Chapter 8: Debt Instruments, Markets and Institutions
A. Treasury Securities and Markets
In terms of dollar volume, the U.S. markets for debt instruments are larger than for any
other type of security. Debt markets, including markets for mortgages, are more than twice as large
as stock markets. Debt securities are IOUs issued by a variety of types of organizations, including
federal, state and local governments and their agencies as well as by corporations and other
institutions. Debt securities are sold for the purpose of raising money. A debt security represents a
claim on the issuer for a fixed series of future payments. For example, a debt security might
specify for its owner to receive a stated series of interest payments until the instrument matures.
The instrument may also provide for principal repayment when the instrument matures. These
securities are issued in primary markets and then traded in secondary markets, just as are other
financial instruments. Debt securities will normally specify terms of payment, including amounts
and dates, collateral and priority (who is to be paid first in the event of issuer financial distress).
Among the various types of debt securities are bonds, notes, mortgages and treasury instruments.
Many of the fixed income securities with shorter terms to maturity are considered to be money
The United States Treasury is the largest issuer of debt securities in the world. In 2003, the
Treasury auctioned $3.42 trillion in Treasury instruments. The federal government raises
(borrows) money through the sale of U.S. Treasury issues including Treasury Bills (T-Bills),
Treasury Notes and Treasury Bonds. By purchasing Treasury issues, an investor is loaning the
government money. The United States government has proven to be an extremely reliable debtor
(at least it makes good on all of its Treasury obligations). Treasury issues are fully backed by the
full faith and credit of the U.S. government, which has substantial resources due to its ability to tax
citizens and create money. Thus, these securities have the lowest default risk and are safer than the
safest of corporate bonds or short-term notes.
The treasury obligations with the shortest terms to maturity are Treasury Bills. They
typically mature in less than one year (13, 26 or 52 weeks). These issues are sold as pure discount
debt securities, meaning that their purchasers receive no explicit interest payments. Such pure
discount instruments are also known as zero-coupon issues.
One variation of a T-Bill issue is a so-called Strip, issued through the U.S. Treasury’s
Separate Trading of Registered Interest and Principle Securities (STRIPS) program beginning in
1985. Strips are portfolios of T-Bills sold by the Treasury in blocks with varying maturities. For
example, a block of five strips maturing at the end of a given year in a five-year period may
provide for a payment of $1,000 at the end of a given period. The individual strips can be
"stripped" from the block and sold in secondary markets.
In addition to the short-term pure discount instrument issues discussed above, the Treasury
also offers a number of longer-term coupon issues. For example, Treasury Notes (T-Notes) have
maturities ranging from one to ten years and make semi-annual interest payments. Similarly,
Treasury Bonds (T-Bonds) typically range in maturity from ten to thirty years and make
semi-annual interest payments. These T-Bonds are frequently callable, meaning that the Treasury
maintains an option to repurchase them from investors at a stated price. More than half the
marketable Treasury debt outstanding as of 2000 was in the form of notes, while bills and bonds
each represented about 20 percent.
The United States Treasury also offers non-marketable issues such as Series EE U.S.
Savings Bonds, Series I U.S. Savings Bonds and Series H U.S. Savings Bonds. These savings bonds
are normally issued only to individuals and cannot be traded among investors. Such issues are
often subjected to certain restrictions (such as a $15,000 maximum level of purchases per year).
These bonds can be purchased through most banks and savings institutions, and many businesses
maintain plans through which their employees can purchase savings bonds through payroll
The Treasury Auction Process
In primary markets, T-Bills are sold by the United States Department of the Treasury to the
public through a Dutch auction process managed by the Federal Reserve Bank of New York.
Auctions of three and six month bills are typically announced on Tuesdays, conducted the
following Monday and settled on the following Thursday. There are two ways to purchase T-Bills.
The first is to enter a competitive bid at the auction where the bidding institution competes for a
given dollar amount of the new issue based on how much it is willing to pay. Only the
approximately 2,000 securities brokers and dealers that are registered to operate in the government
securities market are permitted to participate directly in the competitive bidding process.
However, these registered firms may participate on behalf of their clients. Second,
non-competitive bids can be tendered by anyone where the prospective purchaser states how many
bills he would like to purchase at the average price of accepted competitive bids. Competitive
bidders for T-Bills generally enter their bids just before the deadline (1:00 PM Eastern Time) to
participate in the auction. Noncompetitive bids are limited to $5 million and are normally due
before 12:00 noon (Eastern Time) on the day of an auction. Non-competitive bids are satisfied at
the average price of successful competitive bids. The Treasury determines the dollar amount of
competitive bids that it wishes to satisfy by subtracting the face values of the non-competitive bids
from the level of bills that the Treasury wishes to sell. Successful competitive bids are selected by
ranking them, starting with the highest bid. Successful bidders obtain their bills at the prices that
they bid; the lowest bid is referred to as the stop-out price.
