Exploiting the asset-backed opportunities
Amply demonstrating the old adage that it is an ill wind that blows nobody any good, the effective closure of the corporate commercial paper market for all but the highest quality issuers is causing a fillip in the issuance of asset-backed commercial paper (ABCP). A raft of ratings downgrades are making the alternatives, funding longer dated or drawing down bank credit lines, more expensive options. Instead, companies are selling their assets, be they trade receivables, credit card repayments, car loans or mortgage payments, to bank-sponsored conduits that issue paper secured on or backed by these assets (hence ABCP). These asset-backed deals secure a higher rating than the issuer’s regular paper, and provide access to funding at lower short-term rates.
Companies that are securitising their receivables include the UK’s Tate and Lyle, car makers Ford Motor, GMAC and DaimlerChrysler, Telecom Italia, KPN and Portugal Telecom. The security of these instruments compared with regular forms of funding is amply demonstrated by the case of Enron. Stockholders, bondholders and banks that provided the company back-up credit lines left the party empty-handed. But holders of Enron ABCP backed by collateral and guaranteed by both a bank credit line and insurance policy collected in full on the $58m owed.
Total ABCP outstanding at year end hit $745bn (e849bn) in 2001, of which $136bn was backed by European assets, according to date from Moody’s (see figure 1). The more developed US market has created a total of $5.2trn of such transactions and issuance of $305bn is projected for the current year. The market for European asset-backed deals is forecast to grow to E180bn in 2002. Latest figures from the end of February 2002 show $1.4trn of CP outstanding of which $727.3bn was ABCP. It is actively sought by yield-hungry money market funds for its superior yield with the benefits of a diversified asset base. US funds governed by Rule 2a-7 of the Investment Funds Act 1940 and AAA offshore look-alikes can have only 5% of their funds in assets rated lower than tier 1. A company whose debt is downgraded may have no choice but to securitise assets to obtain reasonably priced non-bank short-term funding. Deal size is increasing, with the debut of a number of e1bn ‘jumbo’ deals which have been used by banks as warehousing facilities for loans in advance of an asset-backed security (ABS) issue. Trade receivables deals can also be extremely large, in excess of e500bn and global.
ABCP issuers are independent bankruptcy-remote companies whose sole function is to refinance financial assets. This special purpose vehicle (SPV), also known as a conduit, issues paper of up to 270 days maturity in the US, or 364 days on European assets. ABCP are unregistered securities that are privately placed. Investors know the characteristics of the assets that may be held by the SPV, but not the specifics of any individual asset. This anonymity of assets could be considered a drawback of ABCP versus the direct association of traditional CP with the issuing company. However, this risk is mitigated by the work of ratings agencies who verify the administration and selection of assets, on inception and frequently thereafter. Because the maturities of notes are not generally matched to the cashflows of any particular asset, these conduits are generally supported by liquidity facilities from banks to ensure that notes issued are repaid on time. Notes often have direct recourse to the underlying assets in case of non-performance. There are other structural enhancements such as triggers on portfolio compositions linked to the performance of assets held and credit enhancement.
The biggest European-based sponsors of ABCP programmes are the Dutch banks – for example, ABN Amro (whose $32bn of ABCP in issue includes the $21.1bn Amstel and $5.4bn Tulip conduits), Rabobank’s $13.9bn Atlantis conduit and the ING Mont Blanc $7.1bn SPV (see table 1). Other major sponsors include the UK’s Halifax and German banks WestLB and Dresdner. Although some 60% of the total ABCP market is multi-seller programmes, a particular feature of European ABCP conduits are those termed special investment vehicles, whose assets comprise credit default swaps and securitised bank loans, sometimes from the sponsor’s loan books alone. Halifax’s Pennine conduit is an example of a credit arbitrage conduit, some 15% of the total ABCP market, which buys fixed income securities for the purpose of regulatory capital relief, yield arbitrage and increasing funds under management.
The massive Amstel and Atlantis conduits are also examples of ‘single seller’ credit arbitrage conduits. European head of ABCP at ABN Amro Rob Koning comments that “these deals differ from conventional credit arbitrage conduits that buy assets from many sources”. The distinction between these two types of conduits is diminishing, with most new conduits set up as hybrids to hold both pools of receivables as well as highly rated ABS. Dresdner has led the field in providing conduit facilities to other smaller regional banks that do not have the ability to structure and administer their own conduits. This allows these banks to maintain client relationships and generate fee income.
