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Asset-backed commercial paper (ABCP or Conduit) is set up as a program that issues short-term ABCP to finance medium- to long-term assets. The word ABCP can refer to both the program and the commercial paper such programs issued. The maturities of ABCP range up to 270 days but average about 30 days. . Like banks, ABCP programs provide liquidity and maturity transformation services. Over time, ABCP, along with other financial innovations, come to be called “shadow banking”. A prominent feature of many ABCP program is that they were created by banks to fund bank assets in an off-balance sheet conduit, possibly as a way to avoid regulatory capital requirements. Due to this character, ABCP is blamed to be one of the reasons of the 2008-09 global financial crises.

History

ABCP programs first appeared in the mid-1980s. Initially, ABCP conduits were primarily sponsored by major commercial banks as a means of providing trade receivable financing to their corporate customers. Over the past decade ABCP programs have grown to serve a wide variety of needs such as: asset-based financing for companies that cannot access the commercial paper market, warehousing assets prior to term security issuance, investing in rated securities for arbitrage profit, providing leverage to mutual funds, and off-balance sheet funding of bank assets. In general, any asset class that has been funded in the term market has been funded in a conduit, and there are a wide variety of assets that are unique to the conduit market. ABCP programs issue commercial paper as their primary liability.

As of September 2001, there were approximately 280 active ABCP programs, with more than $650 billion in outstanding . During the mid-2000’s, ABCP saw a steady rise in popularity because of the high ratings from the perspective of investors and the low borrowing rates from companies wanting money. Gradually, even more conservative investors, such as money market mutual funds and retirement funds began purchasing ABCP. This optimism pushed the outstanding of ABCP to $1.3 trillion by the time of July 2007. At that time, ABCP was the largest money market instrument in the United States, following by Treasury Bills with about $940 billion outstanding. However, this trend came to an abrupt end in August 2007.

On August 2007, the French bank BNP halted withdrawals from three funds invested in ABCP and suspended calculation of net asset values. Even though defaults on mortgages had been rising throughout 2007, the suspension of withdrawals by BNP has a profound effect on ABCP market. The interest rate spread of over-night ABCP and Federal Funds rate increased from 10 basis points to 150 basis points within one day of announcement. Subsequently, the ABCP market experienced a modern-day bank run and ABCP outstanding dropped from $1.3 trillion to $833 billion in December 2007. Till now, the outstanding of ABCP is still steadily decreasing.

Structure

An ABCP conduit is set up by a sponsoring financial institution (henceforth, sponsor). The sole purpose of a conduit is to purchase and hold financial assets from a variety of asset sellers. The conduit finances the assets by selling asset-backed commercial paper to outside investors such as money market funds or other “safe asset” investors like retirement funds.

Take the conduit Grampian as an example. Grampian is a conduit set up and managed by HBOS. HBOS’s management responsibilities consist of selecting the assets (Airbus, mortgages, etc.) to be purchased by Grampian and issuing short-term ABCP in order to finance the assets (Airbus, mortgages, etc.). HBOS sells the ABCP to outside investors such as Fidelity and rolls over the ABCP at regular intervals.

Figure 1 illustrates the typical conduit structure.

File:Abcp.jpg

Figure 1. Structure of a ABCP conduit

As in banks, the maturity of assets in ABCP conduits generally is longer than the maturity of the liabilities. More than half of ABCP daily issuance has maturities of 1 to 4 days, referred to as “overnight”, and the average maturity of outstanding paper is about 30 days. ABCP programs regularly roll over their liabilities and use proceeds from new issuances to pay off maturing commercial paper. Loan and lease receivables, which are assets commonly purchased by ABCP conduits, likely have terms of 30 days or more, and while relatively short, are still longer than most ABCP. Most of the conduit assets are medium- to long-term assets with maturities of three to five yours.

Financial institution (sponsor)

The sponsors of the conduit play two roles: manage assets and provide liquidity. Sponsor types range from large U.S. commercial banks to non-bank institutions, like mortgage lenders and asset managers. Large U.S. banks have long sponsored ABCP programs, some smaller U.S. banks sponsor a very modest share. Foreign banks sponsor a substantial share of ABCP, about 40 percent in 2007. Non-bank institutions, such as mortgage lenders, finance companies, or asset managers, also sponsor a considerable share of the market. Programs sponsored by non-bank institutions grew more dramatically than other programs from 2004 to 2007, more than doubling in assets to $400 billion.