Treasury auctions are designed to minimize the cost of the public debt. Many bids at an
auction are entered through TAAPS (Treasury Automated Auction Processing System), an
automated system for processing Treasury auction bids. Consider the following example involving
a Dutch auction of $20 billion in 91-day T-Bills, where the bids (based on yields to maturity) by
financial institutions are given as follows:
Citigroup $2.0 billion at 5.15%
Morgan Stanley $4.5 billion at 5.20%
UBS $5.5 billion at 5.25%
Deutsche Bank $7.5 billion at 5.30%
JP Morgan/Chase $5.5 billion at 5.35%
Bank of America $6.5 billion at 5.40%
Further suppose that individual investors have placed non-competitive bids totaling $2.5 billion.
Obviously, the Treasury wants to sell as many bills as possible at the lowest possible prices. This
results in the lowest yields. The bid-to-cover ratio in this illustration is $34 billion/$20 billion =
1.7. This means that some bids will not be successful. First, the $2.5 billion in non-competitive
bids will be subtracted from the $20 billion total to determine the stop-out price. Bids will be
satisfied from the lowest yield (highest price) until $17.5 billion in bills have been allocated to the
competitive bidders. The stop-out price will be at a yield of 5.30% and all winners (Citigroup,
Morgan Stanley, UBS, Deutsche Bank, non-competing bidders) will pay this same price. Non-
competing bidders will be allocated $2.5 billion and Deutsche Bank will be allocated $5.5 billion.
Secondary Bond Markets and Trading
Highly liquid secondary markets exist for Treasury instruments. Treasuries are normally
traded through decentralized dealer intermediated over-the-counter (OTC) markets. An investor
can easily purchase and sell Treasury instruments through a broker in the OTC Markets.
Transactions costs for Treasury instruments are among the lowest for all securities.
Prices on long-term Treasury bonds are usually quoted as a percentage of par, with trading
in eighths or finer increments. The quoted price of a note or bond is the ‘‘clean price,’’ which
excludes accrued interest. When a transaction is executed, the purchaser must pay the seller the
clean price plus the accrued interest, which is determined by the coupon amount multiplied by the
fraction of the coupon period that has elapsed. On the other hand, Treasury bills are quoted in
terms of the “bank discount rate,” which is the difference between the face value and the market
price as a percentage of the face value, scaled to an annual rate assuming a 360-day year.
B. Agency Issues
The United States federal government has created and sponsored a number of institutions
known as agencies. These agencies enable the government to make funds available for a number
of functions. Among the oldest of these agencies is The Federal National Mortgage Association
(FNMA or Fannie Mae), created in 1938 by the Federal Housing Administration (FHA) to expand
the flow of money to housing markets during the Great Depression. This institution was intended
to spur investment into real estate, improve employment during the depression and to help enable
people to purchase homes. The primary functions of Fannie Mae were to purchase, hold, and sell
FHA-insured (and, after World War II, VA Administration-insured loans) mortgage loans
originated by private lenders. Created with a Congressional charter, FNMA was, until September,
2008, one of the largest privately owned corporations in the United States with shares traded on the
New York Stock Exchange and other security holders as well. However, the institution was taken
over by the Federal Government during the Financial Crisis of 2008.
FNMA facilitates capital acquisition in the mortgage industry through the creation of
mortgage-backed securities, instruments denoting ownership in these pools of mortgages.
Mortgage-backed securities are created by their sponsors who purchase residential mortgages
from banks and thrift institutions and then create debt and other securities backed by pools of these
mortgages. In effect, FNMA purchases the mortgage obligations held by banks and thrifts,
repackages them as debt security portfolios, insures them and re-sells them to the general public.
The funds raised by the sale of these securities are then used to purchase additional mortgages
from banks, increasing capital available to the mortgage and housing markets. These portfolios of
mortgage-backed securities are also called pass- through securities because the interest and
principal obligations associated with the mortgages are passed through to the security holders.
FNMA can obtain money directly from the U.S. Treasury should it need to do so.
The Government National Mortgage Association (GNMA or Ginnie Mae), established by
Congress in 1968 as a “spin off” of FNMA, is a corporation owned by the U.S. federal
government. GNMA guarantees mortgage-backed securities for the FHA (Federal Housing
Administration), VA (Veteran’s Administration) and other agency mortgage issues. Many
mortgages issued by these agencies are targeted towards particular groups such as families in
lower-income brackets or veterans and experience relatively high default rates. The mortgages
issued by these agencies are full faith and credit instruments, meaning that the U.S. Federal
Governments backs them with its full ability to tax and create money.
