We recently became aware of another academic study involving events surrounding the "Subprime Liquidity Crisis." A paper entitled, "When Safe Proved Risky: Commercial Paper during the Financial Crisis of 2007-2009," written by two Assistant Professors of Finance at the Stern School of Business of New York University, Marcin Kacperczyk and Philipp Schnabl, was recently published in the Journal of Economic Perspectives.
The paper says, "Commercial paper is a short-term debt instrument issued by large corporations. For issuers, commercial paper is a way of raising capital cheaply at short-term interest rates. For investors, commercial paper offers returns slightly higher than Treasury bills in exchange for taking on minimal credit risk. At the beginning of 2007, commercial paper was the largest U.S. short-term debt instrument with more than $1.97 trillion outstanding. Most of the commercial paper was issued by the financial sector, which accounted for 92 percent of all commercial paper outstanding."
It continues, "Commercial paper played a central role during the financial crisis of 2007–2009. Before the crisis, market participants regarded commercial paper as a safe asset due to its short maturity and high credit rating. Two events changed this perception. The first event began to unfold on July 31, 2007, when two Bear Stearns' hedge funds that had invested in subprime mortgages fifi led for bankruptcy. In the following week, other investors also announced losses on subprime mortgages. On August 7, 2007, BNP Paribas suspended withdrawals from its three investment funds because of its inability to assess the value of the mortgages and other investment held by the funds."
The work explains, "Given that similar assets served as collateral for a specific category of commercial paper -- asset-backed commercial paper -- many investors became reluctant to purchase asset-backed commercial paper. The total value of asset-backed commercial paper outstanding fell by 37 percent, from $1.18 trillion in August 2007 to $745 billion in August 2008. Other categories in August 2007 to $745 billion in August 2008. Other categories of commercial paper remained stable during this period."
Kacperczyk and Schnabl write, "The second event occurred on September 16, 2008, when the Reserve Primary Fund -- a large money market fund with $65 billion of assets under management -- announced that it had suffered significant losses on its $785 million holdings of Lehman Brothers' commercial paper. Instead of each of its shares being worth $1 -- a common rule in the money market industry -- the Reserve Fund announced its shares were worth only 97 cents. In other words, the fund 'broke the buck' -- an occurrence that had happened only once before in the history of money market funds."
They continue, "This news triggered the modern-day equivalent of a bank run, leading to about $172 billion worth of redemptions from the $3.45-trillion-worth money market fund sector. The run stopped on September 19, 2008 -- three days after it started -- when the U.S. government announced that it would provide deposit insurance to investments in money market funds. Even though the announcement halted the run on money market funds, most funds nonetheless reduced their holdings of all types of commercial paper because they deemed them too risky. Within one month after the Reserve Fund's announcement, the total value of commercial paper outstanding fell by 15 percent, from $1.76 trillion to $1.43 trillion."
The paper adds, "To stop the sudden decline in commercial paper, the Federal Reserve decided -- for the first time in its history -- to purchase commercial paper directly. The Federal Reserve started purchasing commercial paper on October 26, 2008, and its action promptly stabilized the market. By early January 2009, the Federal Reserve was the single largest purchaser of commercial paper and owned paper worth $357 billion, or 22.4 percent of the market, through a variety of lending facilities. Throughout the year 2009, the Federal Reserve steadily reduced its holdings and by October 2009 it held $40 billion of commercial paper, accounting for 3.4 percent of the market."
Finally, they say, "We will offer an analysis of the commercial paper market during the financial crisis. First, we describe the institutional background of the commercial paper market. Second, we analyze the supply and demand sides of the market. Third, we examine the most important developments during the crisis of 2007–2009. Last, we discuss three explanations of the decline in the commercial paper market: substitution to alternative sources of financing by commercial paper issuers, adverse selection, and institutional constraints among money market funds."
