Note: This is post 1 of 3. See also here and here.
Before there was asset backed commercial paper …
Asset backed commercial paper is a relatively new invention, but commercial paper is not. Traditional commercial paper is way for firms to borrow money without offering the lender any collateral for a period of time from overnight up to 270 days. Because there is no collateral to secure the loan, typically only large well-known firms can issue commercial paper.
Commercial paper has been around for centuries and predates the development of a modern banking system. World famous bankers like the Medici in Florence, the Fuggers of medieval Germany and the Rothschilds made fortunes by trading in commercial paper. Thus, commercial paper is an asset class that has stood the test of time.
The basic idea behind commercial paper is this: When a large company with stable revenues and sound finances like General Electric Corporation wants to borrow money for three months, there are plenty of people who will lend the company money on an unsecured basis (in other words, with no guarantees aside from GE’s promise to repay the funds). Why are people willing to trust GE with their money? Because there is virtually no likelihood that GE will go bankrupt within the three month duration of the loan instead of paying off the debt.
Of course, once in a while a firm that issues commercial paper does go bankrupt. One of the more recent examples, Mercury Financial Co., a major issuer of automobile loans, defaulted on $315 million of commercial paper in 1997. But such cases are very rare, so large, creditworthy firms in the US continue to borrow huge sums using commercial paper on a daily basis, and this has been common practice in the US and Europe for centuries.
Since the 1970s, the number of buyers in the commercial paper market has increased dramatically in the United States. The reason for this is the growth of money market mutual funds. Money market mutual funds accept investments of as little as $1,000 and invest in short-term assets like commercial paper and U.S. Treasury bills. Because they aim to invest in assets that are so safe that they will not experience losses (and historically there have been almost no losses),[1] each share in a money market fund is worth $1 and this allows the fund to function just like an interest paying bank account. Many money market funds even allow investors to withdraw money using checks.
The reason money market funds grew so dramatically in the last quarter of the 20th century is that they offered investors interest payments close to the return on U.S. Treasury bills – and this return was much higher than that offered by banks on savings or checking accounts. Chart 1 shows how the assets in money market mutual funds have increased from 1975 to today. You can see that in 1980 less than $100 billion were invested in money market funds, and nowadays more than $2 trillion is held by investors in money market funds. Thus over the past quarter of a century there has been approximately a 20 fold increase in the funds available to purchase commercial paper.
Chart from “US Money Market Funds: A Regulatory Success Story”, Peter G. Crane, Crane Data LLC – 28 Nov 2006
What has been happening over the past 25 years is that corporations have been able to borrow money directly on the commercial paper market instead of turning to banks for loans. The flip side of this transition is that investors have been choosing not to deposit their money in banks, but to invest in money market mutual funds and thus indirectly in commercial paper. This process where the traditional lending relationship between firms and banks is displaced by market based lending is called disintermediation. Charts 2 and 3 show how the issue of commercial paper increased from 1965 to the present.
from Instruments of the Money Market, edited by Timothy Q. Cook and Robert K. Laroche, 1993
Asset backed commercial paper: The early years
Asset backed commercial paper (ABCP) was first issued in the mid-1980s. An important impetus for the development of ABCP was the introduction by the Securities and Exchange Commission of regulation for money market mutual funds in 1983. The big change was that money market funds were required to invest the vast majority of their portfolio in first tier commercial paper. First tier commercial paper must receive the highest possible rating from one of the major credit rating agencies, such as Standard and Poors, Moody’s or Fitch. The rating A1 (S&P), P1 (Moody’s) or F1 (Fitch) means that the commercial paper is as unlikely to default as the US government.
This regulation dramatically reduced the demand for second tier commercial paper, which is rated A2/P2/F2 and is somewhat more likely to default than first tier paper. Many firms, which had been actively issuing second tier commercial paper, suddenly found themselves looking for a new source of funds. Asset backed commercial paper programs were established so these firms could continue borrowing on commercial paper markets.
In an asset backed commercial paper program a special purpose entity, often called a conduit, is created.[2] The firm takes a group of assets that it could typically use as collateral for a bank loan, like a portfolio of credit card receivables or car loans, and sells the assets to the conduit. The firm usually continues to service the assets by collecting payments and sending them on to the conduit. In this early period, it was also common for the firm to retain the obligation to buy back assets that go into default.
The conduit, which is legally an independent third party,[3] sells commercial paper to finance its purchases of business loans. This is asset backed commercial paper because it is literally the income from the loans owned by the conduit that enables the conduit to pay the interest on its commercial paper and, as the loans are paid off, to reduce the amount of commercial paper that it issues.[4]
Notice the structure of a commercial paper conduit: the loans owned by the conduit are often scheduled to be paid off only after a few years, while the commercial paper comes due in a matter of months. Thus, the conduit does not have enough money to pay off the commercial paper in full when it comes due. This means that the conduit will run into trouble if it cannot issue new commercial paper when the old commercial paper matures. In other words, the conduit is dependent on the liquidity of the commercial paper market.
From a financial point of view this means that in order for the conduit to find buyers for its commercial paper, it must have a plan for what it is going to do if it cannot issue new commercial paper. To deal with this liquidity risk all conduits pay a bank to guarantee that the bank will buy the conduit’s commercial paper if the commercial paper market is not functioning. This guarantee is called a liquidity facility.