The Federal Home Loan Mortgage Corporation (FHLMC or Freddie Mac), a
stockholder-corporation created in 1970 by the Federal Government, also creates, insures, services
and sells pass-through securities related to single family and multi-family residential mortgages.
Freddie Mac’s creation was essentially to provide competition to the virtual monopoly enjoyed by
Fannie Mae in the secondary mortgage market due to the federal protections offered to Fannie
Mae. Freddie Mac and Fannie Mae were intended to compete in a “separate but equal” regulatory
framework. Freddie Mac was also taken over by the Federal Government during the Financial
Crisis of 2008.
Another agency, the Student Loan Marketing Association (SLMA or Sallie Mae) creates,
insures and sells pass-through securities related to student loans. While originally created as a
government agency, this company remains a privately-held corporation.
Recent Events in Agency and Other Fixed Income Markets: 2006-2008
The debt markets meltdown of 2006-2008 was by no means entirely due to agency issues
and markets, but these markets did play a particularly significant role. This period was a
tumultuous period in fixed income markets, causing many financial institution failures and
spreading well beyond the banking industry and fixed income markets.
The debt markets meltdown started in the subprime mortgage market in the later part of
2006 and early part of 2007. Costs of distress in this market as of April 2007 were expected to be
substantial, with Federal Reserve System Chairman Ben Bernanke estimating in a July 2007
speech that the crisis could cost between $50 billion and $100 billion. However, after the
September 2008 failure of Lehman Brothers, one of the largest “bulge bracket” investment banks,
the government takeover of Fannie Mae and Freddie Mac, and mergers of distressed financial
firms such as Bear Stearns and Merrill Lynch, Congress passed legislation to grant the Secretary of
the Treasury to acquire and use $700 billion to aid banks and other financial institutions in solving
their liquidity crisis. The Treasury had authority to purchase distressed securities from financial
institutions, generally as the Treasury saw fit.
Subprime mortgage loans are higher-risk home loans extended to borrowers unable to
qualify under traditional more stringent lending criteria due to limited or tarnished credit histories.
Subprime borrowers are generally defined as individuals with limited income, high debt/income
ratios, or having FICO (Fair, Isaac and Company) credit scores below 620 on a scale ranging from
300 to 850. These mortgages are popular investments for investors seeking higher rates of return.
However, as one would expect, subprime mortgage loans have higher rates of default than prime
mortgage loans and are priced based on the risk assumed by the originator. Some estimates (e.g.,
Inside Mortgage Finance) place the sum value of the U.S. subprime market at over $600 billion, or
approximately 20% of the total new mortgage market, up from just 6% from 5 years ago.
The subprime meltdown is rooted in a combination of the U.S. real estate boom and the
2005-2006 U.S. interest rate increases and associated ARM rate increases as borrowers at initially
affordable rates during the real estate boom experienced significant difficulties with the higher
loan rate resets. Lenders extended loans to home purchasers without adequate incomes, assets or
credit checks. Many loans were originated at below market adjustable rates, and then sold to eager
institutional investors seeking to increase investment returns. As ARM interest rates rose due to
rising market rates and due to termination of “teaser rates,” borrower default rates began to rise.
Numerous financial institutions with significant positions in these subprime mortgages,
particularly New Century Financial Corporation and Fremont General Corp. faced substantial
distress. During the past year, approximately 50 subprime lenders nationwide have gone out of
business, primarily because of aggressive purchases or originations of mortgages that investors
were not willing to fund. In addition, the so-called Alternative-A (Alt-A) mortgage sector, which
loans to borrowers with somewhat better credit than subprime borrowers has also started to show
signs of distress. 60-day delinquencies have almost doubled from 2006 rates. Countrywide
Financial has announced that its subprime distress has spread to its prime portfolios. In June 2007,
two Bear Stearns hedge funds with significant positions in the subprime market prepared to shut
down two of its hedge funds.1 Later, United Capital Asset Management announced that it also
would shut down its fund with substantial investment in the subprime market. These
announcements, along with the S&P and Moodys downgrading of hundreds of subprime securities
and the dollar sell off and devaluation has fueled concerns that the subprime mortgage meltdown
will expand. The stock market has also been affected. For example, with many observers have tied
the 2% drop in the DJIA to the subprime mortgage meltdown.
Much of the subprime market distress has been tied to abusive, predatory and even criminal
lending practices by subprime lenders (e.g., teaser rates, hybrid and interest-only mortgages and
risk layering). In his May 17, 2007 speech, Bernanke proposed some combination of four types of
tools for regulators to employ to protect consumers and to promote safe and sound underwriting
First, they [regulators] can require disclosures by lenders that help consumers make
informed choices. Second, they can prohibit clearly abusive practices through appropriate
rules. Third, they can offer principles-based guidance combined with supervisory
oversight. Finally, regulators can take less formal steps, such as working with industry
participants to establish and encourage best practices or supporting counseling and
financial education for potential borrowers.
