The Commercial Paper Crisis

On page 661 of Business, Sixth Canadian Edition, the financial instrument called commercial paper is described. The average consumer doesn't pay much attention to the commercial paper market, but it is very important for business firms because it is where they get short-term funds to support their operations. In the summer of 2007, a crisis developed in the commercial paper market in Canada. To understand why this crisis occurred, we must understand how the commercial paper market operates in Canada, and how it has been affected by the problems in the so-called "subprime mortgage market" in the U.S.

The Canadian commercial paper market. Commercial paper is really an IOU that a company gives to an investor. Commercial paper is sold to investors on the promise that the issuing organization will pay back the principal (plus interest) in the near future (usually 30 or 60 days). In effect, the issuer says something like this: lend my company $99 dollars, and in one month my company will give you $100. So, the investor earns $1 of interest in one month on a $99 loan. Individuals and organizations are the investors that buy commercial paper. They want to put their extra cash into a liquid (and safe) short-term investment that will earn interest until they need the money.

This traditional arrangement has operated for years in Canada and the U.S. with no particular problems. But recently, a new kind of company, called a conduit, has grown up to issue commercial paper to interested investors. A conduit hires investment dealers to sell asset-backed commercial paper (ABCP) notes to interested investors. It then buys income-generating assets such as home mortgages and automobile loans. This income provides returns to investors. Conduits rely on liquidity providers like banks to make money available to them if they need it. Some conduits are backed by Canadian banks, and some are backed by independent business firms like Coventree. In Canada, liquidity providers are obliged to step in and provide money to conduits if there is a major disruption in money markets. But the definition of "major" is very vague. In 2007, the banks decided that even though there were problems in the ABCP market, those problems did not constitute a "major" disruption. As a result, the banks generally refused to provide money to non-bank conduits. These conduits were then unable to pay their investors, and the non-bank commercial paper market "froze up." (In 2007, the ABCP market totalled about $120 billion; $86 billion of that was bank-sponsored and $34 billion was non-bank sponsored).

Baffinland Iron Mines Corp. is typical of investors who discovered they were not going to get their money when they wanted it. The company mines iron ore deposits on Baffin Island and needs money to buy equipment of all kinds to carry on its regular operations. In July 2007, the company bought $43.8 million of ABCP to earn interest on extra cash that it had. In August 2007, some of the proceeds of the ABCP (principal plus interest) that were supposed to be paid to Baffinland were not paid, because the company Baffinland had bought the ABCP from was unable to pay. So, Baffinland had a severe cash shortage which would hinder its exploration activities. Another example is Petrolifera Petroleum Ltd. of Calgary. The company invested about $37 million in ABCP, but when $31 million of the notes came due, they were not paid.

Caisse de dépôt et placement du Quebec has a large exposure to the ABCP securities market (perhaps as much as $13 billion). Other organizations with some exposure include NAV CANADA ($368 million), Ontario Power Generation Inc. ($102 million), and Canada Post ($27 million). Major Canadian banks have exposure, too. In December 2007, the Canadian Imperial Bank of Commerce revealed that it had lost $1 billion in the ABCP market and could lose several billion more before the crisis passed.

These problems have developed in Canada because of big problems in the subprime mortgage market in the U.S.

The U.S. subprime mortgage market. As the name implies, the subprime mortgage market is where people who wouldn't usually qualify for mortgage money are able to get money to buy a house. This market became very active in the U.S. as interest rates dropped sharply beginning in 2001. Suppose the Smith family wants to buy a home, but they have a poor credit rating and can't meet the normal criteria for a mortgage. They get a subprime mortgage where low interest "teaser" rates apply for the first two years, and then the rates rise to market rates for the remaining years of the mortgage. Many of these mortgages were sold during 2003 and 2004. Companies with names like Homeside Lending, Plaza Home Mortgage, and Countrywide started up to sell such mortgages to people like the Smiths. These companies then packaged the subprime loans together with other more traditional loans on credit cards, automobiles, and regular home mortgages, and sold them as collateralized debt obligations (CDOs) to investors. These products were much riskier than traditional commercial paper, but investors typically didn't know that.

