What Commercial Is - Research Paper Example

Commercial Paper is said to be an unsecured promissory that has a fixed maturity period of one to about 270 days. It is viewed as a money-marketsecurity sold out by large banks and corporations to enable them meet short term debts like payrolls. It is only backed by an issuing bank’s promise to pay the face amount on the maturity of the specific note as they agreed on signing. The only issue that guides this type of transaction is that only those banks with outstanding credit ratings and are recognized by internationally recommended rating agencies have the ability to trade Commercial Papers at reasonable prices (Stephen, 126). It carries shorter repayment dates than bonds and is usually sold at a discount from face value. Interest increases with the increase in the maturity of the promissory note. However, it is notable that interest rates fluctuate at market conditions given that it is these conditions that dictate the interest rates at any moment. Basically, the interest rates are lower than bank rates making it easier for the corporation to pay at better rates. A major benefit of Commercial Paper is that it does not need to be registered with the Securities and Exchange Commission (SEC) as long as it matures before 270 days, making it a very cost-effective means of financing. The proceeds from this type of financing can only be used on current assets (inventories) and are not allowed to be used on fixed assets, such as a new plant, without SEC involvement. That is why, if the funding meets the above qualifications, it can be issued without the involvement of the Federal Government regulation (Stephen, 127). For the most part, Commercial Paper is a very safe investment since the financial situation of a company can easily be predicted over a few months. Furthermore, only companies with high credit ratings and credit worthiness have the capacity to issue Commercial Paper. Commercial Paper is usually issued in denominations of either a hundred thousand dollars or more. Therefore, smaller investors only invest indirectly in Commercial Paper through money market funds. This makes business growth to be predetermined by the type of business that one owns. The more stable the credit status, the higher the chance that the company or premise will acquire a business loan from the bank. Discount rates offered have been found to be very diverse depending on the type of data that and transaction being carried out. term AA Non-Financial A2/P2 Non-financial AA Financial AA Asset-backed 1-day 0.22 0.55 0.24 0.41 7-Day 0.14 0.56 0.72 15-Day 0.18 0.53 0.21 0.36 30-Day 0.20 0.62 0.22 0.32 60-day 0.15 n.a 0.26 0.64 90-day n.a n.a 0.33 0.48 Discount Rates as posted on June 16, 2009 (Federal Reserve Release, June, 2009) There are different ways in which the company can trade in the Commercial Paper. There is the Asset Backed Commercial Paper and the Asset Backed Security. It is clear that the type of funding will depend on the tenure of the Commercial Paper. Asset Backed Commercial Paper (ABCP) is a device used by banks to get operating assets such as trade receivables funded by issuance of securities. Traditionally, banks devised ABCP conduits as a device to put their current asset credits off their balance sheets and yet provide liquidity support to their clients. On the other hand, an Asset-Backed Security is a security whose value and income payments are derived from and collateralized by a specified pool of underlying assets (Dileep, 100). The pool of assets is typically a group of small and illiquid assets that are unable to be sold individually. It therefore depends solely on the premise willing to transact in this type of asset. The Asset Backed Commercial Paper (ABCP) is meant to fund short-term financing needs. It is very convenient for institutions that are in need of short-term loans to assist them go on with their transactions without having to endure long processes involved in the issuance of loans from banks and also having to follow the regulatory prices that are set up by the Federal Government. The institution wishing to involve itself in this type of transaction has to sell its assets to a Bankruptcy-Remote Special Purpose Vehicle created by financial services companies in order to allow them issue an ABCP. This is meant to allow the issuing institution to be legally separated from the Special Purpose Vehicle. The financial assets serving as collaterals for ABCP are ordinarily a mix of many different assets, jointly judged to have low risk bankruptcy by a rating agency. However, recently, many of these assets performed poorly than expected, making buyers much less willing to purchase ABCP. As markets became unwilling to purchase ABCP, the financial institutions that had relied on sales of ABCP to obtain funds for use in long-term investments were in trouble. In particular, the structured investment vehicles set up by some commercial banks financed their long-term, higher-yield investing through sales of ABCP. This had been very profitable when ABCP was considered safe, but forced SIVs to quickly liquidate their long-term investments, at a substantial loss, when they were no longer able to sell ABCP (Dileep, 103). The safe period was considered such that ABCP buyers accepted a low interest rate. This type of transaction has seen tremendous growth in that it has increased its market outstanding since the late 1980s to early millennium. As shown in the graph below, its outstanding has gained popularity especially during the millennium. Graph showing the growth of Commercial Papers (Charles, 127) To trade in this type of transaction, the following procedure can be used to achieve the required end result that benefits all the involved parties. For example, assume Bank A