Investors in ABCP are principally banks, corporates and money market funds, some of which invest more than 60% of their portfolio in ABCP, according to iMoneyNet. Most pension funds are likely to invest in ABCPs through money market funds, rather than directly. It is estimated that 22% of US money market funds invest in ABCP, for its competitive yield, stable credit history, abundant supply, diversification of credit risk and exemption from Securities and Exchange Commission registration. Offshore US dollar, euro and sterling-denominated money market funds invest on average 41%, 53% and 49% of their portfolio in CP, according to iMoneyNet, of which a good proportion will be in ABCP. Barclays Global Investors (BGI), whose money market funds are in excess of $50bn globally, favours ABCP as providing more protection that the typical corporate note of similar rating, and has built up positions in ABCP of the order of 20% of its funds.
Disincentives to investment are the extensive credit analysis required on the composition of the asset pool, with limited information. As BGI London head of cash management Mark Hannan comments, “We have two people devoted to this market and, for them to do their job, transparency is key. We want to speak to the traders at these conduits and have visibility to their positions on a monthly or quarterly basis.”
Ratings agencies like Moody’s support investors by regular review of ratings and maintenance of approved lists of conduits. A clear structure, consistent good performance of assets in the pool, regular and good quality information and programme marketability qualify ABCP programmes for approval. Downgrade of support provider, high concentration, poor performance and monitoring information and lack of dealer support similarly disqualify a conduit. The highest rating of short-term paper is A1/P1, meaning rated as A1 by Standard & Poor’s and P1, or Prime, by Moody’s. Prime-rated ABCP has outperformed Prime-rated corporate paper, with no defaults and infrequent downgrades, mostly due to deterioration in the rating of the support providers, rather than a weakening in the quality of assets held.
The main risks associated with ABCP fall into three categories: credit, liquidity and structural. Within the asset pools, there may be defaults, or reductions in cashflows from specific assets because of trade disputes, for instance. If cash is collected by the administrator before being passed onto the conduit, there is the small risk of administrator failure affecting one day’s worth of cashflow. There may be fluctuations in the value of assets held by the conduit, insolvency of asset sellers or servicers, and currency and/or interest rate mismatches. Downgrades in the rating of the providers of credit enhancement and liquidity support have a knock-on effect on the rating of the conduit. Mismatches in the cashflows of interest payments and redemptions versus the cashflows generated by the assets create a liquidity risk, which should be mitigated by the liquidity support. Various checks must be done on the proper procedures and documentation before funding can be commenced and the quality of the administration and management of the conduit is key.
ABCP can be partially or fully supported, in terms of liquidity and credit enhancement. Partial support means that the nature of the pool must be examined in detail. The rating of a fully supported vehicle is mostly a function of the support providers’ credit rating and the mechanics by which that support becomes available to the conduit. Full liquidity support is based on the entire amount of ABCP outstanding. Partial support will be linked only to the amount of non-defaulted assets. Across the spectrum between full and partial support there are many nuances and circumstances within which liquidity support may or may not be available. To realistically offer liquidity support to a conduit, the bank or other financial institution must have ready access to funds and the capacity for same day delivery. Only Prime-rated and the most sophisticated institutions are credible in this role.
The other form of support generally provided to conduits comes in the form of credit enhancement. Credit enhancement addresses risks not covered by the liquidity facility, and provides sufficient credit protection to achieve the targeted rating. Full support links the ABCP programme’s rating directly to that of the provider, whereas partial support only covers defaulted assets and other liabilities not incorporated within the liquidity agreement. Support can be specific to an asset pool or program-wide, underwritten by cash collateral, insurance, a letter of credit or loan commitment with full recourse. Moody’s assesses the amount of credit enhancement required to achieve the targeted rating as a proportion of the ABCP outstanding, a floor amount, a dynamic formula or the sum of the largest obligors in the pool. To determine pool specific enhancement, historic asset performance and volatility, the strength of triggers and remedies and the impact that issuer insolvency would have on performance must be gauged. Equally, the nature of individual pools is important when determining programme enhancement, but also the degree to which pools are correlated and structural mechanisms such as those that would cause individual pools to cease issuance. Pool-specific credit enhancement involves more careful structuring and tighter triggers but even so the investor is at greater risk to a rapidly deteriorating asset jeopardising the rating.
