December 2007

Commercial paper: what went wrong?

Why is the commercial paper crisis such a big deal?
Taking stock of an idea gone wrong.

The commercial paper crisis will keep tongues wagging for a while longer. Yet, our portfolios have always included this type of investment. We didn't know and we didn't worry about it. So, what happened?

We all have some

Commercial paper has been around for decades. It's a financial product that's issued by a bank or corporation, generally for short-term financing needs. Banks, for example, issue commercial paper that clients buy for a certain sum of money, with the guarantee that their capital plus interest will be repaid at maturity. In that sense, certificates of deposit, bank drafts and promissory notes are all types of commercial paper.

Investment funds have always been big buyers of commercial paper, which they use as a liquid investment and which they generally renew at maturity. So, through them, chances are we all have commercial paper in our portfolios. Usually, the bank itself backs the paper it issues, but often, the backing consists of debt securities, like mortgages. In such cases, the paper is called asset-backed commercial paper (ABCP). And here's the rub: if the quality of the underlying debt turns out to be poor, major investors become concerned and prefer not to renew their investment at maturity. They ask for their money back - money that the bank no longer has since it's locked up in mortgages. And that's exactly what happened this fall.

Hence, the crisis.

Was too much put on the American consumer's shoulders?

The scope of the crisis can be explained by the considerable amount of ABCP contained in the larger commercial paper category. At the present time, there are more than $2.2 trillion of outstanding commercial paper in the U.S. More than half of that is asset-backed commercial paper.

Why so much ABCP? Let's go back to the beginning of the decade. Financial markets were dropping and the world economy was shaken (except for some emerging countries). However, one noteworthy player - the American consumer - was astonishingly resilient. On its own, the American consumer generated more than 20% of the world's growth, although it represented a mere 4.5% of the population. Credit was cheap and easy to access. So Americans took out sizeable mortgages and, in the process, got extra cash, which they used to spend heavily. For financial institutions, it was only natural to try to tap into this high-growth provider in an effort to give their clients additional points of return over that offered by traditional commercial paper.

But then, with interest rates rising, the exhausted American consumer was finally brought to its knees. What was a good idea in principle had, in reality, become a major risk.

In Canada

Because the mortgage market in Canada is structured differently, Canadian banks are not as directly involved as U.S. banks. In fact, our market is essentially controlled by six big banks and risky loans are rigorously supervised and insured. Mortgage interest is not deductible in Canada, while in the U.S., the interest deductibility and the possibility of financing a property for more than 100% of its value became a double-edged incentive, one that was both irresistible and dangerous.

However, the fact remains that our banks and other financial institutions have been affected in a major way since all of them were actively trading on the attractive ABCP market, looking for a more attractive rate of return than that offered by traditional commercial paper.

As a result ...

At the present time, Canadian financial institutions are evaluating their actual exposure to the ABCP risk. Concerted efforts are being made to restructure the debt and, in time, restore market liquidity and minimize losses.

Most individuals are not direct commercial paper holders. Nevertheless, they should expect to see some of their investment funds, particularly those invested in financial companies, affected by the ABCP turmoil for several quarters. Also, anyone looking for a loan in the foreseeable future will quickly realize that credit conditions are no longer what they used to be. Financial institutions now impose much stricter criteria, and access to credit has tightened.

Having said this, like all other crises, this one can prove to be a good opportunity for the patient investor. A great many stocks are now in a downturn and some experts feel that this may be the right time to start replenishing one's portfolio at low prices.

Just a few weeks away from another RRSP season, this could very well be good news. At least, the idea is an interesting one to discuss together.