An asset-backed commercial paper program (ABCP program, ABCP conduit, or simply conduit) is a type of non-bank financial entity that issues short-term debt, known as asset-backed commercial paper (ABCP), to fund medium- to long-term assets.Acharya, Viral, Philipp Schnabl and Gustavo Suarez (2010). Securitization Without Risk Transfer, September 2010, NBER Working Paper No. 15730 These programs act like banks by providing liquidity and transforming maturitiesCovitz, Daniel, Nellie Liang and Gustavo Suarez (2009). The evolution of a financial crisis: Panic in the asset-backed commercial paper market. Division of Research & Statistics and Monetary Affairs, Federal Reserve Board.—borrowing short-term to finance longer-term investments—but operate outside traditional banking regulation. This structure makes them part of the shadow banking system,Pozsar, Zoltan, Tobias Adrian, Adam Ashcraft and Hayley Boesky (2012). Shadow Banking. Staff Report No. 458. Federal Reserve Bank of New York Staff Reports which involves financial activities beyond the oversight of standard banking rules.
Often set up by banks, ABCP programs typically manage bank assets off-balance-sheet, possibly to bypass regulatory capital requirements, a practice that tied them to the 2008 financial crisis.
In terminology, "ABCP" refers to the commercial paper itself, with maturities ranging up to 270 days and averaging around 30 days, while "conduit" means the issuing program.Board of Governors of Federal Reserve System. http://www.federalreserve.gov/releases/cp/about.htm.
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 security issuance, investing in rated securities for arbitrage profit, providing leverage to mutual funds, and off-balance sheet funding of bank assets.The Fundamentals of Asset-Backed Commercial Paper. Structured Finance Special Report. http://www.imf.org/external/np/seminars/eng/2010/mcm/pdf/rutan1.pdf
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.
As of September 2001, there were approximately 280 active ABCP programs, with more than $650 billion in outstanding.Asset-Backed Commercial Paper Explained. Fitch Ratings. http://people.stern.nyu.edu/igiddy/ABS/fitchabcp.pdf 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. 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.
Subprime mortgage crisis
In 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. 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.
In December 2007, ABCP outstanding dropped from $1.3 trillion to $833 billion. By the end of 2008, there was no SIVs left. As of March 2013, the outstandings of ABCP were about $300 billion.Asset-backed Commercial Paper Outstanding. Federal Reserve Economic Data. http://research.stlouisfed.org/fred2/series/ABCOMP
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. HBOS sells the ABCP to outside investors such as Fidelity and rolls over the ABCP at regular intervals.
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 years.
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: Citigroup (U.S.) ABN AMRO (Netherlands) Bank of America (U.S.) HBOS Pls (U.K.) JP Morgan (U.S.) HSBC (U.K.) Deutsche Bank AG (Germany) Société Générale (France) Barclays Plc (U.K.) 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 meet 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 paper 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 United States (68%), Germany (15%) and United Kingdom (10%).Acharya, Viral, Philipp Schnabl(2010). Do Global Banks Spread Global Imbalances? Asset-Backed Commercial Paper during the Financial Crisis of 2007–09. IMF Economic Review, 58(1), 37-73.
Outside investors