has a client X, whose working capital needs are funded by the bank. If the bank wants to release the regulatory capital that is locked in this credit asset, the bank can set up a conduit, essentially an SPV that issues Commercial Paper. The bank will have to provide some support for the liquidity of the SPV, as it is practically impossible to match the maturities of the Commercial Paper to the realization of trade assets. Thus, the credit asset is moved off the balance sheet giving the bank a regulatory relief. So depending upon whether the bank provides full or partial liquidity support to the conduit, ABCP can be either supported fully or supported partly. ABCP conduits are virtual detachments of the parent bank. If the bank provides full support for the liquidity of the conduit, for regulatory purposes, the liquidity support given by the bank may be treated as a direct credit substitute in which case the assets held by the conduit are aggregated with those of the bank. Not only are ABCP conduits set up by banks, there are also large issuers who set up their own conduits. The best way that a financial institution can engage in this transaction is by consulting with experts in this field. This is because, it has been noted that ABCP carries high risk if not well looked at especially during the market stress days. These stress days come in the form of market value disrupting the underlying assets and causing a reduction. The reduction in market value introduces market risks in the liquidity of the company. The Commercial Paper primarily relies in the strength of the underlying assets to transact normally and for all the parties to be fairly represented in the agreement. The ABCP market will most definitely follow the way of the underlying assets making it venerable to risks. For example, ABCP can be created from any type of asset-backed security, such as student loan asset-backed, credit card asset-backed or residential mortgage asset-backed securities. If significant negative developments in any of the underlying markets are noted, they will affect the perceived quality and risk of ABCP (Charles, 125). Just because investors with the Commercial Paper may be risk reluctant, concerns about ABCP may cause them to seek other short-term, cash-equivalent investments like traditional Commercial Paper and Treasury bills. This means that the ABCP issuers will not be able to roll their ABCP, as they will have no investors to buy their new issuance. Thus the rules that will govern the ABCP programs will have to be adhered to. These rules may sometimes require that liquidation on the assets be done should certain conditions not be met. This is meant to imply that a company could potentially have several large ABCP programs selling their depressed assets at one particular time. This will put even more pressure downward pricing on an equally stressed asset-backed securities market. This is why these rules have to be put in place to ensure the protection of all the investors in the ABCP sector. SIV sponsors may not specifically be liable for the performance of the ABCP issued, but may suffer reputational risk if they do not repay investors. Therefore, a large commercial bank that is involved in a failing SIV may have more incentive to repay investors as opposed to a small hedge fund or investment company specifically set up for this type of arbitrage. It would be seen as bad business if a large, well-known bank let investors, who thought their money was safe in a cash-like asset, lose money on an ABCP investment. This is seen especially when investors sometimes take for granted that what they have purchased has a different set of risks than its predecessors. Often, these risks are not apparent until a financial crunch puts pressure on the market values. ABCP is a Commercial Paper, but under certain market conditions, has characteristics that make it much more risky than traditional Commercial Paper. The asset-backed security kind of transaction on the other hand is derived from a specific pool of underlying assets that has been put aside to be sold to general investors in a process called securitization. This is basically the process by which a structured finance process will involve pooling and re-packaging of cash-flow-producing financial assets into securities. These are then sold out to investors. The term is derived from the fact that the transactions used to obtain funds from the investors will be in the form of securities. This is actually the backbone of this type of transaction as it is concerned with the credit quality of the scrutinized debt as it is non-stationary given the volatility of the time-and-structure-dependent changes (Jason, 123). How this step is handled tells of how the relationship will be: if it is properly handled, it will entail the improvement of the credit risks of all the transactions being carried. This means that the pooled assets have performed as expected and have been structured properly. However, if they are improperly structured, the affected tranches will experience dramatic credit deterioration and loss. A special purpose vehicle (SPV), which is a separate institution, is created to enhance the securitization of the asset-backed securities. The SPV which is meant to create and sell the securities uses these proceeds from the sales to repay the bank from which the underlying assets originated from. This SPV is also responsible for bundling the underlying assets into specified pools and also ensure that they fit in the risk preferences better. The SPV’s are also concerned with laying down the needs of the investors who might want to buy the securities and also how to manage the credit risks often done through the transfer of credit into an insurance company after the repayment of