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Vanishing Commercial Paper A Symbol Of Credit Woes

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I'm sure this is bad news but how / can this affect us this side of the pond?

I know that there were issues with Barclays etc. Is this linked?

A response from one of you "experts" would be much appreciated.

LINK

NEW YORK (Reuters) - The U.S. commercial paper market shrank again last week and has lost 11 percent of its value in just a month, according to Federal Reserve data showing credit markets remain troubled.

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I'm sure this is bad news but how / can this affect us this side of the pond?

I know that there were issues with Barclays etc. Is this linked?

A response from one of you "experts" would be much appreciated.

LINK

Well, no-one else has had a go so I will - I am a partial expert on some bits of this but not all of them, perhaps some of the various hedge fund managers and structurers on the forum can fill the gaps and make corrections.

Banks and large credit-worthy companies often need to borrow money over a short period of time. By a short period, I mean overnight, for a week, a month and up to a few months at most. Because they are big and stable and have been highly rated by credit rating companies such as Moody's, S&P and Fitch, there's plenty of people out there who are willing to lend to them. Over the years, an informal market for this lending has grown up and now most, if not all, banks participate as do some non-financial companies. When a bank borrows money in this way, it is said to issue commercial paper - confusingly, the story is told from the bank's point of view rather than the more obvious way which would be to say 'fred bloggs insurance gave Barclays an overnight loan'. Interest is paid on the loan of course and it does vary a bit from deal to deal. An averaged out version of the rate between banks is calculated by the BBA (http://www.bba.org.uk) and is called the London Interbank Offered Rate (LIBOR). Other countries have similar indexes.

When an organisation issues commercial paper, it goes into the company's accounts as a debt, just like any other. In the case of a bank, this uses up some of its regulatory capital (the cash it has to have to hand to meet liabilities in case of economic turbulence) which is obviously, from the bank's point of view, a bad thing since all banks like to think they can use all the money they can get efficiently. There's a limit to how much debt they are allowed to have on the balance sheet and that pisses them off.

At some point, someone had a bright idea. They figured that, if they were to set up a new company (referred to as a SIV or SPV) who's sole function was to borrow short term money by issuing commercial paper and invest it long term in low risk assets such as bonds, mortgage backed securities, packages of loans make to private equity firms and the like, they could make a profit at the same time as keeping it out of their accounts (aka off their balance sheet). The commercial paper issued by these companies is called Asset Backed Commercial Paper (ABCP).

There was just one catch though, in order to persuade people to lend money to the new firm, it had to have a very good credit rating and the only way to achieve that was to have the bank make a commitment to provide funds should the new company not be able to repay the people who lent it money for some reason. Over the last few years, that requirement has been watered down somewhat and some of these ABCP issuers have limited or no commitments from parent companies although I think that's still a minority in terms of total cash.

All of this was rolling along nicely until a short while ago when a load of American poor people (and it was almost entirely poor people I'm afraid) found that they had no hope in hell of paying their mortgages. At first, the financial companies tried to pretend nothing was wrong but, eventually, some of the financial instruments created out of packages of sub-prime mortgages started to fall apart - i.e. the interest payments stopped being made. In the old days, this would probably have played out quite quickly since most of the debt would have been held by a small number of easily identifiable firms who would have promptly gone best. No though, we have all these things called CDOs which have packaged up the bad debts and spread them all over the world. This was thought to be a good thing in that it meant the pain of any big bust would be shared around. In reality, it's turned out to be a bad thing as no-one knows for sure who's holding it.

Anyway, back to commercial paper. Two problems have emerged. Firstly, no-one's quite sure who's holding the toxic waste so no-one wants to lend money to anyone they're not totally sure about. Secondly, the banks who thought they were being so clever by getting debt off their balance sheets and into SPVs, suddenly find that they're being called on to meet their funding commitments to these companies who can no longer find anyone to flog their ABCP to. In the case of two German Banks (IKB and Saschen) the amount of money they had to provide to their SPVs effectively bankrupted them. In the case of HBOS, the amount they had to cough wasn't enough to put them in danger but it must have hurt.

Overall then, banks are suddenly finding it much harder to raise short term cash by issuing CP at the same time as finding themselves on the hook for funding commitments to companies that issue ABCP. On top of this, there are also quite a number of ABCP issuers with lesser backing that are finding that they have to sell their assets at a knockdown price so as to be able to repay loans coming due - that's what Barclays were involved with on behalf of some of their clients. Into all of this have stepped the Federal Reserve and European Central Bank who are deeply worried about a rapid unwinding of this trillion dollar market. So much so, that they're prepared to lend tier 1 banks as much money as they need to keep going whilst things settle down.

The immediate result of all of this is that banks have less money to use for other things. The really big players have not been hit too hard so will probably not pass on much, if any, of the pain to their customers. The lesser banks, e.g. Northern C*ck, are finding it much harder to raise money in any way and have therefore started to raise rates they charge borrowers quite substantially (e.g. more than 1% for some customers).

The medium term result could be that some more banks go bust or get taken over but, since no-one knows who's holding the toxic waste at the moment, it's hard to have any clue who that might be. One thing that is worth saying though is that none of the big clearing banks are showing any signs of being in trouble and, even if they were, you can be absolutely sure the Bank of England would have to bail them out given the catastrophic consequences of letting them fail.

Hope that helps and wasn't too incoherent.

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Hope that helps and wasn't too incoherent.

Thanks, tbatst2000! I didn't know what the connection between the banks and their SIVs and SPVs was - doesn't surprise me that they're essentially an accounting trick. Great post & very coherent!