However, congressional leaders have not been convinced that the Fed has been forceful
enough. For example, House Financial Services Committee Chairman Barney Frank blamed the
Federal Reserve for allowing the abuses that caused the subprime-mortgage market meltdown. He
suggested that Congress should consider taking away the Fed's legal power to write
consumer-protection rules, explaining that the board must "use it or lose it." Meanwhile,
Congressman Spencer Bachus of Alabama has introduced his “Fair Mortgage Practices Act,”
which is intended to curb unscrupulous lending and increase consumer protections. This bill would
set licensing standards for mortgage loan originators maintain a national registry of originators,
who would submit to a criminal background checks and FBI fingerprinting. This bill would require
mortgage lenders to consider a prospective borrower's ability to repay the loan and would restrict
penalties levied on homeowners who refinance.
The 2007 subprime crisis worsened considerably and spread and spread to the entire
financial sector and to the economy as a whole in 2008. In March 2008, as it became clear that
investment banking giant Bear Stearns was approaching failure, it was purchased by JPMorgan
Chase at a fire sale price with federal government assistance. This situation broadened and
worsened in September 2008. Lehman Brothers, one of the largest “bulge bracket” investment
banks, filed for bankruptcy protection. The Federal Government took over Fannie Mae and
High-Grade Structured Credit Strategies Enhanced Leverage Fund and High Grade Structured Credit Strategies
Freddie Mac. The Federal Reserve provided $85 billion in emergency financing to insurance giant
AIG. Merrill Lynch was taken over by Bank America. Washington Mutual Bank was seized by the
FDIC. Congress passed legislation to grant the Secretary of the Treasury to acquire and use $700
billion to aid banks and other financial institutions in solving their liquidity crisis. The Treasury
had authority to purchase distressed securities from financial institutions, generally as the Treasury
C. Municipal Securities and Markets
The municipal securities markets owe much of their success to U.S. federal taxation code
that permits investors in municipal instruments to omit from their taxable income any interest
payments received on these issues. Thus, interest received on municipal bonds need not be
declared as part of income subject to federal income taxation. This feature makes municipal bonds
more attractive to investors, enabling issuers to offer these bonds at a reduced interest rate.
Several types of municipal issues are offered by state and local governments. The first,
so-called General Obligation Bonds are full faith and credit bonds. This means that the issuer
backs the bonds to the fullest extent possible, given its assets and other obligations. However,
municipal issuers lack the unlimited taxing and money creation abilities of the federal government.
Limited Obligation Bonds provide for the issue to be backed only by specific resources or assets.
For example, a revenue bond may be backed only be the cash flows generated by a specific asset
such as a toll bridge.
Most municipal issues are rated for default risk by private rating agencies such as Fitch.
Some municipal issues are insured by private insurance institutions. This insurance is intended to
reduce the default risk associated with the issue, and make them more attractive to investors. This
reduced risk would enable issuers to offer bonds with reduced interest rates to the public. Among
the larger insurers of municipal bonds are The American Municipal Bond Insurance Association
and the Municipal Bond Insurance Association.
D. Financial Institution Issues
Non-government financial institutions are also important participants in primary markets
for debt instruments. For example, the Federal Funds markets allow banks and other depository
institutions to lend to one another to meet Federal Reserve requirements. Essentially, this market
provides that excess reserves of one bank may be loaned to other banks for satisfaction of reserve
requirements. The rate at which these loans occur is referred to as the Federal Funds Rate.
Normally, bank accounts are not regarded as marketable securities. One exception to this
are Negotiable Certificates of Deposit (also known as Jumbo C.D.'s). These are depository
institution certificate of deposit accounts with denominations exceeding $100,000. The amounts
by which jumbo C.D.s exceed $100,000 are not subject to FDIC insurance. Money Market Mutual
Funds are created by banks and investment institutions for the purpose of pooling together
depositor or investor funds for the purchase of money market instruments (short term, highly
liquid low risk debt securities).
Banker's Acceptances are originated when a bank accepts responsibility for paying a
client's loan. Because the bank is likely to be regarded as a good credit risk, these acceptances are
usually easily marketable as securities. Repurchase Agreements (Repos) are issued by financial
institutions (usually securities firms) acknowledging the sale of assets and a subsequent agreement
to re-purchase at a higher price in the near term. This agreement is essentially the same as a
collateralized short-term loan. The counterparty institution buying the securities with the
agreement to resell them is said to be taking a reverse repo.
