Commercial Paper – What Are they & Economic Affects
August 30th, 2008 | by admin |
In the United States, the term commercial paper refers to promissory notes that have a fixed maturity of less than two hundred seventy days. These negotiable instruments are issued by corporations or banking institutions in exchange for capital that can be used to meet short term financial obligations such as regular operating expenses. Less expensive than using a bank credit line and normally sold at a discount of face value, commercial paper is an extremely liquid market that is mutually attractive and beneficial to both issuers and investors.
Due to the short time frame, commercial paper is routinely a very safe investment that very few companies default on. However, since commercial paper is typically sold in denominations of one hundred thousand dollars or more, smaller investors must participate through money market funds. A type of mutual fund, money market funds pool money from different sources in order to invest in short term instruments with high yields.
Although commercial paper is required by the Securities and Exchange Commission (SEC) to have terms of less than nine months, the majority of the notes are issued for 30-45 days. Due to the short and favorable credit terms, companies tend to issue commercial paper on a very frequent basis, which contributes to positive economic growth in the United States.
When the market for commercial paper slows, however, it can lead to a multitude of economic problems, including large increases in procurable interest rates, reduced production of goods and services, and loss of income for American companies. In addition, credit shortages often affect the housing, automobiles, and consumer spending industries. However, this type of situation in the commercial paper market seldom occurs and, when it does, the market usually recovers within three months.
Despite the normally secure behavior of these instruments, an adverse event did take place in the commercial paper sector in September 2008. Alongside other credit crisis events in the United States economy, the market for commercial paper uncharacteristically and effectively froze for about twelve hours, leading to a lack of available funds in the short term credit market. As a result, the cost of borrowing rose, and even proven companies with outstanding credit ratings had difficulty acquiring short term loans to pay their rent, payroll, and other bills.
In fact, the size of the commercial paper market shrunk by $110 billion, paving the way for average interest rates to rise from the customary 2% to a much higher 4.5%. The effects of the freeze were widespread and remain ongoing, touching even companies with very dependable cash flows. Since the health of the commercial paper market is absolutely essential to the financial well being and existence of most corporations and financial institutions in the United States, it is important to keep the issuance of affordable short term credit instruments flowing smoothly.