Commercial Paper Jim Kelly BA May 12, 2005

What to Expect (all in 20 Minutes) Definition A Brief History The Contemporary Commercial Paper Issuers and Dealers Buyers Credit Ratings Recent Innovations Foreign Markets Concluding Remarks Answer A Few Insightful Questions

What is Commercial Paper? Unsecured, Negotiable Promissory Note Made Payable on a Stated Date Typically Issued at a Discount Short-Term: Maturity of 3 to 270 Days in the U.S. Does Not Require SEC Registration Maturity < 90 Days; Collateral for the Federal Reserve

A Brief History Lesson Colonial Commercial Paper: The Yanks and the Sox (See Map)See Map 1840s: Interest Rates First Published The Reconstruction The Panic of 1907 The Great Depression The Post-War Boom Penn Central Crisis of 1970 Mercury Finance Company Default of 1997

The Contemporary Commercial Paper Market Average Maturity of Commercial Paper = Days Small Secondary Market Most Issuers (At Their Discretion) Continuously Roll Over Debt Sold in Large Denominations Commercial Paper Rates –1½% to 3% Below the Prime Rate –1/8% to ½% Above the T-Bill Rate

Contemporary Market – Recent Growth Explosive Growth in Commercial Paper Outstandings (12% CAGR): –1981: $160B –1991: $530B –2001: $1,530B Federal Reserve CP Statistics Chart of Nonfinancial CP Outstandings

Issuers Finance Companies –GMAC –GE Capital –Ford Motor Credit –Merrill Lynch –JP Morgan –PepsiCo Short-Term Needs and a Very High Credit Rating

Intermediaries Investment Banks and Commercial Bank Holding Companies Place More Than 70% of all CP. The Big Three Investment Banking Firms Are: –Goldman Sachs –Lehman Brothers –Merrill Lynch Underwriting Spread of 5 to 10 Basis Points Internal Sales Forces

Buyers and Consumers CP is a Highly Liquid, Low Risk Asset (See Chart)See Chart Money Market Mutual Funds (1/3 of All CP) Commercial Bank Trust Departments (1/4 of All CP) Industrial Firms Insurance Companies Colleges and Universities Large Corporations

Creditworthiness Credit Ratings Issued by A Credit Agency –Standard and Poor’s –Moody’s –Duff and Phelps –Fitch Almost All Issuers Maintain 100% Backing Through Bank Lines of Credit Credit Enhancements Are Leased from Higher-Rated Firms

Credit Ratings Strong Correlation Between Commercial Paper Debt Ratings and Term Debt Ratings Somewhat Archaic System (Credit Cliff) Term RatingTerm Ratings Outstandings CP RatingCP Ratings Oustandings AAA to A68%Tier-188% A- to BBB20%Tier-27% BBB- and lower 10%Tier-3 and lower 4% Unrated2%Unrated1%

Recent Innovations Asset-Backed Securities –Special-Purpose Entities (SPEs) or Special Purpose vehicles (SPVs) –Moving Assets and Liabilities Off the Corporate Balance Sheet FASB Does Not Require the Disclosure of Off- Balance Sheet Activities Highly Rated Asset-Backed Paper is an Easy Sell “Independence Day” Financed Through CP Tied to Film Receivables

Foreign Markets European Commercial Paper Market –Longer Maturities Due To Different Regulatory Environment –Active Secondary Market –Higher Default Rate –Dealers Play a Much More Active Role Japan France

Concluding Remarks Growth in Commercial Paper Signals Decreasing Role of Commercial Banks in Corporate Financing (See Chart)See Chart Higher Interest Rates Increase Activity No Significant Defaults Since 1970; The Market is Untested Still a High Reliance on the Banking System for Insurance

Questions?