E. Corporate Bonds and Markets
Corporations are also important issuers of debt securities. Large, well-known,
credit-worthy firms needing to borrow for a short period of time may issue large denomination
short notes frequently referred to as Commercial Paper. Well-developed markets exist for these
short-term promissory notes. Firms requiring funds for longer periods of time may issue corporate
bonds. These longer-term instruments are often issued with a variety of features, including
callability, convertibility, sinking fund provisions, etc. There are a large number of different types
of corporate bonds. The terms of the bond will be specified in a contract known as a bond
Callable bonds may be called by the issuing institution at its option. This means that the
issuing institution has the right to pay off the callable bond before its maturity date. The callable
bond typically has a call date associated with it as well as a call price. The call date is the first date
(and perhaps only date) that the bond can be repurchased by the issuing institution. The call price is
normally set higher than the bond’s par value and represents the price that the issuing institution
agrees to pay the bond owners. Because the issuing institution retains the option to force early
retirement of callable debt, the call provision can be expected to reduce the market value of the
callable bond relative to otherwise comparable non-callable bonds.
Convertible bonds can be convertible by bondholders into equity or other securities. This
normally means that the convertible bondholder has the right to exchange the convertible bond for
a specified number of shares of common stock or some other security. The convertibility provision
of such a bond enhances its value relative to otherwise comparable non-convertible bonds.
Debentures are not backed by collateral. Many other bonds are either backed by collateral
or have some other device such as sinking fund provisions to provide for additional safety for
bondholders. One type of sinking fund provisions provides for the issuing institution to place
specified sums of money into a fund at specified dates that will be accumulated over time to ensure
full satisfaction of the firm’s obligation to bondholders. In some instances, sinking funds will be
used to retire associated debt early. Serial bonds are issued in series with staggered maturity dates.
Many more innovative bonds have been offered in the market. Floating rate bonds have
coupon rates that rise and fall with market interest rates; reverse floaters have coupon rates that
move in the opposite direction of market interest rates. Indexed bonds have coupon rates that are
tied to the price level of a particular commodity like oil or some other value like the inflation rate.
Catastrophe bonds make payments that depend on whether some disaster occurs, like an
earthquake in California or a hurricane in Florida. These catastrophe bonds provide a sort of
insurance for issuers against the occurrence of the disaster. In some respects, purchasers of these
bonds are providing insurance to the issuers.
Most corporate bonds are rated by well-known agencies with respect to anticipated default
risk. Corporations pay institutions like Standard & Poor’s and Moody’s to rate the risk of their
issues. Other rating agencies include Fitch, A.M. Best, Duff and Phelps and Dun and Bradstreet.
Bonds without ratings assigned by these agencies are very difficult to sell; in fact, many
institutions face restrictions on purchasing bonds that are either unrated or have ratings below a
given level. Reputations enjoyed by these rating agencies are often solid enough that government
regulatory agencies rely on them to restrict banks and other institutions from investing in low-rated
instruments. For example, federally chartered banks are often restricted from purchasing bonds
with ratings below investment grade (BBB or higher). However, some critics argue that these
agencies are often too slow in responding to dramatic shifts in market conditions and that traders
are often at responding to such shifts. Standard & Poor’s and Moody’s use the rating schemes
depicted in Table 1.
Description Standard & Poor’s Moody’s
Least likely to default AAA Aaa
High quality AA Aa
Medium grade investment quality A A
Low grade investment quality BBB Baa
High grade speculative quality BB Ba
Speculative B B
Lower grade speculative CCC Caa
Highly speculative CC Ca
Likely bankruptcy C C
Already in default D D
Table 1: Standard & Poor’s and Moody’s Corporate Bond Ratings
Bonds rated BBB (or Baa) and higher are typically referred to as investment grade bonds
while bonds below this level are considered to be of speculative grade. Speculative grade bonds
are often called junk bonds. There is significant evidence that these bond ratings are highly
correlated with incidence of default, suggesting that these agencies are least reasonably in
forecasting default and measuring default risk. Furthermore, it is fairly unusual for ratings
provided by these agencies to differ by more than one grade. Bond markets seem to agree with
these statistical findings, pricing bonds such that their yields are strongly inversely correlated with
Bond rating agencies make extensive use of financial statement and ratio analysis to
compute their ratings. Such analyses are frequently supplemented by statistical techniques such as
Multi-discriminate Analysis, Probit and Logit modeling. While their ratings have been almost
universally accepted in financial markets, even to the extent that numerous Fed and other
regulations are based on these ratings, there have been problems with the ratings. First, rating
agencies are paid by the firms that issue debt instruments, creating potential conflicts of interest.
Second, rating services provide consulting services to issuing firms, advising them on strategies to
improve their ratings. Third, rating agencies have missed major bond crises. For example, Enron
bonds were rated as investment grade until just a few days before the firm filed for bankruptcy
protection. Orange County bonds were also rated as investment grade until very shortly before its
crisis was revealed.
