Globe and Mail Update

December 23, 2007 at 6:43 PM EST

The world's eyes have suddenly fallen on what used to be a quiet, but crucial corner of the global financial machinery – the commercial paper market. That's where companies go to get very short-term loans (about 30 days on average) and investors go to park money for similarly short terms. Usually, there are plenty of willing buyers and sellers and everybody's happy. Until the past two weeks, that is, when investors suddenly started to get very nervous about what was backing those loans, and stopped buying.

You probably thought you'd never need to know anything about the market for commercial paper (known to the besuited types who trade it as CP). But apparently you do, so here are five facts.

1. IT'S BEEN AROUND

Commercial paper may be short-term debt, but it's much older than you might think. It appeared in the United States even before the Civil War, a time when banks were small and regional, and transportation networks consisted of little more than mud tracks and river boats.

So when there was a busy lending season for the First National Bank of Podunk, because all the local farmers wanted to borrow money to plant spring crops, the First National Bank of Podunk would start to run out of money, driving up interest rates. (These days, a bank would just borrow from another bank sitting on excess cash, but back then it just didn't work that way. The next bank might be 100 miles up the road, if there was a road.)

So, commercial enterprises in Podunk had a problem, one they solved by skipping the bank entirely and borrowing directly from investors by issuing, in essence, IOUs. Lend me $98 today, they'd say, and I'll give you a piece of paper with a promise to pay you back in a month, along with an extra two bucks for your trouble. Commercial enterprises, plus paper IOUs … and voila: the commercial paper market is born.

2. COMMERCIAL PAPER? IT'S NOT REALLY PAPER

When commercial paper began, and for most of its history, it actually was paper. There were notes, or vouchers, handed from seller to buyer and back again when the loans were redeemed. But as the market got busier, and bigger, such paper transactions got more and more inconvenient.

So for the past 20 years commercial paper has been issued mostly electronically, with computers to keep track of who owns what. Using the electronic system (oddly known as “book-entry,” even though there's really no physical book, either) saves a tremendous amount of time, effort, cost (think of all the courier fees) and, well, paper.

3. THIS WHOLE MESS? IT'S PAUL MARTIN'S FAULT

Haven't been able to say that in a while, have we? Fun, wasn't it? And true, in a tangential sense, because the asset-backed commercial paper market that is giving investors fits owes its existence in large part to Paul Martin's fiscal policy.

Mr. Martin's surpluses in Ottawa meant the government didn't have to issue as much debt in the form of Treasury bills, the short-term investment of choice for many investors. Traditional companies weren't going to step in and issue a whole lot more commercial paper because they are only allowed to sell enough to fund short-term needs.

And financial markets abhor a vacuum or, at least, the financial wizards who can earn fees creating new products abhor a vacuum, so they came up with asset-backed commercial paper to fill the gap left by the missing Treasury bills. In essence, bankers created commercial paper out of thin air. They set up companies known as conduits, filled them with assets such as credit card loans, and sold commercial paper backed by those assets.

4. NOBODY'S WATCHING

Unlike most securities, which have to be registered with regulators like the Ontario Securities Commission and the U.S. Securities and Exchange Commission that have a read of the terms to make sure nobody's hiding any troublesome details before the securities are sold, commercial paper has an exemption because of the short-term nature of the loans and the fact that it is generally sold to sophisticated buyers by companies with solid reputations.

5. WELL, ALMOST NOBODY'S WATCHING

DBRS, a Canadian bond rating company, helped to vet the asset-backed commercial paper sold in Canada by assigning ratings to the issues. And DBRS was alone because other international bond raters declined to put their stamp of approval on almost all Canadian asset-backed commercial paper, saying, in essence, that it was too easy for banks that had pledged to support the market to back out of those agreements (easier than anywhere else in the world, in fact) if things got hairy.

And what happened when the market blew up? The banks, mostly foreign, refused to support the commercial paper, leaving investors on the hook.

Source: http://www.theglobeandmail.com