The Great Commercial Paper Meltdown of 2007
23 Oct 07
Federal Reserve, Treasury, and major U.S. commercial banks fire the first salvos in the counter-offensive against the deflationary shock waves
The U.S. commercial paper market is a vital source of liquidity that supports a broad range of financial activity and transactions in the economy. But the market encountered severe stresses in the past three months; stresses that had their origins in the extended housing market recession, and the fact that roughly one-third of asset-backed commercial paper outstanding was backed by mortgages on real estate assets.
The primary risk of the commercial paper meltdown, taken in the context of other stresses in the credit markets, is a business cycle recession— with the additional distinct risk of above-average severity—induced primarily by tighter lending conditions, further asset price deflation in the housing market, substantial destruction of bank capital, and a generalized contraction of credit and spending in the economy. Recent aggressive policy action to provide liquidity to the banking system and reduce interest rates in August and September by the Fed has helped. Further downward pressures in the housing market—which depressed the prices of even the most highly rated asset-backed securities in October— still represents a significant threat to the stability of the financial system and the business cycle expansion.
The unclear regulatory and legal status of some commercial paper-backed programs (particularly structured investment vehicles, or "SIVs") exacerbated the crisis of confidence and raises serious questions about the adequacy of regulatory supervision not only in the United States, but also in Europe and other G7 countries. Moreover, the opacity of the asset composition of many commercial paper programs and "conduits," in conjunction with repetitive rating downgrades, generated a general pull-back in investor confidence and trust. The crisis led to a freezing up of rollovers, significant pressure on commercial paper borrowing spreads, and a sharp decline in net issuance of an unprecedented velocity.
The program recently announced by major commercial banks, with an endorsement from the Treasury, to back-stop one area of the commercial paper market (the "SIVs") with a super fund (named "M-LEC") is a financial innovation involving private sector resources that is a step in the right direction: it would unlock liquidity and forestall unnecessary "fire sales" of collateralized financial assets. Private sector innovation needs to be encouraged here. But let there be no mistake about it— the M-LEC proposal is neither a panacea for the severe problems in the credit markets, nor a "bailout" of the banks. No public sector financial resources whatsoever have been committed to this new facility; the additional liquidity for the super fund will come entirely from the private sector.
It seems inescapable that if the M-LEC program is successful at the AAA level of credit rating, then the next logical stop would be to set up a second fund for the AA level, and then progressively work down the credit rating ladders with additional funds to segregate the various tiers of risk. Without sufficient liquidity and a properly functioning market for the securities, it will be impossible to have reliable and differentiated price discovery across risk classes. This is a necessary condition for the orderly recognition of losses by the financial sector. Once the securities markets start to function more normally, financial sector entities need to come clean on their losses. However, this could take a considerable number of months. Instant gratification on financial sector write-offs is not in the cards.
The proposed super fund is only the first span in a multi-span bridge that needs to be constructed jointly by the private sector, the Treasury, and the Fed over the torrent of deflationary forces that have been unleashed. The Treasury and the Fed need to make these points, as well as the risks to the economy, more transparent to the public.
The U.S. commercial paper (CP) market is a vital source of liquidity that supports a broad range of financial activity and transactions in the economy (see "Background on the Commercial Paper Market"). However, this key segment of the financial market encountered some major stresses in August and September; stresses that led to significant pressure on commercial paper borrowing spreads and a sharp decline in net issuance of an unprecedented velocity. The ultimate source of the problem was in the U.S. housing market, where a protracted housing recession—the current housing recession is on track to be the worst since the early 1980s in terms of housing activity—combined with higher borrowing rates and downward pressure on housing prices precipitated significant upward pressure on mortgage delinquencies and foreclosures. Associated downward pressure on mortgage backed securities' credit ratings and prices led to a significant flight to quality, and this contagion spread from mortgage-backed securities to engulf other major areas of the credit markets, including asset-backed commercial paper, jumbo mortgage loans, and less-than-AAA-rated corporate bonds.
