Asset-backed commercial paper carries high risks

Commercial paper is a financial tool with a long history and easy to understand. But like many other things in the currency world, financial engineers have adjusted the traditional commercial paper market.

The result is asset-backed commercial paper (ABCP) and its related channels, structured investment vehicles (SIV), which is a special channel whose structure makes it more risky.

In this article, we will describe the operation of the ABCP market, including pipelines, and show you what you need to pay attention to.

Key points

  • Asset-backed commercial paper (ABCP) can be backed by any type of securitized assets, such as student loans, credit cards, and residential mortgages.
  • Structured investment vehicles (SIVs) managed by other asset management companies such as commercial banks or hedge funds will issue ABCPs to fund the purchase of these securities.
  • Since the value of ABCP is linked to the value of the underlying asset, any disruption in the underlying asset market will affect ABCP.
  • ABCP plans are usually accompanied by regulations, if the value of the underlying asset falls too much, liquidation is mandatory. This is to protect investors.

What is asset-backed commercial paper

Asset-backed commercial paper, like traditional commercial paper, has an issuance period of one year or less (usually less than 270 days) and is highly rated. Commercial paper, as a short-term tool for investing in cash, can be called cash equivalent.

The difference between ABCP and ordinary commercial paper is that ABCP is not an unsecured promissory note representing the obligations of the issuing company, but is backed by securities. Therefore, the perceived quality of ABCP depends on the underlying securities.

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The pipeline is a bankruptcy remote special purpose vehicle or entity, which means that it is an independent business entity and is not included in the originating company’s balance sheet. You will not see the assets and liabilities of the ABCP plan in the consolidated financial statements of the originating company. This is done to free up the balance sheet of the sponsoring company and increase its financial ratio.

ABCP is issued by one of these remote bankruptcy channels that are nominally capitalized. There are four types of channels: multi-seller, single-seller, securities arbitrage, and SIV.

Here, we will mainly focus on SIVs, as they are most prone to problems under certain market conditions. However, the selected pipeline structure depends on the goals of the plan sponsor. For example, in the case of a mortgage finance company, the proceeds from ABCP issuance in a multi-seller and single-seller channel may be used to fund new mortgage loans. The structure or type of the pipeline is very important, there are many reasons, we will discuss later.

Through the multi-seller channel, the asset-backed securities purchased for the plan are purchased from multiple originators. For a single seller, it is just an initiator. For this reason, multi-seller channels provide more promoter diversification and lower potential risks. Multi-seller plans also often use some type of credit enhancement to help mitigate credit and liquidity risks. This credit enhancement can be cash reserves or guarantees from the originator or a third-party bank.

Single-seller channels generally do not use the same type of credit enhancement as multi-seller channels. However, most single-seller channels are extendable, so if they cannot renew ABCP when they expire, they can be extended beyond the original expiration date. Rolling means repaying the commercial paper with the proceeds of the newly issued commercial paper. However, the extension is not indefinite; if they cannot roll over the extended period, they must auction the assets.

In the securities arbitrage channel, the goal of financial sponsors is to issue ABCP as a way to receive funds to purchase regular securities. In this way, they earn the difference between the interest rate paid to ABCP buyers (lower) and the return (higher) they receive on the fixed-term securities they purchase. Like multi-seller programs, most condo arbitrage channels have some type of third-party credit enhancement.

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Structured investment vehicle or SIV is a special channel because it issues ABCP. Many SIVs are managed by large commercial banks or other asset management companies (such as investment banks or hedge funds). They issue ABCP as a way to fund the purchase of investment-grade securities and earn the difference.

They usually invest most of their portfolio in AAA and AA assets, which include the allocation of residential mortgage-backed securities. Compared with multi-seller or securities arbitrage channels, SIV does not use credit enhancement, and related SIV assets are priced at least weekly by market value.

Market disruption

What happens to ABCP when the market value of the underlying asset decreases? This reduction introduces liquidity risk. Why does this market have liquidity problems? All commercial papers should be stable and safe investments, right? Well, the ABCP market is a bit different because its fate is related to the value of the underlying asset.

The ABCP market follows the path of the basic asset market. If there is a market disruption in the underlying market, this may have a real impact on the ABCP market.

For example, ABCP can be created from any type of asset-backed securities, such as student loan asset-backed, credit card asset-backed, or residential mortgage asset-backed (including primary and secondary) securities. If there are major negative developments in any underlying market, this will affect ABCP’s perceived quality and risk.

Since commercial paper investors may be risk-averse, worries about ABCP may lead them to seek other short-term, cash-equivalent investments, such as traditional commercial paper and treasury bills. This means that ABCP issuers will not be able to renew their ABCP because they will have no investors to buy their new offering.

Liquidation and failed SIV

If certain conditions are not met, certain terms related to the ABCP plan may require the liquidation of the underlying assets.This means you may have several large ABCP plans to sell their depressed assets at the same timeBrings greater downward pricing pressure to the stressful asset-backed securities market. These regulations are made to protect ABCP investors.

For example, if the mark-to-market impairment is greater than 50%, a forced liquidation may occur. Therefore, in times of market pressure, the composition of basic assets is very important. If SIV is concentrated in an asset class that is subject to huge price downward pressure, it will face greater risks of liquidation or failure.

SIV promoters may not bear specific responsibility for the performance of the ABCP issued, but if they do not repay investors, they may suffer reputational risks. Therefore, large commercial banks involved in failed SIVs may be more motivated to repay investors than small hedge funds or investment companies set up specifically for such arbitrage.If a well-known large bank makes investorsWho thinks their money is safe in cash-like assets-losing money on ABCP investments?

Bottom line

The understanding of investors often lags behind new developments in financial markets. Investors sometimes take it for granted that the products they buy have different risks than previous products. Usually, these risks will not become apparent until a period of market pressure. ABCP is a commercial paper, but its characteristic is that under certain market conditions, it is more risky than traditional commercial paper.

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