The ten largest sponsors as of January 2007 are:

1. Citigroup (U.S.)
2. ABN AMRO (Netherlands)
3. Bank of America (U.S.)
4. HBOS Pls (U.K.)
5. JP Morgan (U.S.)
6. HSBC (U.K.)
7. Deutsche Bank AG (Germany)
8. Société Générale (France)
9. Barclays Plc (U.K.)
10. Rabobank (Netherlands)

Conduits can generate significant risks for the sponsor. The sponsor’s guarantee typically covers the conduit’s roll-over risk, which is the risk that a conduit cannot refinance maturing commercial paper, possibly because of a deterioration of conduit asset values. In that case, the sponsor has to assume the losses from lower asset values, because under the guarantee sponsors are required to repurchase assets at par. In exchange for assuming this risk, the sponsor receives the conduit profits.

Types of guarantees

Conduit sponsors use four different types of guarantees which provide different levels of insurance to outside investors. The four types of guarantees, ranked from strongest to weakest, are full credit guarantees (“full credit”), full liquidity guarantees (“full liquidity”), extendible notes guarantees (“extendible notes”), and guarantees arranged via structured investment vehicles (“SIV”).

Full credit

Full credit guarantees are guarantees that require the sponsor to pay off maturing asset-backed commercial paper independent of the conduit’s asset values. From a regulatory perspective, full credit guarantees are considered equivalent to on-balance sheet financing, because they expose banks to the same risks as assets on the balance sheet. Therefore, if the bank offer full credit guarantee, the backing assets will be on the balance sheet, thus are included in the calculation of capital needed to meat capital requirement. In practice, these guarantees are infrequently used by financial institutions that have to satisfy bank capital requirements.

Full liquidity

Full liquidity guarantees are similar to full credit guarantees with the main difference being that the sponsor only needs to pay off maturing asset-backed commercial paper if the conduit assets are not in default. Hence, there is a possibility that full liquidity guarantees expire before the asset-backed commercial matures. This form of guarantees is weaker than full credit, but from the bank’s side, they can move these assets off the balance sheet.

Extendible notes

Extendible notes guarantees are similar to full liquidity guarantees with the main difference being that the conduit issuer has the discretion to extend maturing commercial paper for a limited period of time (usually 60 days or less). By extending the maturity of the commercial paper, it is more likely that the conduit’s assets are in default before the commercial paper matures. From the viewpoint of an outside investor, extendible notes guarantees are therefore riskier than full liquidity guarantees. This guarantee was used by weaker financial institutions and by conduits with higher quality assets.

SIV

SIV guarantees are also similar to full liquidity guarantees with the main difference being that SIV guarantees only cover a share of the conduit liabilities (usually around 25%). Since SIV guarantees do not cover all conduit liabilities, they are considered partial insurance to outside investors. SIV guarantees were primarily used by commercial banks and other financial institutions to cover high quality assets.

Asset types

The asset types that conduits invested in are mostly asset-backed securities (ABS), residential mortgages, commercial loans and CDOs. Most of the assets are AAA-rated, some holds un-rated assets generated by the sponsor financial institution. The asset origins are mostly Unites States (68%), Germany (15%) and United Kingdom (10%).

Outside investors

The outside investors are mostly risk sensitive investors like money market mutual funds and retirement funds.

Risk

Most conduits minimize their credit risk by holding a diversified portfolio of high quality assets. Typically, they are restricted to purchasing AAA-rated assets or unrated assets of similar quality. Some conduits exclusively purchase unrated assets originated by their sponsoring financial institutions. Other conduits mostly purchase securitized assets originated by other financial institutions. Many conduits combine the two strategies by purchasing both securitized and un-securitized assets from several financial institutions.

Outside investors consider asset-backed commercial paper a safe investment for three reasons. First, the pool of conduit assets is used as collateral to secure the asset-backed commercial paper. Second, the conduit’s sponsor provides guarantees to the conduit, which ensures that the sponsor repays maturing asset-backed commercial paper in case the conduit is unable to pay off the maturing paper itself. Third, asset-backed commercial paper is very short-term, so that investors can easily liquidate their investment by not rolling over maturing asset-backed commercial paper.