Most of the recent stresses in the commercial paper market impacted the asset-backed sector of the CP market. Roughly one-third of this market was backed by mortgages on U.S. real estate assets, which explains why this market was particularly vulnerable. Total commercial paper outstanding dropped by $370 billion from July 25 to September 26, while ABCP dropped $267 billion—accounting for 72% of the decline—and financial paper dropped $86 billion, or about 23% of the decline. As a partial buffer to the meltdown, bank commercial and industrial credit expanded at an accelerated pace of $88 billion.
A decline in commercial paper outstanding of this order of magnitude has not been seen since the Fed started publishing this data in early 2001. The shock to the markets from September 11, 2001 precipitated a drop of $61 billion in one week, but markets recovered thereafter. The crunch in CP credit markets in August and September was several times the order of magnitude of what we saw on September 11, 2001.
In order to put this decline in even better perspective, the peak- (May 9, 2001) to-trough (April 21, 2004) decline in combined CP and bank commercial and industrial credit during the last recession was $408 billion over close to three years. The decline in the same broad measure of total credit was $282 billion in August and September—clearly this decline is of recessionary proportions.
We believe that the roughly $203 billion in financial assets backing the CP programs which were unable to rollover, or did not revert to bank balance sheets, were liquidated at an average discount of perhaps 10–20% to a variety of private investors, including hedge funds and other private equity groups. Most of the assets sold in the past two months were distressed mortgage-backed securities, which accounted for perhaps one-third of the asset-backed CP market. That would have generated gross losses (before fees) of about $30 billion, with perhaps two-thirds of this absorbed by the domestic financial sector. Indeed, the U.S. financial sector reported approximately $30 billion in net losses through mid October, and a substantial share of these losses was connected with mortgage-backed securities and mark-downs on other securities that banks retained on their books. Given the lack of liquidity in many of these markets, and related breakdown of the price discovery mechanism, however, these losses are likely just preliminary estimates.
We estimate that the contraction in non-asset-backed financial CP outstanding was of the order of $79 billion. This, we expect, will show up in a sharp increase in inter-banking lending. Indeed, we saw a very large net increase of about $111 billion in short-term lending by U.S.-based banks to overseas banks in August, particularly banks in Europe.
The SIVs, which also got caught up in the credit crisis whirlpool, are somewhat distinct as they typically raise third-party capital and issue senior debt, and do not necessarily rely on back-stop liquidity support from commercial banks. Commercial paper in this case is only one source of potential funding. The unclear regulatory and legal status of SIVs exacerbates the crisis of confidence and raises serious questions about the adequacy of regulatory supervision not only in the United States, but also in Europe and other G7 countries.
The Risks Are Significant
Just what are the risks associated with this collapse in the commercial paper market? These risks must be evaluated in the context of the generalized tightening of credit conditions and upward pressure on borrowing costs for all but the highest tier of borrowers that we saw in conjunction with the collapse, and would include:
- Further downward pressure on the prices and ratings of mortgage-backed and other asset-backed securities, thereby impairing a significant proportion of bank capital beyond the write-offs that have already been taken.
- A pronounced shift towards risk averse lending, in part due to efforts to preserve and/or rebuild bank capital; thereby disqualifying more home buyers, and exacerbating the downward spiral in the housing market, which is already on track to be the worst cycle since the early 1980s.
- A more generalized tightening of credit conditions that spreads to the business sector, putting a dampening effect on hiring and business capital spending.
- In view of the huge stresses on the federal budget from defense spending, there is little that can be done on the side of fiscal policy to buffer a potential downturn. The absence of substantive fiscal policy levers, unlike the previous recession, increases the downside risk.
The bottom-line is that the primary risk of the 2007 commercial paper meltdown, taken in the context of other stresses in the credit markets, is a business cycle recession, possibly severe, induced primarily by asset price deflation in the housing market, substantial destruction of bank capital, and a generalized contraction of credit and spending in the economy.
Enter the Fed and the Treasury
The Federal Reserve progressively ramped up its response to the crisis in the credit markets in August and September, culminating with a 50-basis-point cut in the target federal funds rate by the FOMC on September 18. This has contributed to some degree to stabilization in the financial markets. Borrowing spreads generally have declined from spikes that we saw in mid-August. In the commercial paper (CP) market, spreads over 3-month T-bills on prime and A2P2 paper have declined by about a percentage point: from 1.83 and 2.55 percentages points respectively at their zenith on August 22, to 0.9 and 1.48 percentage points in the early days of October. On net, prime borrowing costs are now down about 50 basis points from pre-crisis levels in July, while A2P2 costs are now about unchanged. In addition, net issuance of CP has started to show signs of stabilization, with financial paper net issuance picking up, and much smaller reductions in net issuance of asset-backed paper. The upshot is that total CP outstanding, after declining by $370 billion from July 25 to September 26, started to stabilize in early October.
