Tuesday, October 7, 2008

Renewed Interest in "Commercial Paper"!

Photo by friendofdurutti

Finally, the sexy topic of commercial paper has made it onto the front page of the Wall Street Journal! No more hemming and hawing when our students ask for examples of commercial paper--here it is.

Ordinary people no longer use promissory notes as a payment/value device, endorsing notes from payee to payee (as used to be the case in the U.S. and elsewhere). Indeed, I doubt that most ordinary people ever put an endorsement on a check other than the restrictive "for deposit only." The whole notion of commercial paper and negotiation thus seems so artificial to our students, and I've had a hard time convincing myself that teaching the odd intricacies of this system is worth the effort (setting aside the bar examiners' idiotic continuation of testing on this anachronistic material).

Now, the main modern use of the term "commercial paper" has been thrust onto the public stage. Rather than taking short-term loans at the Prime Rate (5.0% or more currently) from a bank, large companies borrow from investors, like money market funds, by issuing promissory notes in exchange for loans, usually payable in 9 months or less, at rates much closer to the Fed's 2.0% target lending rate (thought rates have been elevated, in the 3.0% range, for nearly a month). While the investing market was awash in liquidity, this was a cheaper way to fund operations, leverage results, and have every last penny of a company's capital working at all times. When Reserve Primary Fund " broke the buck" on September 16 by admitting that losses on investments in Lehman Brothers (probably largely in its commerical paper) caused the value of its assets to fall below $1 for every $1 invested in the money market fund, public confidence in the stability and safety of money market funds was rattled, and other money market funds faced something close to a run on the bank as investors yanked money out. The commercial paper market dried up, as the primary investors in the market hoarded cash instead of investing in short-term loans to business, no matter how stable the borrower, because loans of longer than overnight would jeopardize the funds' ability to make funds available to investors who sought withdrawals--besides, who knew which company would be the next to make an ugly announcement about its financial stability and default on its short-term commercial paper loans. Again, in rides the Fed on its white horse, offering to buy commercial paper directly from companies and supply liquidity to this crucial corner of the market. What unprecedented move will we see next from the U.S. Treasury?!

Back to the classroom, though, I wonder if this "commercial paper" (1) actually satisfies the conditions for negotiability in Article 3, (2) actually changes hands more than once, from maker to payee, and (3) whether anyone in the system really cares, as these short-term loans are likely never subject to any payment dispute for which the maker-liability and holder-in-due-course rules would be relevant (they're enforceable payment contracts one way or another, one would think). Anyone have any direct knowledge on any of these points? My bet is that this paper (like the notes associated with home mortgage loans) is generally festooned with caveats and other requirements that violate the "extraneous undertaking" restriction in Article 3, removing the entire affair from the realm of negotiable instruments law. This makes me wonder whether we're really on a fool's errand in continuing to harp on these rules in Payment Systems, Commercial Paper, or whatever else the course might be called elsewhere.

Anyway, the fact that something called commercial paper has grabbed the headlines today makes me feel pretty cool in any event. Thanks, Ben and Hank!

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