Not only does a conduit need to have a liquidity facility, but it also needs to have a plan for what it will do if a bunch of the loans that it owns go into default. In particular, since the SEC requires that a money market’s assets be composed mostly of first tier commercial paper, asset backed commercial paper programs need an A1/P1/F1 rating. To earn their highest rating the credit rating agencies require (i) that a liquidity facility covers 100% of commercial paper issues and (ii) that an asset backed commercial paper program protect lenders from default by ensuring that even if 15% (and sometimes more) of the assets go into default, the commercial paper will be paid. This protection against default is achieved by some combination of the following three possibilities: (a) the firm that sells the loans is required to buy them back if they go into default, (b) over-collateralization, where the amount of commercial paper issued (and the amount paid by the conduit for the assets) is less than the full value of the assets, and (c) credit enhancement, where a bank commits – for a fee – to purchase some of the conduit’s assets at full value if they go into default.
For a bank that sells a liquidity facility only, the distinction between credit enhancement and a backup line of liquidity is important. In the event that the conduit cannot roll over its commercial paper because it has assets that are in default, the bank does not need to honor the liquidity commitment. (Legally this is usually called a “material adverse circumstance,” which negates the initial commitment.)
As you may have noticed, from the beginning ABCP programs provided ample opportunities for banks to earn income from fees. Not only could banks provide credit enhancement and liquidity facilities, but they often earned income from advising the firms that set up ABCP programs. Banks usually determined the credit standards for assets that were placed in an ABCP program including the appropriate level of over-collateralization, and they monitored the program’s portfolio of assets on an on-going basis. Thus, banks were very supportive of the growth of ABCP because it opened up an important role for them to play in the new world of market-based lending.
The regulatory changes faced by banks in the 1980s also encouraged the development of asset backed securitization programs. Regulators were increasing the capital requirements for banks. To increase capital, a bank needs to raise money. This can be done by holding onto and reinvesting profits or by selling new shares of ownership in the bank.
Another way to meet the higher capital requirements demanded by regulators was to reduce the quantity of assets on which the capital requirements were based. When a bank makes a loan and keeps it until it is completely paid off, the loan is an asset on the bank’s balance sheet. When the bank sells the loan, the asset is removed from the bank’s balance sheet. Bank capital requirements are based on the assets a bank holds on its balance sheet. Thus banks could meet regulators’ demands by selling some of loans that they held on their balance sheets.
Asset backed commercial paper programs give firms access to the funds they seek, generate fee income for banks, and place the loans created with a third party, the conduit. By keeping these loans off the bank’s balance sheet, these programs help reduce the capital requirements faced by banks.
Asset backed commercial paper conduits are one of the founding pillars of the securitization revolution. Securitization is a term that refers to the practice of financing loans that were traditionally held on a bank’s balance sheet by selling the loans to an independent conduit. Securitization takes hard-to-sell loans and turns them into a tradable asset.
The commercial paper issued by these conduits can only be sold if it carries a first tier credit rating, and a first tier credit rating will only be granted if the conduit has sufficient liquidity protection and credit enhancement. Thus the legal contracts that are used to create the conduit must be carefully structured to meet the demands of the credit rating agencies.
Let’s pause for a second and think about what it is that securitization is doing in the commercial paper market. It replaces traditional commercial paper, or a promise of repayment backed by the full faith and credit of a large firm, with ABCP, or a promise supported by collateral and bank guarantees. Now, since the extra interest you can earn by investing in asset backed commercial paper is much less than 1% and ABCP is very short-term, it simply isn’t worth an investor’s time to go through and carefully check out the quality of the collateral backing the conduit. This means that investors in ABCP are placing their trust in the bank guarantee and sponsorship of the conduit – even though the bank usually only guarantees a fraction of the assets.
The fundamental contradiction of these structured finance products is this: the investor is counting on the bank sponsorship and guarantee of the conduit to protect the investor from losses, while the bank is counting on the investor to absorb the losses if the conduit turns out to have more bad assets than expected. Because exposing the investor to losses on low-yield commercial paper is a sure-fire way of scaring the investor away from that bank’s conduits, if not from the ABCP asset class as a whole, banks face a very strong incentive to provide support to the conduit well beyond a bank’s contractual obligations. Of course, when a bank takes action to protect the investors in a conduit, one cannot help but question whether the conduit is in fact a truly independent third party. As ABCP programs evolved, signs of this fundamental contradiction between the contractual and the actual behavior of these conduits continued to grow.
Sources: Asset-backed commercial paper programs.
From: Federal Reserve Bulletin | Date: 2/1/1992 | Author: Boemio, Thomas R.; Edwards, Gerald A., Jr.; Kavanagh, Barbara
The evolution of the U.S. commercial paper market since 1980.
From: Federal Reserve Bulletin | Date: 12/1/1992 | Author: Post, Mitchell A.
[1] “Only one small money market fund in the US has ‘broken the buck’, in the 1990s.” http://www.ft.com/cms/s/0/5fe75d52-f9db-11dc-9b7c-000077b07658.html
[2] The terms conduit, special purpose entity (SPE) and special purpose vehicle (SPV) are used interchangeably. (Observe, however, that a qualifying SPE (QSPE) is a distinct term defined by the accounting regulation SFAS 140.)
[3] To be more accurate the conduit needs to be “bankruptcy remote.” This is a very technical term, which speaking roughly means that its activities are strictly limited in scope, that it has an independent director, that any claimants to the assets in the conduit other than the commercial paper owners cannot force it into bankruptcy and that it is run as a business entirely separate from all other persons and entities. The last two conditions are meant to ensure that, in the event of the bankruptcy of the sponsoring bank or firm, the conduit’s assets are protected from the bankrupt entity’s creditors. For the gory details see http://www2.standardandpoors.com/spf/pdf/fixedincome/Legal2002.pdf pp. 19 ff.
[4] In practice, the conduits that are created by asset backed commercial paper programs are typically designed as on-going concerns that continuously replace any loans that are paid off with new loans and replace any commercial paper that is paid off with new commercial paper.
Synthetic Assets 