Asset-Backed Commercial Paper Carries High Risk

Commercial paper (CP) is a long established and easily understood financial instrument. But, like so many other things in the finance world, "financial engineers" have taken the traditional CP market and tweaked it. The result is asset-backed commercial paper (ABCP) and its associated conduits, structured investment vehicles (SIVs), which are special kinds of conduits whose structure makes them riskier. In this article, we'll describe the workings of the ABCP market, including conduits, and show you what you need to look out for.

ABCP is like traditional CP in that it is issued with maturities of one year or less (typically less than 270 days) and is highly rated. CP is used as short-term vehicles for investing cash, and can be referred to as a "cash equivalents." The difference between ABCP and CP is that instead of being an unsecured promissory note representing an obligation of the issuing company, ABCP is backed by securities. Therefore, the perceived quality of the ABCP depends on the underlying securities. (See also: Money Market: Commercial Paper.)

A conduit is a bankruptcy remote special purpose vehicle or entity, which means that it is a separate business entity and is not rolled up into the sponsoring company's balance sheet. You will not see the assets and liabilities of the ABCP program in the sponsoring company's consolidated financial statements. This is done to free up the sponsor company's balance sheet and improve its financial ratios. (See also: Off-Balance-Sheet Entities: The Good, the Bad and the Ugly.)

ABCP is issued by one of these nominally capitalized, bankruptcy remote conduits. There are four categories of conduits: multi-seller, single-seller, security arbitrage and SIVs. Here, we'll focus primarily on SIVs, because they are the most prone to problems under certain market conditions. However, the chosen conduit structure depends on the goal of the plan sponsor. For example, the proceeds from the ABCP issuance in multi- and single-seller conduits might be used to fund new mortgage loans in the case of a mortgage finance company. The structure or type of conduit is important for a number of reasons that we'll discuss below.

With a multi-seller conduit, the asset-backed securities that are purchased to be used in the program are bought from more than one originator. With a single seller, it is just one originator. For this reason, a multi-seller conduit provides more originator diversification and is potentially less risky. Multi-seller programs also often employ some type of credit enhancement that helps to mitigate credit and liquidity risks. This credit enhancement can be a cash reserve or guarantees from sponsor or third-party banks.

Single-seller conduits do not usually employ the same type of credit enhancements as multi-seller conduits. However, most single-seller conduits are extendible, so they can extend past the original maturity date if they are unable to roll the ABCP at maturity. To roll means repaying commercial paper with the proceeds from a new issuance of commercial paper. However, the extension is not indefinite; they have to auction assets if they cannot roll on the extended deadline.

In a securities arbitrage conduit, the aim of the financial sponsor is to issue ABCP as a way to receive funds to purchase term securities. This way, they earn a spread on the rate they pay to purchasers of the ABCP (lower) and the return they receive on the term securities they purchased (higher). Like multi-seller programs, most security arbitrage conduits have some type of third-party credit enhancement.

A structured investment vehicle, or SIV, is a special kind of conduit because it issues ABCP. Many SIVs are administered by large commercial banks or other asset managers (investment banks or hedge funds). They issue ABCP as a way to fund purchases of investment grade securities (also to earn the spread). They usually invest the majority of their portfolios in AAA and AA assets, which include an allocation to residential mortgage-backed securities. In contrast to a multi-seller or securities arbitrage conduit, an SIV does not employ credit enhancement, and the underlying SIV assets are marked-to-market at least weekly. (See also: Profit From Mortgage Debt With MBS.)

What happens to ABCP when the market value of the underlying assets is reduced? This reduction introduces liquidity risk. Why would there be liquidity concerns in this market? All CP should be stable, safe investments, right? Well, the ABCP market is a little bit different in that its fate is tied to the value of the underlying assets.

The ABCP market goes the way of the underlying asset market. If market disruptions occur in the underlying market, this can have real effects in the ABCP market. For example, ABCP can be created from any type of asset-backed security, such as student loan asset-backed, credit card asset-backed or residential mortgage asset-backed (including prime and subprime) securities. If there are significant negative developments in any of the underlying markets, this will affect the perceived quality and risk of ABCP. Because CP investors may be risk averse, concerns about ABCP may cause them to seek other short-term, cash-equivalent investments (traditional CP, T-bills and so on). This means that the ABCP issuers will not be able to roll their ABCP, as they will have no investors to buy their new issuance. (See also: Subprime Meltdown.)

There are certain rules pertaining to ABCP programs that may require liquidation of the underlying assets if certain conditions are not met. This means you could potentially have several large ABCP programs selling their depressed assets all at the same time; putting even more downward pricing pressure on a stressed asset-backed securities market. These rules are put in place to protect the ABCP investors.

For example, forced liquidation might occur if mark-to-market impairment is greater than 50%. Therefore, the composition of the underlying assets is important in times of market stress. If the SIV is concentrated in an asset class that is experiencing great downward price pressure, it will be at greater risk of liquidation or failing.

SIV sponsors may not be specifically liable for the performance of the ABCP issued, but may suffer reputational risk if they do not repay investors. Therefore, a large commercial bank that is involved in a failing SIV may have more incentive to repay investors as opposed to a small hedge fund or investment company specifically set up for this type of arbitrage. It would be seen as bad business if a large, well-known bank let investors, who thought their money was safe in a cash-like asset, lose money on an ABCP investment.

Investor understanding tends to lag behind new developments in the financial markets. Investors can sometimes take for granted that what they've purchased has a different set of risks than its predecessors. Often, these risks are not apparent until times of market stress. ABCP is commercial paper, but it has characteristics that, under certain market conditions, make it much more risky than traditional CP.