When people with subprime mortgages started defaulting in 2006 because they couldn't afford the higher interest rates, the subprime market collapsed. As the number of Americans defaulting on their mortgages surged further in 2007, foreclosures increased and the returns that normally would have been earned on these mortgages dropped sharply. And since the subprime mortgages were included in commercial paper that was sold to investors, the conduits couldn't pay their investors as they had promised. Gradually, investors became aware that subprime mortgages were being packaged together with other, lower-risk debt, and they became suspicious of all commercial paper. When that happened, investors refused to "roll over" their ABCPs (i.e., they wouldn't agree to keep their money in the ABCP for another 30 or 60 days) because they felt that it was too risky. That meant that the conduits experienced a sharp decline in the money they had available, so they went to their liquidity providers to get more money. But the liquidity providers argued that the whole ABCP market hadn't seized up (just the non-bank part of the market), so they weren't obliged to provide the conduits with any money. The result was that many holders of commercial paper did not receive their principal and interest when they thought they would.

An obvious question is this: Why did so many individuals and organizations invest in non-bank sponsored commercial paper? They did so because they could get higher interest rates than they could on bank-sponsored commercial paper. As it turned out, the non-bank commercial paper was riskier, but investors didn't know that because they had relied on the rating of ABCP by the Dominion Bond Rating Service (DBRS), the only company that rated non-bank ABCP. U.S. companies like Moody's and Standard & Poor's refused to rate non-bank ABCP because they said that Canada's rules about emergency-funding provisions were very poor and provided virtually no protection for investors. But Moody's and Standard & Poor's are not off the hook, either. The U.S. Congress is investigating their role in the subprime mess. The concern is that these firms gave overly favourable ratings to mortgage-backed securities and also that they were too slow in downgrading their ratings.

Who is really to blame for the subprime mess? There is plenty of blame to go around. Borrowers are to blame because they took out mortgages on homes that they could not afford once the initial "teaser" rates rose to regular market rates. Mortgage brokers are to blame because they helped people with poor credit ratings get mortgage money. Mortgage lenders are to blame because they relaxed their lending rules and began approving mortgages to people who normally would not have been able to get a mortgage. Investment banks are to blame because they facilitated the sale of risky mortgages to investors who didn't know how risky they were. The U.S. Federal Reserveis also to blame because it kept interest rates so low for so long and expressed approval of subprime mortgages. Rating agencies are to blame because they were slow to downgrade certain financial instruments after problems developed in the subprime mortgage market. Investors who relied on the ratings agencies were, therefore, unclear about the level of risk they were buying into. (Note: Unlike common stock, commercial paper is short-term in nature and does not need to be registered and approved with securities regulators like the Ontario Securities Commission or the U.S. Securities and Exchange Commission. Thus, any protection that may have been provided by these agencies was not available to people who invested in commercial paper.)

How will this problem be solved? One solution is to simply convert short-term commercial paper into longer-term debt and then gradually pay off investors. But that ignores the very reason that investors buy commercial paper in the first place (i.e., short-term liquidity). That solution might be acceptable to some individuals and organizations who don't actually need their money right now, and they may be willing to roll over their ABCP. But what about companies like Baffinland that can't do business without the ABCP money they were counting on? Lawsuits have already been filed. For example, Astra Technologies is seeking damages from HSBC Securities because of Astra's purchase of ABCP that is now illiquid.

In December 2007, a group called the Pan-Canadian Investors Committee was formed for the purpose of resolving the commercial paper mess. On December 23, the group announced an agreement to restructure $33 billion of ABCP (i.e., exchange short-term notes for longer-term ones). Purdy Crawford, the chair of the group, said that most companies would likely get all their money back if they held the restructured notes to maturity. But even with an agreement, some companies are having problems. For example, Vancouver-based Strategem Capital holds commercial paper with a face value of $6.5 million, but has written that down to just $3.6 million.

Questions for Discussion

1. Why do investors buy commercial paper? Why did some investors buy non-bank commercial paper?
2. How does the commercial paper crisis demonstrate the risk–return principle?
3. Explain how problems in the U.S. subprime mortgage market caused difficulties in the Canadian commercial paper market.
4. Should Canada's federal government become more involved in regulation of the commercial paper market so problems like the one described above won't happen again?