premiums. When it comes to trading the asset-backed securities, the process of issuing the securities in the primary market is similar to that of issuing other securities like corporate bonds and is hence governed by the Securities Act of 1933 and the Securities Exchange Act of 1934 (Jason, 124). They have to be permitted by the Securities and Exchange Commission to operate in the markets. It has to satisfy the under-set conditions and disclosure requirements. It is also required to file periodic financial statements. The process of trading in the secondary markets is mostly done over the counter markets and telephone deals are meant to act on security basis. There are no particular public measures with which to measure the number of dealers involved or the amount of trading volumes that are to be transacted in one occasion. It is noted that most of the asset-backed securities are not liquid and their prices are not transparent. This is explained by the fact that they are not standardized as treasury securities or even mortgage-backed securities. This implies that the investors have to evaluate the different structures, maturity profiles, enhancements of credits and also on the other features of asset-backed security before trading them. Market participants sometimes view the highest-rated credit cards and auto-mobile securities as having default risk close to that of the highest-rated mortgage-backed securities which are reportedly viewed as substitutes for the default risk-free treasury securities (Jason, 125). The main advantage of asset-backed securities is the fact that they bring together a pool of financial assets that otherwise could not easily be traded in the existing form. This is mainly advantageous to the loan originators but is a demerit for the investors. By bringing together these financial assets, it is easier to convert them into instruments that could be used to freely sell in the capital markets. The tranching of these securities into instruments facilitates marketing of the bonds to the investors with different risk and investing time horizons. Selling the pooled financial assets reduces the risk-weighted assets and there-by frees up their capital enabling them to originate more loans in the benefit of the loan originators. They also lower the risks at which the originator of the loan has to pay should the pools not live up to their expectations (Lakhbir, 346). The risks are measured and countered by the risk originator of the last resort given that time to time auctions and other instruments will be used to re-inject the same bad loans held over a longer time duration to the appropriate buyers over a period of time based on the instruments available for the bank. This will enable the bank to carry out its business as per the business charter or the licensing granted to the specific banks. The risk can also be diversified by using the alternate vehicles of investments and alternate division of the bank, depending on the type and magnitude of the risk. This can be sort out by proper securitization process that will ensure the eligibility of the assets and to identify those that may be in need of re-insurance or write-off. This is built on a totality that entails the need to have the banks represented in terms of these deposits and dynamic updating of the same. They are also meant to be adjudged by the financial and diversifiable risks with a contingency for the non-diversifiable risks (Lakhbir, 348). The ability of earning substantial fees from originating and securitizing loans skews the incentives for the originators in favor of loan volume rather than the quality of the loan. It is noted that the bigger and more stable a company is financially the better its chances of obtaining lower credit facilities. It is advisable however that all the interested parties seek expert advice before they can venture into any type of transaction just to make sure that they engage in the correct types of deals. This will also give them an upper hand when it comes to handling losses should market values depreciate (Frank, 60). In conclusion, we can rate the Commercial Paper as a part of transaction that will deal with credit risk but will offer better service to all financially stable companies at cheaper rates. It is noted that the way people transact with the Papers is dependent on the amount of risks they are willing to undertake. It is clearly stated that risks will be observed according to the way securitization of the credits will be done and how accountable the process will be. Therefore, investors stand to lose a lot should they neglect the role of verifying the transactions they involve themselves in. It is also important to note that rating is done to ensure that minimum loss is experienced should the market value depreciate and should the company be forced to repay the loans in the present circumstances. Works cited Charles A., Structures of Asset-Backed Securities: The securitization markets handbook, Michigan: Bloomberg Press, 2005, p.125-130 Dileep R., International Bank Management, Massachusetts: Wiley-Blackwell, 2004, p.100-118 Frank J., Fixed Income Securities, New York: John Wiley and Sons, 2002, p.59-65 Frank J., Investing in Asset-Backed Securities, New York: John Wiley and Sons, 2001, p.56-60 Jason H., Securitization of Financial Assets, New York: Aspen Publishers, 2005, p.123-128 Lakhbir H., Salomon Guide to Mortgage-Backed Securities and Asset-Backed Securities, New York: John Wiley and Sons, 2002, p.346-350 Stephen G., Accounting and Disclosure Rules: Financial instruments and institutions, New York: John Wiley and Sons, 2007, p.126-130 Federal Reserve release (of 15th June, 2009), Commercial Paper ratings and outstanding. 6 June 2009 < http://www.federalreserve.gov/releases/cp/> Read More