F. Eurocurrency Instruments and Markets
Eurodollars are freely convertible dollar-denominated time deposits outside the United
States. The banks may be non-U.S. banks, overseas branches of U.S. banks or International
Banking Facilities (not subject to reserve requirements). Eurodollar markets began after World
War II when practically all currencies other than the U.S. dollar were perceived as unstable. Thus,
most foreign trade between countries was denominated in U.S. dollars. However, the Soviet Union
and Eastern Europeans were concerned that their dollars held in U.S. banks might be attached by
U.S. residents in litigation with these countries. Thus, they dealt not with actual U.S. dollars, but
merely denominated their debits and credits with dollars. Monies owed to them were simply offset
by monies that they owed. In a sense, they dealt with "fake" euro-dollars, but since their trading
partners did also, and their accounts tended to "zero out" over time, this did not create significant
problems. Their euro-dollars were left in Western European banks. During the 1960s and 1970s,
these markets thrived due to regulations imposed by the U.S. government such as Regulation Q
(interest ceilings), Regulation M (reserve requirements), the Interest Equalization Tax imposed
beginning in 1963 to tax interest payments on foreign debt sold in the U.S. and restrictions placed
on the use of domestic dollars outside the U.S. More generally, eurocurrencies are loans or
deposits denominated in currencies other than that of the country where the loan or deposit is
created. Approximately 65% of eurocurrency loans are denominated in dollars.
Eurocredits (e.g: Eurodollar Credits) are bank loans denominated in currencies other than
that of the country where the loan is extended. They are attractive due to very low interest rate
spreads which are possible due to the large size of the loans and the lack of reserve, FDIC and other
requirements directly or indirectly with domestic loans and deposits. Their rates are generally tied
to LIBOR (the London Interbank Offered Rate) and U.S. rates. Loan terms are usually less than
five years, typically for six months. Euro-Commercial paper are short-term (usually less than six
months) notes issued by large, particularly "credit-worthy" institutions. Most commercial paper is
not underwritten. The notes are generally very liquid and most are denominated in dollars.
Euro-Medium Term Notes (EMTN's), unlike Eurobonds, are usually issued in installments. Again,
most are not underwritten. Eurobonds are generally underwritten, bearer bonds denominated in
currencies other than that of the country where the loan is extended. Eurobonds often have call and
sinking fund provisions as well as other features found in bonds publicly traded in American
Euro-Commercial paper is the term given to short-term (usually less than six months) notes
issued by large, particularly "credit-worthy" institutions. Most commercial paper is not
underwritten. The notes are generally very liquid (much more so than Syndicated loans) and most
are denominated in dollars. They are usually pure discount instruments. Euro-Medium Term Notes
(EMTN's) are interest-bearing instruments usually issued in installments. Most are not
underwritten. Eurobonds are generally underwritten, bearer bonds denominated in currencies other
than that of the country where the loan is extended. Eurobonds typically make annual coupon
payments and often have call and sinking fund provisions.
G. Private Placements
Primary providers of long-term private placements to business firms are banks and insurance
companies. Private placements will be reflected on the firm's balance sheet under notes payable.
The promissory note agreed upon by the lending institution and the borrowing firm will include all
of the terms of the loan. Such terms will include specification of the interest rate and maturity of
the loan, any options or special rights granted the lending institution or borrower and collateral
arrangements. The major advantages to the borrower of private placements over a public offering
are the potential flexibility of such loans and reduced transactions costs. Individually negotiated
loans are often more flexible in that both loan parties have the opportunity to re-negotiate terms of
the loan if circumstances concerning the economy or either loan party change. Public placements
lack this flexibility because the borrowing company's bonds are likely to be held by hundreds or
thousands of investors. Furthermore, private placements involve smaller transactions costs
because only one lending institution is involved (or, at most, a small syndicate of lending
institutions). The borrowing institution need only negotiate with one lender and is exempt from the
various Securities Exchange Commission requirements associated with public offerings.
Small Business Funding and the SBA
According to a 1998 Federal Reserve Board survey of small businesses, over 80% of small
businesses have borrowed money, with 55% having used traditional loans, and 71% using
nontraditional sources such as loans from owners, personal and business credit cards, vehicle
loans, credit lines. The smallest firms are the least likely to use bank loans, while borrowing from
depository and other financial institutions becomes more likely as the firm grows. Commercial
banks provided the bulk of this financing and most of the remainder is provided by savings and
loans associations, leasing companies, the Small Business Administration, consumer finance
companies and commercial finance companies. The typical small business loan is made on an
adjustable-rate loan basis, frequently tied to the prime rate. Additional financing can be provided
by trade credit and factor companies (firms that purchase accounts receivable).
