeks I have given a brief overview of financial assets and their vital role as the main form of saving in the economy.  I explained that the impact on the economy of saving in this way depends on how the proceeds from the sale of financial assets are used.  They could be used to fund investment; they could be used to fund consumer debt (increasing consumer spending); or they could be used to purchase further assets.

We will look at these dynamics in detail in a future series of posts, but I thought it would be useful to give a concrete example of one financial asset, so I’m going to look at commercial paper (CP).  You may well not have heard of it (or may have heard of it but not really know how it works) and I want to illustrate to you that there’s a lot about financial markets that you don’t know or understand, and that you need to if you are going to understand how the economy as a whole functions.

Commercial paper is a form of short term loan.  A company sells CP on the market, and after a set period of time (usually 270 days or less) has to repay the money with interest.  It is an unsecured loan – if the company defaults on the loan the holder of the paper has no automatic recourse to any asset of the company (unlike, for example, a mortgage, where the bank can repossess your house if you default).  Hence, CP is only issued by large institutions with excellent credit ratings.  It is usually issued in denominations of $100,000.  As you can see we’re talking big money here, and at time of writing there is nearly a trillion dollars outstanding in the US and half a trillion in Europe.  That’s a lot of wealth/saving, and how it is used will have a major impact on the economy.

Originally, commercial paper would literally have been a piece of paper – an official promissory note, endorsed by the company.  The paper stated a face value and a date, and the company would pay the owner of the paper its face value on that date.  The company would sell the note for less than the face value, so the purchaser made a profit when the paper was redeemed (equivalent to interest, although its more usual to talk of the yield on the asset).  But the paper purchaser could also sell the paper before the due date (at a discount on its face value) to someone else, who would then collect the debt from the company.

These days, of course, this is all done digitally, but the name “commercial paper” has stuck.  And CP remains a highly “liquid” form of asset – meaning it is very easy to find a buyer (whether you are a company issuing CP, or a holder of CP who wants to sell the asset on).

Although CP is offered for short periods, companies will offer the paper as part of a continuous rolling programme, so the debt is continually renewed by new issues of paper.  Why not just take out a long-term loan?  The short-term nature of the debt avoids the need to register with the Securities and Exchange Commission (SEC) in the US, where most CP is issued, which benefits both buyers and sellers.  The companies also have to pay a lower rate of interest than they would on a long-term debt, but carry the risk that there is no guarantee that they will continually find buyers for their commercial paper.  On the other side, those saving in commercial paper receive a lower rate of interest than they would for a long-term loan, but it is attractive to investors who do not want their wealth tied up long-term.

Having access to your funds is called liquidity.  You may be very wealthy, but if your wealth is tied up in assets that may take a long-time to sell then if you have an emergency need for cash you could go bankrupt before you can “liquidise” (i.e. sell) your assets.  Assets that can be bought and sold easily are liquid assets, and liquidity comes at a price.  Hence, long-term loans have a higher rate of interest than short-term loans because the lender’s liquidity becomes tied up in the long-term loan.  CP is so liquid it is known as a “cash equivalent”.  Institutions with cash pools running into billions do not want to leave this money in bank accounts.  Aside from the low interest rate, the deposit insurance only covers a measly $100,000, so bank accounts are not seen as a safe option when you have “spare cash” in the billions.

I mentioned that by having a continuous rolling programme of CP, companies benefit from lower interest rates (and less regulation) but run the risk of not finding a buyer for future issues.  In normal times this risk is negligible, but in the financial crash the commercial paper market froze – all part of the credit crunch, and all part of the mess that the Federal Reserve Bank had to sort out quickly, or the economy would have choked through lack of credit.

And what are the proceeds of CP used for?  Typically, you would think of CP funding purchase of inventory and filling the gap until invoices are paid.  Hence, it is a form of saving that would typically see savings flowing back into the real economy.

CP is also one way that finance companies fund car loans.  The company then sells these loans on to other finance companies, so they make their profit not on the repayments by the consumer, but by selling the loans on (and repaying the CP with the proceeds from this sale).  This is just the start of a chain of transactions, in which the loans are structured into asset-backed securities (ABS) and then into collateral debt obligations (CDO), which are sold to money market mutual funds.

Okay, I may have lost you there.  If you want, you can read about it on page 12 of this excellent Federal Reserve Bank Staff Report on “shadow banking”.  I just wanted to illustrate that commercial paper forms part of a wider system of assets that can transform a simple car loan into a tradeable asset (a security).

Throughout this series of posts I have continually demonstrated that the saving of one participant in the economy does not necessarily increase national saving – it all depends on how those savings are put to use.  Financial assets are the most significant way that saving is channelled back into the real economy.  If we want to understand whether whether the saving and wealth of society are being used in the most effective way to enhance productivity, such that we can provide enough for everyone, then we need to understand this system.

But it is so poorly understood – by academics, economists and politicians – that they actually refer to it as being in the shadows – “shadow banking”.  And don’t worry, I don’t expect you to understand it as a result of this post!  I just wanted to use a concrete example to illustrate the importance of financial assets and their operation in the economy.  If you’ve grasped the basics of CP and got the picture of a more complex world, that’s enough for now.

But having said that we need to understand how these systems operate in the real world, this marks the end of this series of posts that is dealing purely with concepts using abstract models.  We’re now going to start looking at the real world, but I hope a grasp of these concepts will help you understand the significance of what we are looking at.  Before we move on, I’m going to post a summary of everything so far next week, and the week after we’ll start looking at money and banking in the real world.

It will start getting easier, and a lot more interesting.