Is CP heading for a credit crunch?

CP BACKSTOP FACILITIES

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Bankers and regulators are keeping a close eye on the commercial paper market, which performs a vital short-term financing role for companies and financial institutions. In recent weeks there have been a spate of emergency drawdowns of back-up credit lines, which are provided by banks as liquidity facilities in the event that borrowers are unable to issue or roll over CP.







View graph.

These back-ups are generally priced at below-market levels, in the expectation that they will not be drawn, and banks have often provided them as loss-leaders to win more lucrative corporate finance business.
In addition, rating downgrades have made it more difficult for several companies to access the CP market and a number of money market funds - an important element in the investor base for high-grade CP - are increasingly nervous about buying corporate paper in the post-Enron environment.
According to the Federal Reserve, outstandings of non-financial CP have fallen by almost $20 billion in the past two months, from a high of over $210 billion to just over $190 billion. Bankers say the numbers could be even higher.

US conglomerate Tyco first drew attention to the potential problem in early February when it found itself frozen out of the CP market and drew down its entire $14.5 billion back-up facility.
Since then, problems in the telecom sector have led Qwest Communications to draw down a large chunk of its $4 billion back-up facility and rumours that other companies such as Sprint, Nortel Networks and Worldcom might follow suit.
Regulators such as the UK's Financial Services Authority have started to voice fears of a possible market risk. Speaking at Euromoney's Bond Investors Congress in mid-February, FSA chairman Howard Davies said: "Questions are being asked as to whether these back-up lines have been priced appropriately for the degree of risk involved."
He added: "Some argue that banks have put these lines in place as a kind of loss-leader to win business but without any serious expectation that they would be used. In the event of any further bout of market nervousness, could there be a destabilizing problem here?"
US regulators appear to be less concerned. The Office of the Comptroller of the Currency says it is keeping an eye on the market but that recent events are what should have been expected at this stage in the credit cycle.
The US CP backstop facility business is dominated by three banks - JPMorgan Chase, Citigroup and Bank of America - with an 85% market share.
According to Loan Pricing Corporation, JPMorgan Chase arranged 46% of all CP backstop facilities in the US in 2001, totalling $178 billion. But the bank's real exposure is far less than this, as much of the credit will have been syndicated to other banks or hedged in the derivatives markets.
At an investor briefing in February, Dina Dublon, chief financial officer at JPMorgan Chase - whose own credit spreads have widened sharply in recent weeks as a result of concerns about lending exposures - forecast that more companies would draw down their credit lines because they were unable to roll over CP.
CP back-up lines are usually priced with an undrawn and a drawn margin. According to Loan Pricing Corporation, the spread between drawn and undrawn margins for triple-B rated borrowers is around 50 to 100 basis points. But this is way too low. In the case of Qwest, its back-up loan was priced at Libor plus 45bp - compared with bond yields for the borrower of around 400bp over treasuries.
Many backstop facilities are negotiable each year. The main renewal period is in the second quarter of the year, and bankers expect a sharp rise in pricing levels for drawn margins. "In many cases the drawn margin has been set at a cosmetic level in favour of the borrower," says one US banker. "Pricing is going to become much more realistic but the extent of the increase will only be clear once the renewal season gets going."
He adds that the fact that companies can walk way from the CP market and access credit from the banks proves the system works. "What would be a real cause for alarm is if borrowers were being locked out of the CP market and had no place to go for funding," he says. "That is not the case - people have access to the loan markets, the bond markets and the asset-backed securities markets, and there is not going to be a credit crunch. Even if they have to pay a higher price to term out their funding, most borrowers will see that access to credit at times like this is more important than price."
But others say there are structural factors at work. "The dynamic of this part of the market has changed," says Tom Okel, head of corporate syndicated capital markets at Banc of America Securities. "The biggest disconnect is that when these facilities are drawn, it is usually because something is going wrong within the company. That is not the way they were priced and structured, and we are now going to see much tighter structures to protect lenders and much higher utilization premiums."
In the February 19 edition of the firm's Global Credit Strategist report, CSFB analysts outlined what they described as a "horror movie scenario".
It goes like this: "Buyers of second-tier (A-2/P-2) paper flee the market, forcing borrowers to drawn on back-up lines of credit, as Qwest did last week. Buyer resistance extends to top-tier (A-1/P-1) CP. Banks lay off the incremental credit risk in the default swaps market, forcing spreads even wider. Banks spreads widen in response, prompting banks to pull in their horns further. A generalized credit crunch ensures, provoking a vicious circle of credit troubles."
The CSFB analysts were quick to point out that this was unlikely. "There is nothing - repeat, nothing, on the visible horizon to suggest that it is occurring at the moment," the report stated.
But, in the current jittery environment, people are starting to ask questions. And recent events serve as a reminder that the CP market can shrink, that companies must ensure that they have access to credit and liquidity come what may, and that banks do not find themselves proving emergency credit at cheap rates just when it is at its riskiest.

Abigail Hofman:

No. 6: If you don’t give it to me you’ll only lend it to someone else and look where that got us

Is CP heading for a credit crunch?

CP BACKSTOP FACILITIES

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