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BOARD OF GOVERNORS
□ F THE

FEDERAL RESERVE SYSTEM

Office Correspondence
To_

Chairman Burns

From.

Peter M. Keir

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Snhjprt; Effects of a possible default
by a major corporation on its maturing
commercial paper.

Among the numerous uncertainties recently‘troubling members of

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the U.S. financial community has been the question whether intensified
strains on corporate profits and liquidity have seriously increased the
odds that some major industrial firm or finance company will find it

paper at maturity.

A situation of this type could develop if doubts about

the underlying liquidity and solvency of a particular corporation led
investors to shun new offerings of its commercial paper.

If, at the same

time, the firm’s maturing commercial paper were not fully backed by bank
credit lines, if the firm had already exhausted its own liquidity reserves,
and if no other new source of credit were immediately available, the
corporation could be forced abruptly into receivership.

Apprehension in

market circles about the possible repercussions of such a default has been
heightened because the rapid expansion of outstanding commercial paper
over the past two years -- both in total volume and number of issuers -has raised questions about the general vulnerability of the commercial paper
market to any sudden cooling of investor interest.
This memorandum considers the range of effects that might be
expected to follow from the default of a firm on a significant block of
its maturing commercial paper.

Two types of effects need to be differentiated:

one is the general impact that might develop on attitudes and confidence
throughout financial markets if a major firm went into receivership; the other




t c p fo O ld R Fr Library
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impossible to roll-over a significant block of outstanding commercial

"2"
is the more direct impact on the commercial paper market itself, on closely
related short-term credit markets, and on^the banking System.

Finally,

an important related question is what public policy actions might be taken
to minimize the severity of the second category of efforts.

-

General Impact on Market Confidence
The possible effects of a major corporate bankruptcy on financial

human psychology.

If the firm in question were widely known to be a "swinger"-

for example, a !wheeler-dealer, conglomerate--its default would be less
,
f
likely to generate major secondary repercussions, than the unexpected
default of a major corporation which the public had generally assumed to
be sound--particularly if the latter were in an industry where no major
bankruptcies had occurred since the 1930!s.

In addition, regardless of

the type of firm involved, the response would obviously be much more sen­
sitive to a default that occurred in a period when financial confidence
was already under more strain--due for example to persistently declining
stock prices and general fears of a liquidity crisis--than it would be
when general confidence was less fragile.
Most recently, the relative fragility of securities markets does
appear to have lessened somewhat, and members of the financial community do
seem to be generally aware that several particular industrial firms are pos­
sible candidates for default.

However, there is no guarantee that markets

will continue to become less fragile, and it is difficult to determine what
odds market participants are actually placing on the near-term possibility
of a major corporate bankruptcy.




Photocopy from Gerald R. Ford Libri

confidence are difficult to forecast since they involve a judgement about

-3-

Impact on Short-Term Credit Markets
The key concern of those associated directly with the commercial
paper market is that any default by a major corporate issuer may trigger
an abrupt investor reappraisal of the quality of such paper, with a con­
sequent sharp shrinkage in demand.

Investors have typically been attracted

to commercial paper by its high yield, flexible amounts and maturities, and
In addition, the traditional

back-up with bank credit lines has provided an extra assurance of liquidity.
Given this general investor presumption of soundness and liquidity,
any development that seemed to cast doubt on the underlying quality of
commercial paper could trigger a substantial switch to other short-term in­
vestment alternatives.

Non-financial corporations are estimated to hold

around 70 per cent of outstanding commercial paper, the bulk of the remaining

Photocopy from Gerald R. Ford Librai

the high credit ratings of most issuers.

^

shares being held by life insurance companies, pension and trust funds, colleges
and other non-profit institutions taken together.

Institutions of these

types usually elect to invest their liquidity reserves at high yields only
so long as the assets also have a low risk.

Consequently, if any real

question were to develop regarding the degree of risk involved, they would
probably very quickly decide to accept a lower yield on an asset where the
degree of risk was not in doubt.
The cut-back in demand for commercial paper occasioned by the
changed investor view of underlying quality would, of course, tend to focus
on the paper of issuers about which there might already be some question, as
well as on that of smaller less well-known issuers.

But in any general

backing away from commercial paper, investors might easily overreact




Chairman Burns

-4-

and begin to shun the paper of even well-known issuers as well.

In these

circumstances, firms that were unable to roll over commercial paper at
maturity would be forced to turn to their bank credit lines.

To the extent

an issuer's paper was not fully covered by firm bank lines, it would have
to solicit new bank loans.

In situations where regular bank lenders were

under severe pressure or there was question about the underlying soundness of

trigger further bankruptcies.
Any substantial shrinkage in outstanding commercial paper would
thus create a sharp increase in demands for bank credit.

The banks directly

affected would be forced to bid more aggressively for funds themselves, or
to sell other assets.

Assuming no change in overall monetary policy, the

extent to which the expanded demands for bank credit were also reflected
in added general pressures on short-term credit markets would depend in
part on how the funds that investors had been holding in commercial paper
were reallocated to alternative assets.
To some extent investors might shift from the commercial paper
of industrial corporations and finance companies, directly to new commercial
paper issued by the banks under pressure.

