Think Twice Finance

The Subprime Mortgage Crisis, Part 6: Commercial Paper Gets “Innovative.”

In Part 5, we reported the ultimate financial reality check. Regulators told banks to get rid of the standby Letters of Credit (LCs) that provided 100% protection for the Commercial Paper that has become the dominant means by which corporations finance their short term and increasingly, their longer term, financing needs.

Standby LC’s were gone, but not forgotten. Banks continued to back a percentage of the Commercial Paper obligations with standby LCs. Companies seeking to finance their short term funding needs agreed to provide collateral. (Of course the circumstances in which the commercial paper would be at risk were identical to the circumstances in which the collateral would not stand up, but never mind that.) In any event, the regulators put an end to the all-nude commercial paper review. An innovative g-string was now required. One of the innovations, the one that made the new vehicle dodgy, was that the collateral was off-balance-sheet for the sponsoring bank, and no capital required to support the assets.

Some of us wondered about that. It seemed to us that whether or not the bank was writing little bitty LCs to protect the commercial paper or not, in the event of a collapse of the value of the collateral, the bank would be forced by reputational effects, as well as the fact that the buyers of this commercial paper were often themselves subsidiaries of the bank, to swallow the whole obligation.

Accountants, in particular, were thinking this way. That’s why they took advantage of the Enron legislation, with its mandate to eliminate dodgy investment vehicles like those employed by Enron; to promulgate regulations, FAS 46, that eliminated off-balance-sheet commercial paper vehicles.

“Not so fast!” responded the Federal Reserve, in action eerily reminiscent of the regulation-induced accounting barriers to small bank use of financial futures 25 years earlier. “The commercial paper vehicle is a “necessary service.” Let’s back it with more capital and keep it around.” So a compromise was worked out whereby a third party would provide a “capital cushion” to protect the commercial paper. How much more capital? In most cases, less than 50 cents per $100 of commercial paper. The all-nude review had added pasties.

It is a tribute to journalistic discretion that I have not read a single major newspaper commentary on this sorry regulatory decision.