The Small Business Administration (SBA) is an independent agency of the U.S. Federal
government that was established in 1953 to provide assistance of a variety of types to small
businesses. The SBA administers three separate loan programs with lenders to small qualified
businesses (7a loan guarantees), Community Development Organizations that target small
businesses serving special purpose needs (504 Loan Program) and microloan institutions that
make loans for less than $35,000 (7m Loan Program). The SBA doesn’t actually make these loans,
but guarantees them, eliminating much of the default risk associated with small business lending
and making these loans more affordable to small businesses. Borrowers apply for and obtain
funding from participating financial institutions such as banks. The SBA also administers through
its Office of Field Operations and SBA district offices a Loan Prequalification Program that allows
small business applicants to have their loan applications for under $250,000 reviewed and
potentially approved by the SBA before submitting them taken to lenders (usually participating
banks) for consideration. This prequalification program focuses on the applicant’s character,
credit, experience and reliability rather than his financial strength and wealth. An SBA-designated
agent will work with the applicant to attempt to complete and strengthen her loan application. e
The 7a SBA Loan program requires that borrowing firms meet somewhat flexible
standards with respect to size. These requirements vary with industry types:
Manufacturing: The number of employees may range from 500 to 1500
Retailing: Average annual receipts will fall between $3.5 million and $21.5 million
Wholesaling: Number of employees should not exceed 100
Services: Average annual receipts will be between $5 million and $21 million
Construction: Average annual receipts will be between $9.5 million and $17 million
Special Trade Construction: Average annual receipts will not exceed $7 million
Agriculture: Average annual receipts will be between $1 million and $9 million
The SBA also maintains other criteria with respect to how the funding can be used and restrictions
on the business and services provided by the small firm.
The 7m Microloan Program provides smaller loans to start-up and growing businesses.
SBA microloans usually target low- and moderate-income entrepreneurs, particularly those that
cannot receive funding from the mainstream financial services industry. Typical microloan clients
have either no or poor credit histories, lack collateral and other attributes that would qualify them
for more traditional commercial debt financing. Under this program, SBA makes funds available
to nonprofit community based lenders (intermediaries) which, in turn, make loans to eligible
borrowers for up to 6 years in amounts up to a maximum of $35,000. Non-profit organizations may
apply to the SBA to participate in the 7m program as lenders. They will also provide management
and technical counseling services to small business borrowers. The average 7m program loan size
is about $13,000 and loans are typically collateralized (such as with homes of borrowers) and will
require personal guarantees from the entrepreneur. Loan terms (maturities and interest rates) vary
according to loan size, business purpose, requirements of the intermediary lender, and the needs of
the borrower. Interest rates tend to range between 8 and 13 percent.
Since 1958, the SBA has licensed Small Business Investment Companies (SBICs),
privately owned and managed investment firms who provide capital (partly with funds borrowed
at favorable rates through the Federal Government). These SBICs provide venture capital to small
independent businesses. We will discuss SBICs in greater detail later.
The SBA’s Surety Bond Guarantee (SBG) Program was created to provide surety bonds
(contract guarantees) to small and minority contractors to enable them to bid on contracts for up to
$2 million. These surety bonds assure potential clients accepting contracting bids that bidders will
execute and honor their contracts, enabling them to compete with bids that require such
Finance companies specialize in the granting of consumer and business loans. The primary
types of finance companies are sales finance companies, consumer finance companies and
commercial finance companies. A sales finance company provides funding to consumers through
retailers for the purchase of durable goods such as automobiles, appliances, mobile homes and
furniture. Retailers offer their customers installment contracts for purchases, then sell the contracts
to a sales finance company. One such company is the General Motors Acceptance Company
(GMAC) which purchases installment contracts used to finance purchases of General Motors
products. A consumer finance company such as Household Financial Services makes consumer
loans to individuals. Most of these loans are relatively short term, typically providing financing for
purchases of automobiles, furniture, medical bills, etc. Interest rates charged on consumer finance
company loans tend to be somewhat high, due in part to high losses from non-payment.
Commercial finance companies make loans to businesses. These loans are frequently used to
purchase inventories of saleable merchandise; in many instances, the finance company will
maintain collateral or even retain title to inventory to be sold. Many commercial finance
companies have become lessors in financial lease arrangements where the finance company
purchases a fixed asset (such as heavy equipment) on behalf of its client then leases the assets to its
client on a long term basis. In addition, commercial finance companies often provide funding to
businesses through factoring, that is, by purchasing accounts receivable from their clients.