But if bank paper were also viewed

less favorably by investors, the switch would more likely be to U.S. Govern­
ment and Federal agency securities.

Even so, larger flows of funds into

Treasury and agency issues might reduce yields in these markets sufficiently
to make large negotiable C D fs at banks -- even at their existing ceiling
rates -- more competitive with alternative money market instruments.
Freeing up of the CD flow to banks could obviously help considerably to




Photocopy from Gerald R. Ford Library

the commercial paper issuer, bank funds might not be available and this could

-5- minimize the pressure from expanded calls of commercial paper issues on
their bank lines.
The degree friction and illiquidity likely to develop, in
fact, from a sizeable transfer of credit demands from commercial paper to
commercial banks would depend in large measure on how large and how rapid
the shrinkage in commercial paper proved to be.

The experience with large

negotiable CD fs over the past few years suggests that U.S. financial

scale redistributions of fund flows.

Whether another large adjustment

would be absorbed as smoothly in the near-term, given the generally fragile
state of securities markets in recent weeks, is, of course, one of the key
points at issue.
Unfortunately, there is no very recent U. S. example of
a shrinkage in outstanding commercial paper to look to for guidance in
judging how large a shrinkage might develop in present circumstances.

For

this reason, many market analysts tend to look to the Canadian experience
of 1965, following the demise of the Atlantic Acceptance Corporation, as
a possible model.

At the end of 1964, the total volume of Canadian finance

and commercial paper outstanding was approximately $1.3 billion.

By the

end of 1965, following the Atlantic Acceptance failure, outstanding finance
and commercial paper in Canada had declined by around $400 million or
nearly one third.

The lions share of the shrinkage represented a drop in

paper held by non-Canadian investors.

The magnitude of this decline was

clearly exacerbated by the reaction of foreign investors, a situstion
that is fairly typical in Canadian financial markets which are particularly
sensitive to foreign exchange developments and the reactions of foreign
investors, principally U.S. investors.




Photocopy from Omld R. Ford Library

markets generally have the capacity to adjust fairly effectively to large-

-6-

Dintensions of U.S. Commercial Paper Market
As the table suggests, the U.S. commercial paper market is vastly
larger than the Canadian market, but like the Canadian market before the
Atlantic Acceptance Corporation default, the U.S. market has grown very
rapidly over the past year, even if one abstracts from the entry of com­
mercial banks.
Total Commercial and Finance
Paper Outstanding in the
United States
(in millions of $*s; not seasonally adjusted)
April
1969

April
1970

3

Change
Amount
Per cent

s
q!

Total outstanding paper

37,881

24,390

55.3

*

13,491

Amount placed through dealers

13,735

10,076

36.3

3,659

Amount placed directly

24,146E/

14,314

68. 7

9,832

nj
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1

Total of bank-related paper
included above in the total

6,542

200

j / Preliminary.
p
Number of Commercial Paper
Issuers
1967
Number
Percentage
e/ Estimated.




1968

1969 (November)

391

e/
475-

e/
630"

21.5

32. 6

i

If the U. S. market were-to react as sharply to a major nearterm default as the Canadian market in 1965, the commensurate shrinkage
in outstanding paper would amount1to about $11 billion.

This is un­

doubtedly an extreme comparison, given the generally more volatile char­
acter of the Canadian market and the observed sensitivity of U. S. investors
to unfavorable foreign developments when they are investing in foreign
markets.

Nevertheless, the Canadian experience does suggest that a

shrinkage of several billion dollars in outstanding U. S. commercial
paper would be a distinct possibility if the default of a major U. S.
corporation were to result in a failure to roll-over a large block of
maturing paper.
Frictions created by a shrinkage in outstanding U. S. commercial
paper totaling several billion dollars would, of course, tend to be less
troublesome if paper that was not rolled over was for the most part fully
covered by bank credit lines.

A number of the major finance companies

that place their paper directly with investors have substantially less
then full coverage of their outstandings -- in some cases less then 50
per cent.

Similarly, some major industrial corporations that place paper

through dealers are not fully covered by bank lines, although their cover­
age is higher then in the case of the direct placers.

However, small

firms, and firms with lower credit ratings have almost invarially been
required to maintain bank lines at close to 100 per cent of their out­
standings.




- 8 -

Conclusions
On balance, so long as the shrinkage in outstanding paper is
limited to several billion dollars, spread over aboutr the same time period
as the Atlantic Acceptance experience, U. S. financial institutions can
probably respond sufficiently well to the redistribution of funds involved
The Federal Reserve could help facilitate

this result by providing liberal discounting at the Federal Reserve
window*

This could include conduit loan arrangements to banks that were

called upon to lend to commercial paper issuers unable to roll over
maturing issues and without full coverage by credit lines, but which
nevertheless were good credit ratings.
On the broader question whether a major corporate default would
seriously weaken the general confidence of financial markets, the answer
is more difficult.

But this effect could prove to be even more important

than the direct impact on the commercial paper market.




Photocopy from Gerald R. Ford Library

to avoid a serious crisis.


Federal Reserve Bank of St. Louis, One Federal Reserve Bank Plaza, St. Louis, MO 63102