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nice post tbatst. makes more sense to me now.

but you seem to imply that the major banks will be ok and that lending to the public will continue at current pace.. no HPC here then :unsure::(

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but you seem to imply that the major banks will be ok and that lending to the public will continue at current pace.. no HPC here then :unsure::(

Oh, I wouldn't say that! If all the marginal lenders put up prices or stop lending then there will be less competition and higher prices all around. Also, if fewer people can get mortgages to begin with that's got to help.

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Oh, I wouldn't say that! If all the marginal lenders put up prices or stop lending then there will be less competition and higher prices all around. Also, if fewer people can get mortgages to begin with that's got to help.

true

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Guest DissipatedYouthIsValuable

I have no smartarse comment to make. Thanks.

Edited by DissipatedYouthIsValuable

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Oh, I wouldn't say that! If all the marginal lenders put up prices or stop lending then there will be less competition and higher prices all around. Also, if fewer people can get mortgages to begin with that's got to help.

Yes thanks, a very helpful post indeed.

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All of this was rolling along nicely until a short while ago when a load of American poor people (and it was almost entirely poor people I'm afraid) found that they had no hope in hell of paying their mortgages. At first, the financial companies tried to pretend nothing was wrong but, eventually, some of the financial instruments created out of packages of sub-prime mortgages started to fall apart - i.e. the interest payments stopped being made.

....I understood a lot of these people were not necessarily poor...... sub prime does not always = poor as the UK is about to find out ......and there was a 'suggestion' that a large proportion of these mortgages in the rising IR market were missold in such away that it would have been imposssible for the borrower to succeed in keeping up repayments .....has this suggestion been changed or adjusted....?....... :o:o:o

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tbatst2000, many thanks for your response.

So to try and summarise (to ensure I understand).

Banks lend money between themselves over short periods using LIBOR as the rate and until March these outstanding loans were valued @ $2 trillion. Since the fit hit the shan the amount being borrowed has decreased to $1.98 trillion as no-one is sure if they will be paid back? These loans are called "commercial paper"?

Currently there is $184 Billion on loans overdue.

Because no-one is prepared to lend; liquidity (read as cash flow) is low the FED and Bank of Europe have been lending this money to banks and the rate of borrowing (LIBOR) has gone up so it now costs more when "commercial paper" is borrowed.

The result from all this is any bank (financial institution) that needs liquidity to pay bills, purchase items or lend to others will now be paying a premium and charging that on to their customers hence increased interest rates, arrangement and redemption fees (where possible) on loans / mortgages to the public and commercial entities including Private Equity.

This will also mean that to obtain debt; risk will now be better managed and lending standards improved?

If I understand this correctly ..... ROLL ON HPC!

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This will also mean that to obtain debt; risk will now be better managed and lending standards improved?

If I understand this correctly ..... ROLL ON HPC!

.... and will actively pursue fraud going forward.... we hope..... :lol::lol::P

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....I understood a lot of these people were not necessarily poor...... sub prime does not always = poor as the UK is about to find out ......and there was a 'suggestion' that a large proportion of these mortgages in the rising IR market were missold in such away that it would have been imposssible for the borrower to succeed in keeping up repayments .....has this suggestion been changed or adjusted....?....... :o:o:o

You're right, they certainly aren't all poor and I don't think there are any reliable statistics (at least that I could find) that give the full picture. I based my comment on anecdotal evidence such as this: http://news.bbc.co.uk/1/hi/business/6528387.stm and the general observation of conditions on the ground (I spend several months a year in the US for work purposes and it's clear that the bulk of the repos are happening in the poor areas). It's certainly true that many of these mortgages were criminally miss sold and that the borrowers were 100% sure to default if they couldn't re-mortgage at the end of the various fixed rate and teaser rate periods.

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Banks lend money between themselves over short periods using LIBOR as the rate and until March these outstanding loans were valued @ $2 trillion. Since the fit hit the shan the amount being borrowed has decreased to $1.98 trillion as no-one is sure if they will be paid back? These loans are called "commercial paper"?

Yes, but LIBOR is derived from the average rate at which these loans are made rather than the other way around.

Currently there is $184 Billion on loans overdue.

None of it's overdue AFAIK - that would force banks into receivership - it's just been paid back and not-re-issued as no-one wants to buy it. The amount that's been withdrawn over the last two weeks in 189B, which is about 10% of the total I think (i.e. a lot!).

Because no-one is prepared to lend; liquidity (read as cash flow) is low the FED and Bank of Europe have been lending this money to banks and the rate of borrowing (LIBOR) has gone up so it now costs more when "commercial paper" is borrowed.

The result from all this is any bank (financial institution) that needs liquidity to pay bills, purchase items or lend to others will now be paying a premium and charging that on to their customers hence increased interest rates, arrangement and redemption fees (where possible) on loans / mortgages to the public and commercial entities including Private Equity.

Yes, spot on.

This will also mean that to obtain debt; risk will now be better managed and lending standards improved?

If I understand this correctly ..... ROLL ON HPC!

Well, that would be the logical outcome wouldn't it? I've never found markets to be very logical myself.....

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What rate of interest does the Gov borrow at?

At whatever rate it can sell its bonds for. The BBC has a nice list of current prices:

http://newsvote.bbc.co.uk/1/shared/fds/hi/...ilt/default.stm

The way to interpret this is to look at when the money would need to be repaid (the 'maturity' column) and then check the yield column. The yield is around about what the government would have to offer now if it wanted to borrow money to be repaid on the maturity date. It would do this by issuing new bonds.

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tbatst2000

Thanks for updating my previous post, I think it is now clear.

And thanks for taking the time to explain this to everyone else who wanted clarification.

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