Sources: "Strategem Issues ABCP Warning," National Post, www.nationalpost.com/story-printer.html?id=209530; Gary Norris, "Financial Rescue Has Holes," Winnipeg Free Press, December 26, 2007, p.B17; David Berman, "Agreeemtn Reached to Restructure ABCP Funds," National Post, www.nationalpost.com/story-printer.html?id=194924; Duncan Mavin, "Subprime Torpedoes CIBC," Winnipeg Free Press, December 7, 2007, p. B1; Matthew McClearn, "The Asset-Backed Commercial Paper Crunch has Burned Investors: Now Lawyer Purdy Crawford is Trying to Sort out the Mess," Canadian Business, November 5, 2007, pp. 130-139; Thomas Watson, "Issues of Trust," Canadian Business, November 5, 2007, pp. 141-147; Aaron Lucchetti and Kara Scannell, "Ratings Firms: A Dollar Short and Day Late?," Wall Street Journal, September 26, 2007, pp. C1-C2; Karen Mazurkewich and John Greenwood, "Caisse Top ABCP Holder," National Post, September 18, 2007, pp. FP1, FP5; Peter Eavis, "Oh, the People You'll Blame," Fortune, September 17, 2007, pp. 118-124; John Greenwood, "Banks Left on Hook in Credit Market Freeze," National Post, September 15, 2007, p. FP7; John Greenwood and Duncan Mavin, "Credit Rout far from Over," National Post, September 12, 2007, pp. FP1, FP13; Jeff Sanford, "How This Happened," Canadian Business, September 10, 2007, pp. 87-88; Doug Alexander, "Banks Feel Heat of ABCP Meltdown," National Post, September 8, 2007, p. FP7; Tara Perkins, "Misguided, or Misunderstood?" Globe and Mail, September 8, 2007, pp. B4-B5; John Greenwood, "ABCP Losses Could Hit 50%," National Post, September 5, 2007, pp. FP1, FP5; Kara Scannell and Deborah Solomon, "Unraveling the Subprime Mess," The Wall Street Journal, September 4, 2007, p. A6; "Mortgage Mayhem," Fortune, September 3, 2007, pp. 82-83; Jon Birger, "Markdown," Fortune, September 3, 2007, pp. 77-78; Shawn Tully, "Risk Returns with a Vengeance," Fortune, September 3, 2007, pp. 51-56; Boyd Erman, "Commercial Paper had Never Suffered for a Lack of Buyers and Sellers—Until Recent Liquidity Concerns Sent Investors Running for the Exits," Globe and Mail, August 25, 2007, p. B2; John Greenwood, "Legal Actions Looming," National Post, August 24, 2007, pp. FP1, FP3; Barbara Shecter, "Greenspan's Rate Cuts Helped Create a Culture of Debt that Ignored Borders and was Ultimately Shunned as Too Risky," National Post, August 18, 2007, pp. FP1, FP4; Sean Silcoff, "Warnings were Issued Well Ahead of Crisis," National Post, August 18, 2007, pp. FP1, FP3; Andrew Willis and Boyd Erman, "Credit Crunch Claims Victim in Canada," Globe and Mail, August 14, 2007, pp. B1, B4; David Wolf, "The Butterfly Market," Canadian Business, August 13/27, 2007, p. 15.

Answers to Questions for Discussion

1. Why do investors buy commercial paper? Why did some investors buy non-bank commercial paper?

   Investors buy commercial paper when they have excess cash that they don't need in the very short term (30-90 days). This cash earns interest that is paid by commercial paper sellers.

   Investors bought non-bank commercial paper because they were promised a higher rate of return than investors who bought bank commercial paper. Unfortunately, investors in non-bank commercial paper did not know that the assets underlying their commercial paper included some high-risk assets like subprime mortgages. They didn't know this because DBRS rates the commercial paper as low risk. It might be argued that these investors should have known that the commercial paper they were buying was riskier than traditional commercial paper simply because they were getting a higher rate of return. But it can also be argued that investors might have simply assumed that the non-bank commercial paper providers were more efficient than bank providers and were passing the savings on to investors in the form of higher rates of return. Consider a parallel situation: credit unions often pay higher interest on GICs than banks do. Does that make credit unions a riskier place to put your money? Perhaps, but many investors put their money in credit unions and very few of them ever lose any money. So, perhaps investors in non-bank commercial paper thought that even though they were promised a higher rate of return, they were not really accepting a higher level of risk. Unfortunately, their assumption proved to be wrong.