However, asset holdings of ABCP conduits, like at banks, are not transparent. While the vast majority of ABCP programs have credit ratings from the major rating agencies, credit support mechanisms vary and the specific assets held in the programs are not widely known. For example, some ABCP programs viewed their holdings to be ‘proprietary’ investment strategies and deliberately did not disclose. Thus, random events or concerns about an economic downturn can create uncertainty about asset values. This uncertainty is greater when less information is available about the assets.

While ABCP programs are like banks, a key distinction, with important implications for financial stability, is that ABCP programs do not have explicit deposit insurance provided by the government. Most traditional ABCP programs are sponsored by commercial banks that provide explicit liquidity support.

Types of ABCP programs

There are five principal types of ABCP program:

• General purpose multi-seller
• Credit arbitrage
• Structured investment vehicle (SIV)
• Single-seller
• Loan-backed

General purpose multi-seller

The most traditional ABCP program is a multi-seller program, in which a conduit purchases receivables and loans from multiple firms. The sponsor is typically a financial institution that provides the conduit with a committed liquidity line, administers its daily operations, and sometimes also provides the conduit with credit enhancement through a letter of credit that absorbs credit losses. At the end of July 2007, just before the widespread turmoil, there were 98 multi-seller programs in the U.S. ABCP market with outstanding of $525 billion, about 45 percent of total ABCP outstanding.

Credit arbitrage

These programs involve banks sponsoring conduits to finance long-term assets through a special purpose entity that has a lower regulatory capital charge than if the assets were held on balance sheet. The sponsor banks typically provide full liquidity support. By using off-balance-sheet funding, commercial banks exploit regulatory capital arbitrage opportunities. In July 2007, there were 35 programs that accounted for about 13 percent of the U.S. ABCP market.

SIV

Structured investment vehicles (or SIVs) fund highly-rated securities. But unlike the credit arbitrage programs, SIVs do not have explicit agreements with their sponsoring banks for committed back-stop liquidity lines covering all their short-term liabilities. Instead SIVs relied on dynamic liquidity management strategies, which involved liquidating assets to pay investors if needed. At their peak in July 2007, there were 35 SIVs that accounted for $84 billion of U.S. ABCP. Some ABCP is issued by collateralized debt obligations (CDOs), sometimes called SIV-lites. CDOs are similar to SIVs in structure, but are not actively managed and tend to rely on explicit but only partial liquidity support. There were 36 ABCP CDO programs in July 2007, with ABCP outstanding of $47 billion.

Single-seller

Single-seller programs involve a conduit that issues paper backed by assets from only one originator, which frequently also sponsors the conduit. The majority of single-seller conduits mainly fund credit-card receivables, mortgages, mortgage-backed securities, or auto loans. Such programs tended not to have explicit liquidity support, but were thought to be implicitly supported by originators. In July 2007, there were 40 non-mortgage single-seller programs, about 11 percent of the U.S. ABCP market. There also were 11 mortgage single-seller programs that primarily warehoused mortgages prior to their securitization.

Loan-backed

Loan-backed programs are bank-sponsored programs and fund direct loans to the bank’s corporate customers. These loans are generally closely managed by the bank, and have a variety of covenants designed to reduce credit risk.

Relation to 2008-09 global financial crises

Economists think that the main feature of many ABCP is that they were created by banks to fund bank assets in an off-balance sheet conduit, possibly as a way to avoid regulatory capital requirements . Thus the ABCP market may be inherently unstable and a source of systemic risk.

Before the 2008-09 financial crises, the global financial system manufactured riskless assets, totaling over $1.2 trillion, by selling short-term ABCP to risk-averse investors, predominantly U.S. money market funds, and investing the proceeds primarily in long-term U.S. assets. As negative information about U.S. assets became apparent in August 2007, banks experienced difficulties in rolling over ABCP and as a result suffered significant losses. The losses together with the panic in liquidity market form a liquidity shock to the banking sector, which helped the contagion of the crisis.

Category:Finance Category:International macroeconomics Category:International finance Category:Financial crises