The initial signs of stabilization of the commercial paper market in early October are a welcome development. However, there are still major problems in the much larger mortgage-debt market. Global Insight estimates that within this $10 trillion market, approximately 60% are securitized, or roughly $6 trillion of the total debt outstanding. We estimate that there is as much as $1.2 trillion in securitized sub-prime and Alt-A debt outstanding, with perhaps one-half of this total held by U.S. domiciled financial institutions and other investors. While yield spreads on higher rated securities have improved in recent weeks, spreads on jumbo mortgage loans, low-rated securities and second-lien mortgages have either been flat, or have moved up. The "ABX" discounts (which trades derivative type discounts on various rating tiers of asset-backed debt) across the rating spectrum showed some improvement from the height of the crisis mid-August to early October, but then deteriorated sharply in mid October, with all the rating tiers below AA showing sharp price declines in the middle of the month. The continued price erosion in the bottom tier of the credit rating scale, and renewed downward pressure on A- and AA-rated securities in mid-October—which potentially could further negatively impact several hundred billion dollars of securitized mortgage debt—still poses a significant threat to the capital reserve positions of the financial system, and the general availability of credit to the economy.
The program recently announced by the Treasury department and major commercial banks to back-stop SIV conduits is a financial innovation that is a step in the right direction. The creation of the $100 billion M-LEC super-fund, to be managed by Citigroup, J.P. Morgan, and Bank of America hopefully would unlock liquidity and forestall additional fire sales of collateralized financial assets which carry the risk of further depressing securities valuations and unleashing a vicious downward spiral. Let there be no mistake about it, this proposal is neither a panacea for the severe problems in the credit markets, or a "bail out" of the major banks involved. The deflationary forces that were unleashed in August with the collapse in the commercial paper market and general tightening of credit standards pose significant risks to the sustainability of the business expansion. The M-LEC fund is only the first span in a multi-span bridge that needs to be constructed over the torrent of deflationary forces that have been unleashed.
The banks and the Treasury were correct in addressing the SIV conduits first, since they are the ones that typically do not have a liquidity back-stop— therefore facing the highest degree of roll-over risk—and concentrating on highly rated assets in order to prevent contagion from spreading upwards from the lower rated securities (which has been a major problem in the multi-tiered conduits).
However, the underlying problems in the commercial paper and securitized mortgage market go far beyond the highly rated assets in SIV conduits; the proposed fund would deal with only about 25% of the SIVs outstanding. The M-LEC program, while laudable as a first step, carries significant risk of stranding the less-than-prime-rated securities. But this is exactly where most of the current stresses are concentrated; where is the liquidity going to come from to normalize these markets? It seems inescapable that if the M-LEC program is successful at the AAA level of credit rating, then the next logical stop would be to set up a second fund for the AA level, and then progressively work down the credit rating ladders with additional funds to segregate the various tiers of risk.
The banks and the Treasury also have a fairly major public relations hurdle to overcome, as there is a widespread misperception in the media that the super-fund is some kind of bail out of the banks, particularly the large players. Let there be no mistake about it: this innovation is neither a panacea for the problems in the credit markets, nor a bail-out of the banking system. Rather, it is an innovative approach to provide liquidity and to unlock trading of distressed securities without precipitating a fire sale. Similar to the "Brady" bonds (which had Treasury Secretary Brady's endorsement in the late 1980s as a private sector mechanism for working out the third world debt problems – a mechanism that proved over time to be an enormously successful financial innovation), there are no public sector funds involved whatsoever. Rather, what the Treasury is doing is providing an endorsement and regulatory support of the financial innovation that is needed to mitigate serious systemic risk to the financial system and the economy.