2. How does the commercial paper crisis demonstrate the risk–return principle?

   The risk–return principle is described on page 667 of the text. The key point is this: as risk increases, investors demand higher returns to compensate for the increased risk they are taking. This means that investors who are very risk-averse may be willing to invest in GICs even though they will receive only 3 percent or so on their investment because they know there is virtually no chance they will lose their money. In contrast, investors who are risk-seeking may invest in highly speculative common stock and hope for a return of 15 or 20 percent annually. They know they might lose some or all of their money, but their risk preference is such that they are willing to accept the risk in return for the possibility of earning a great deal on their investment.

   The commercial paper crisis demonstrates the risk–return principle because investors in non-bank commercial paper discovered that the higher returns they were promised came with an increased risk that they might lose money (or be unable to get their money when they wanted it). It is not clear whether investors in non-bank commercial paper paid much attention to the risk–return principle when they invested their money. Even if they had, it is not clear that they could have known what kind of assets were underlying the commercial paper they were buying. Most of them probably assumed that the commercial paper they were buying was typical commercial paper, which is usually a safe investment.

3. Explain how problems in the U.S. subprime mortgage market caused difficulties in the Canadian commercial paper market.

   In its most general terms, the problems in the U.S. subprime mortgage market caused difficulties in the Canadian commercial paper market because subprime mortgages were packaged together with less risky loans (for example, car loans and regular home mortgages) in CDOs that were sold to investors. It is not only Canadian investors who had trouble getting back the money they had invested. The problematic CDOs were sold in many different countries around the world.

   The specific mechanism by which the subprime market caused difficulties is described in the case, and parts of that discussion are repeated here for convenience: "The subprime mortgage market is where people who wouldn't usually qualify for mortgage money are able to get money to buy a house. This market became very active in the U.S. as interest rates dropped sharply beginning in 2001. Suppose the Smith family wants to buy a home, but they have a poor credit rating and can't meet the normal criteria for a mortgage. They get a subprime mortgage where unusually low interest "teaser" rates apply for the first two years, and then the rates rise to market rates for the remaining years of the mortgage. Many of these subprime mortgages were sold in 2003 and 2004… When people with subprime mortgages started defaulting in 2006 because they couldn't afford the higher interest rates, the subprime market collapsed. As the number of Americans defaulting on their mortgages surged further in 2007, foreclosures increased and the returns that normally would have been earned on these mortgages dropped sharply. And since these subprime mortgages were included in commercial paper that was sold to investors, the conduits couldn't pay their investors as they had promised. Gradually, investors became aware that subprime mortgages were being packaged together with other, lower-risk debt and they became suspicious of all commercial paper."

4. Should Canada's federal government become more involved in regulation of the commercial paper market so problems like the one described above won't happen again?

   As noted in the case, commercial paper transactions are currently not regulated by securities regulators because they are short term in nature. Suggesting that the federal government should become involved in policing this market means changing a long-standing practice as well as contemplating major changes in the role of government in the financial transactions of a free society.

   There will be two basic types of student answers to this question. Some students will argue that the government should stay out of business activities as much as possible and let the market determine what happens. They will argue that government involvement inevitably leads to distortions in the market which in turn cause all sorts of unintended consequences and motivate individuals to become dependent on government for help instead of helping themselves. Other students will argue that government needs to get much more involved in financial markets because what we have seen during the last decade or so is that greedy and manipulative people in the financial sector are benefiting at the expense of the average investor.

   There is obviously no simple answer to this question, and both viewpoints have some merit. Because there is no simple answer, it is best to ask students to identify the pros and cons of government involvement in a financial market like commercial paper and then determine what steps might be taken to strike a reasonable balance between government involvement and investor freedom.