The role of the administrator is crucial in determining the performance of the asset portfolio and the efficient paying and receiving of funds. A specific credit and investment policy must be in place before funding begins, and every investment made by the conduit must be checked against various due diligence criteria. The administrator must ensure that all procedures are followed in respect of maturity restrictions, balance sheet limits and that remedies following trigger events are enforced. Monitoring asset performance, both in terms of periodic review of sellers and distribution of monthly reports to investors, is the responsibility of the administrator.
Despite these complications, the ABCP market has shown itself to be surprisingly resilient to market interruption. After the 11 September tragedy, some administrative tasks were made more difficult through disrupted telephone and computer operations and relocation to back-up facilities took several days. Liquidity facilities were drawn by a few conduits, generally from the sponsor’s own resources. Spreads widened slightly, but contracted following the Fed’s decision to lower the discount rate and inject liquidity into the monetary system. Funds were reallocated towards money market instruments in the face of equity market declines. Trading at full capacity at normal pricing levels was achieved within four days. ABCP assets linked to car rental, credit card usage and aircraft leasing and those backed by insurance companies were initially impacted and some programmes were placed on ‘creditwatch’. However, because ABCP conduits generally hold diversified pools of highly rated paper, no ABCP issues have been downgraded as a result of 11 September. In fact no P1-rated ABCP programme has ever gone into default with loss of money. The only technical defaults that have occurred were two instances of single seller conduits that paid a day late last autumn.
Growth in European-based issuance is closely intertwined with an increase in European money market funds under management, according to iMoneyNet managing editor Peter Crane, pointing to the $120bn of Dublin-based AAA-rated offshore funds. AIM Global, which manages $3bn across its three Dublin-based STIC Global funds, and numbers European pension plans among its clients, has invested ABCP in all three currency portfolios. Its largest fund, the $1.75bn US dollar fund, holds at times as much as 20–30% of its portfolio in ABCP. Fund manager David Taylor highlights the yield pick-up on ABCP versus similarly rated corporates, and the lack of supply of top- quality corporate CP at present. One complaint Taylor has of the European market is the dominance of credit arbitrage conduits, of which AIM expresses reservations. Taylor would welcome greater issuance in euros from European conduits, provided that portfolio composition changed towards more traditional multi-seller deals. ABN Amro’s Tulip programme has already issued some $1bn worth in euros, and the Amstel conduit will start to issue in euros later this year. Koning blames tax and regulatory inconsistencies across Europe for the slow development of traditional multi-seller conduits, saying “it would be almost impossible and very expensive to structure a pan-European securitisation programme. At best some large European corporates have sold assets in some of the larger regimes, like Germany.”
As yet there is no benchmark that encapsulates the features of the ABCP market, which would allow ABCP investors to track the performance of their investments against the broader market and would provide a snapshot of the risk/return characteristics of the product. Moody’s ABCP analyst and senior vice president Jean Dornhofer notes various features of the market that make this problematic, principally “the vagarity of performance of trade receivables, which make up typically 14% of pools, the markedly different default rates of different assets and conduit compositions, and the private nature of many deals.”
Dornhofer makes the following predictions on market trends. “Future growth in ABCP is likely to feature assets from obligors in countries such as Spain, Italy, Greece and South Africa. Larger regional banks will join the major investment banks as sponsors, either directly or via ‘conduit rental’. Insurance companies, credit insurers and asset managers will form the next wave of sponsors and facility providers. And corporates are becoming active in structuring their own single-seller vehicles.” The as yet indefinite Basel II rules on regulatory capital requirements for liquidity facilities are constraining the explosive growth curve, and promoting ingenious alternative solutions. Under the current 1988 accord, undrawn facilities of less than 364 days duration have a zero weight, although this could increase to 20% under the new proposals. A resolution of this issue should come later this year and will have an impact on the programme composition and structure. A rebalancing in the capital charge may render programmes like Amstel and Atlantis inefficient if it becomes more costly to move loans into an SPV than to hold them on balance sheet, especially if the charge on highly rated assets becomes close to zero.