The new M-LEC super-fund approach is fraught with potential risks, especially in view of further downward pressure from the housing market, and associated deflation in the prices of mortgage-backed securities. The Treasury needs to closely coordinate the launching of these funds with the Federal Reserve, as monetary policy needs to be supportive—at least from a macro policy risk minimization perspective—as a necessary condition for success.
On October 18, Standard and Poor's downgraded the ratings on a wide array of mortgage-backed sub-prime and Alt-A bonds, including several relatively highly rated AAA securities. The repetitive downgrades of mortgage-backed securities by the rating agencies over the past year—a corrosive process that is connected with the extended housing recession—has shell-shocked general investor confidence not only in the securities, but the institutions that have been the major deal makers in this business and the rating agencies themselves. Further downgrades of these securities by the rating agencies will undermine efforts to stabilize these markets and boot-strap investor interest in these securities.
Paulson and Bernanke definitely have their work cut out for them over the next several months to keep the recessionary tiger from breaking out of a cage that has been substantially weakened by the recent credit market crunch.
Background on the Commercial Paper Market
Credit outstanding in the commercial paper market was about $2.1 trillion, or roughly 5% of total credit market debt outstanding of $46.6 trillion at the end of 2007:Q2—about the same share as consumer (non-mortgage) credit. While mortgages (29%) and corporate bonds (22%) are much larger as a share of total credit market debt, the share of commercial paper understates the importance of the commercial paper market as a key source of liquidity. Most commercial paper has a very short maturity (i.e. 90 days or under), so this market rolls over much more frequently than mortgages or corporate bonds. This exposes the commercial paper market to roll-over risk, and that is why many programs have back stopped liquidity support typically from a commercial bank.
With respect to the types of commercial paper, on July 26, 2007—just before the crisis hit with full force—the volume of outstanding asset-backed commercial paper (ABCP) was $1.2 trillion, representing about 54% of the total market, while paper issued by financial entities represented 38%, and paper issued by non-financial entities represented 9%. ABCP is a product that is used to purchase financial assets—usually with a longer term to maturity and a yield pick up—with a collateral pledge. The asset distribution of ABCP is roughly 26% in mortgages, 16% in various forms of consumer loans (student loans, credit cards, etc.), 15% in commercial and industrial assets (including trade receivables), 13% in collateralized debt obligations (CDOs), 10% in automotive-related assets, and 20% in other assets. CDO assets are one of the most opaque areas of the commercial paper market; it would probably be safe to assume that the asset distribution of CDOs mirrors the rest of the ABCP market, with mortgage assets representing perhaps one-third, auto and other consumer loans another one-third, and commercial and industrial assets roughly 15%.
The difficulty with understanding the potential ramifications of recent shocks is related to the rapid innovation in the commercial paper market over the past several years, innovation that has driven this lending off the balance sheets of commercial banks in order to economize on capital adequacy requirements and reduce net margins. This led to the development of a variety of programs, called "conduits," including single seller programs (i.e. Ford Motor Credit), multi-seller programs (commercial bank on behalf of a variety of clients), securities arbitrage, and SIVs.
SIVs are distinct, as they typically raise third-party capital and issue senior debt, and do not necessarily rely on back-stop liquidity support from commercial banks. Multi-seller conduits account for about 54% of the volume, while single-seller and arbitrage account for about 16% and 15%, respectively, and SIVs account for about 6%. While the share of SIVs in ABCP is relatively low—representing about $63 billion in ABCP outstanding—there are a variety of other (non-ABCP) financial SIVs outstanding. The estimated total balance sheet of both ABCP SIVs and other SIVs amounts to a substantial $400 billion.
The asset composition of the collateral across CP programs varies widely. For the most part, CP programs invest mainly in highly rated debt. Roughly 92% of credit arbitrage sellers were rated Aaa by Moody's, while 84% of SIV assets were rated either AAA or AA by Standard and Poor's. The complexity of the programs, the varying asset composition, and the various rating tiers within asset classes has rendered these financial entities difficult to understand even for the most sophisticated of investors. As a result, the commercial paper market became particularly vulnerable to a degeneration of investor confidence and trust linked to contagion effects from deteriorating asset quality in the sub-prime and Alt-A mortgage securities market.
By Brian Bethune