Asset-backed commercial paper program

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 security issuance, investing in rated securities for arbitrage profit, providing leverage to mutual funds, and off-balance sheet funding of bank assets.[5]

Above all these service types, ABCP programs are commonly used by banks to free up their regulatory capitals by moving the seemingly safe assets off their balance sheet. Traditionally, banks keep everything on their balance sheet and owners of the bank have to hold a certain amount of equity to meet the capital requirement. This means if a bank wants to invest in a large new project, i.e. increase its asset largely, it has to increase owners' equity proportionality. Moving such project off bank's balance sheet eliminates the need of increasing equity. Through setting up ABCP conduits, banks can fund assets all by short-term liabilities.

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, however, at the time of 2007, the major asset of most ABCP programs is asset-backed security backed by residential mortgages.[5]

As of September 2001, there were approximately 280 active ABCP programs, with more than $650 billion in outstanding.[6] During the mid-2000s, ABCP saw a steady rise in popularity because of their high ratings from the perspective of investors and the low borrowing rates from companies who need 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.[1] At that time, ABCP was the largest money market instrument in the United States, following by Treasury Bills with about $940 billion outstanding.[1] However, this trend came to an abrupt end in August 2007.[1]

During 2007, as negative information about U.S. residential mortgages spreads out, securities backed with mortgages, including sub-prime mortgages, widely held by ABCP programs of financial firms globally, started to lose their value. ABCP investors started to worry about the value of the asset backing their ABCP and stopped rolling over their position. At the beginning, sponsor banks have enough liquid to pay off these liabilities, but lack of market confidence can create a subprime mortgage crisis.

In August 2007, the French bank BNP Paribas 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 Paribas 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. Several ABCP conduits fell victim to the liquidity crisis. Since the sponsors financial institutions.[1] such as banks only need to keep regulatory capital for on-balance sheet assets, and none for the assets funded by ABCP conduits, they got into huge trouble paying back investors who refused to roll over their ABCP. Several major financial institutions collapsed in the following year because of these solvency issues and had to be bailed out by government.[1] See Financial crisis of 2007–2008 for details on the crisis and see Great Recession for the recession triggered by the financial crisis.

In December 2007, ABCP outstanding dropped from $1.3 trillion to $833 billion.[1] By the end of 2008, there was no SIVs left. As of March 2013, the outstandings of ABCP were about $300 billion.[7]

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.[1] 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.[1]

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. HBOS sells the ABCP to outside investors such as Fidelity and rolls over the ABCP at regular intervals.[1]

Structure of an 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.[2] 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.[1] Most of the conduit assets are medium- to long-term assets with maturities of three to five years.[1]

Originally, banks set up ABCP conduits to finance only safe assets off-balance sheet. Since these assets are considered safe, it is socially optimal for banks to invest more at a lower cost. ABCP conduit provides a way to free up regulatory capital, and thus achieve higher efficiency. At the same time, since safe assets are moved out of balance sheet, policy makers can target regulatory capital requirements only on the risky assets, which is what remains on the balance sheet.

However, due to no capital requirement for off-balance sheet assets, ABCP conduits also induce excessive risk taking. For example, banks may spread their capital very thin, and invest in highly risky projects that they would not have invested absent the mitigating effects of ABCP conduit on regulatory capital requirements. Especially when the sponsor bank is big, ABCP induces high moral hazard. When good state realized, the risky project will yield very high returns, but when bad state realized, the big bank expect government to bail it out. Therefore, banks optimally take on more risk because it does not care about the losses that occur in those states of nature when it goes bankrupt. Creditors will be bailed out and the interest rate at which the bank can borrow is therefore insensitive to bankruptcy risk. This is called "risk shifting"—shifting the risk from banks to the public. Most likely, policy makers find it optimal to bail out the bank, but needless to say, it is socially very costly.

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.[1]

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 ABCPs in case the conduit is unable to pay off the maturing paper itself. Third, ABCP is very short-term, so that investors can easily liquidate their investment by not rolling over maturing ABCPs.[1]

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.[2]

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.[2]

ABCP conduit induces regulatory arbitrage and excessive risk taking. With so few skin in the game, banks will increase their investments, and especially investments in risky projects with negative expected returns. The resulting high leverage and high risk will increase systemic risk of the financial system, which further impose huge risk on the broader economy.

There are five principal types of ABCP program:[5]

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

One feature of ABCP is that they provide the ability to fund bank assets that do not appear on bank balance sheets. One result of keeping these assets off-balance sheet is that they do not factor in for regulatory capital requirements.[2] Thus the ABCP market may contribute to systemic risk.[2]

Before the 2008-09 financial crises, the global financial system "manufactured" risk-less 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 came to light in August 2007, banks experienced difficulties in rolling over ABCP and as a result several banks were bailed out by the U.S. government.[8] Reduced liquidity tightened credit, affecting production sectors. As a result, economic activity worldwide was slowed and international trade declined. Governments and central banks responded with unprecedented fiscal stimulus, monetary policy expansion and institutional bailouts.[9]