Finance companies are second to commercial banks as the most important providers of
loans to small business. They are particularly important in providing loans for vehicles (e.g.,
GMAC) and also important in providing loans for equipment. Finance companies provide
particularly important borrowing opportunities to higher-risk smaller firms. The primary assets
held by finance companies are the loans that they grant. Most of the funding for these loans is
obtained by borrowing from other institutions or by issuing long term bonds and commercial
paper. The finance companies will frequently be owned by the institutions from whom they obtain
funding; in some cases, their owners will be commercial banks or firms whose product sales are
financed by their loans.
Peer-to-peer (P2P) lenders have always played a crucial role in small business and rapid
growth business financing. For example, Sam Walton, founder of Wal-Mart, borrowed $20,000
from his father-in-law to purchase his first retail store in 1945. Fred DeLuca, while attending the
University of Bridgeport borrowed $1,000 from a family friend to start a sandwich shop that grew
into the Subway restaurant chain. But, these loans were orchestrated by family members and
friends. Web-based services have enabled people who do not know each other to participate in the
lending process. Since P2P loans eliminate financial institution middlemen (disintermediation),
they may provide for lower-cost funding for borrowers. However, the lender needs to charge a
minimum interest rate equal to the Applied Federal Rate (AFR) to avoid having the IRS tax the
loan as a gift. The two primary peer-to-peer lending business models are the following:
1. Loan Servicers: These web-based sites formalize and service loans between family and
friends. These sites provide loan documentation, bank crediting and debiting services to
facilitate payments, provide payment reminders, escrow administration, restructuring and
credit reporting. Among the earliest of these services was Circle Lending, which was
acquired by Virgin USA, becoming VirginMoney U.S.A.
2. Auction Sites: Web-based auction sites match lenders and borrowers through a bidding
process where the “winning” lender provides the lowest interest rate loan to the advertising
borrower. These loans can be repackaged, securitized and sold to other intermediaries.
Early participants in this arena included Prosper.com, who arranges loans to borrowers
with both strong and weak credit histories. Lenders can bid on many loans and participate
anonymously on loans with many other borrowers.
3. Social Lending: Lenders contribute to groups invested in diversified portfolios with
specified risk levels as measured by FICO (Fair Isaac Corporation credit score). Borrowers
need to have acceptable lending risk levels and are assigned to portfolios with respect to
their risk levels.
4. Intermediated Loans: Some services such as Zopa US function more like credit unions,
issuing insured CDs and evaluating borrowers themselves. Zopa U.S. normally arranges
loans only to borrowers with stronger credit histories. However, lenders who accept
reduced CD rates can specify approved borrowers to receive reduced borrowing rates.
H. Insurance Company Financing
Insurance companies collect premiums from policyholders who receive payouts in the
event of some type of loss such as those resulting from death, disability, casualty, accident, etc.
Insurance companies employ actuaries who predict frequency and amounts of loss (often with
great accuracy) and investment managers who invest those premiums by making loans and
purchasing securities and other assets. Although loss to a single individual is usually quite difficult
to predict (for example, it is quite difficult to predict when a given individual will die), predicting
loss rates for large groups of people is often quite straightforward. When policyholders file claims
in the event of loss, insurance companies make payment by drawing from the profits of their
investments, selling investments or borrowing. The primary service provided by insurance
companies is allowing policyholders to pool their risks, enabling them to attain a greater level of
The life insurance industry is the largest of the insurance industries, with over two trillion
dollars in assets as of 2004. Life insurance companies sell policies on risks associated with death,
medical disability and old age. In recent years, life insurance companies have been increasing their
sales of annuities, which will make series of payments (fixed or variable) in the future. Such
annuities are often used to fund retirements. When selling policies and annuities, insurance
companies invest funds so as to ensure an ability to satisfy claims when they occur. For example, if
it is expected that a substantial number of claims will be filed in ten years, insurance companies
will employ a hedging strategy to ensure that a large amount of money will be available to satisfy
these claims in ten years. This frequently means that the insurance company will purchase debt
certificates that will mature in ten years. In fact, the typical life insurance company will invest over
half of its assets in long term corporate and government bonds and mortgage loans. Life insurance
companies will also invest in corporate equity securities and the equity of real estate ventures.
Property-casualty insurance companies such as the State Farm Group sell insurance to
cover losses due to fire, earthquake, wind and water damage, theft, medical mal-practice,
workmen's compensation, motor vehicle accidents, etc. Motor vehicle insurance sales are by the
far the largest in this industry, accounting for over a third of property-casualty premiums.
Homeowner's insurance, (along with similar policies for businesses and farms) covering a variety
of potential claims has been increasing in popularity. Because property-casualty claims are
somewhat more difficult to predict than life insurance claims, property-casualty insurers usually
must maintain a higher degree of liquidity than life insurance firms. This means that they will tend
to invest less heavily in corporate bonds and real estate mortgages and more heavily in easier to
sell government securities.