Given the uncertain economic environment, the potential market-altering impact of the Financial Accounting Standards Board's (FASB) exposure draft on consolidation of special purpose entities (SPEs), and several notable corporate downgrades and defaults, it is not surprising that ABCP outstandings have been trimmed by $45 billion, from a record high of $745.3 billion as of year-end 2001 to $700.9 billion as of July 31, 2002. As discussed below, the second half of 2002 may prove equally challenging to a market striving to overcome the hurdles laid out by FASB and other regulatory bodies, while weathering the continued after effects of recent corporate and accounting scandals.
Capital Requirements Enhanced
Though FASB issues continue to vex securitization market participants, ABCP conduit sponsors are also having to reckon with the FDIC's final rules, effective for transactions settled on or after January 1, 2002, that revised the regulatory capital treatment of recourse, direct credit substitutes, and residual interests in securitizations. The revised rule states that the capital requirements for providers of these support features will vary based on the rating of the particular transaction. More specifically, the new approach treats support providers to highly rated exposures more favorably and imposes a higher capital requirement for lower rated or unrated exposures.
These new capital requirements have a significant impact on banks that provide programwide credit support to ABCP programs. Not surprisingly, most program sponsors are looking at ways of providing programwide credit enhancement in the most capital efficient manner possible. Given the possibility of realizing a lower capital charge if a support exposure is rated, many sponsors have approached Fitch about rating their conduit's programwide credit enhancement facilities.
Fitch is working with several program sponsors to assess the credit quality or risk of draw associated with programwide credit enhancement. This analysis draws on elements of Fitch's rating methodology for collateralized debt obligations while factoring in the various structural protections provided by a program's liquidity facilities and transaction-specific credit enhancement features. It is important to note, however, that the programwide credit enhancement provider does not always benefit from the structural protections provided through a liquidity facility, particularly if a liquidity facility provider can seek reimbursement for a draw from the credit enhancement provider. As such, the credit enhancement provider's exposure relates more directly to the credit quality of the underlying transactions in the conduit portfolio.
Various inputs are utilized in Fitch's assessment process including the credit quality of the individual transactions in the conduit portfolio and the interplay or degree of risk shared between the liquidity facilities and the programwide credit enhancement. Depending on the conduit portfolio, Fitch may choose to either evaluate all of the transactions individually or review a representative subset of transactions. By reviewing a broad subset of underlying transactions, Fitch is able to make a base determination of the credit quality of the portfolio, by using the reviewed subset as a proxy for the remainder of the vehicle's portfolio.
Problem Deals in Conduits
Financial markets worldwide were shaken by several notable bankruptcies and defaults in 2002. Much of the credit deterioriation resulted from widely reported accounting scandals and corporate fraud. Names making headlines included Allied Deals, WorldCom, Student Finance Corp., and NextCard. Despite the varying exposures in a handful of ABCP conduits, CP investors were shielded from any losses associated with these deals as a result of the structural protections inherent within the vehicles, and/or due to the remedial steps taken by the program sponsors.
In May 2002, the market learned that top executives at Allied Deals and several related metals-trading companies colloborated on a global metals-trading scam bilking millions of dollars from a consortium of the world's largest banks. The scheme involved using fake invoices, fictitious companies, falsified shipments and a network of accomplices in order to secure financing from banks. Several ABCP conduits, including one rated by Fitch, had financed a pool of metals-trading receivables originated by the company. To protect these conduits from any losses, some program sponsors elected to fully guarantee the transactions while other sponsors removed the impacted transactions fom their conduits.
Also in May, WorldCom announced that it improperly accounted for approximately $3.8 billion in expenses by booking such expenses as capital expenditures rather than current period expenses. The investigation into the alleged fraud continues, and it appears evident that senior management was aware of and advocated the fraudulent accounting practices. The fraud was initially uncovered through an internal audit, which discovered that certain expenses were not accounted for in accordance with Generally Accepted Aaccounting Practices (GAAP). In addition, recent investigations revealed an additional $3.3 billion of improperly booked expenses. WorldCom participated in a syndicated ABCP conduit transaction with several conduits financing up to $2.2 billion for the company's working capital needs. Following the May announcement, and the resulting downgrade of WorldCom's long-term debt rating, the transaction size was reduced to $1.5 billion. Subsequently, all of the participating bank sponsors removed the transactions from their vehicles by drawing on the related liquidity facilities.
A handful of ABCP programs were also exposed to a deteriorating term credit card securitization transaction issued by NextBank, N.A. (NextBank), which marketed its credit cards via the Internet. In February 2002, after finding that NextBank failed to identify substantial credit quality problems, was undercapitalized, and was operating in an unsafe and unsound manner, federal bank regulators closed NextBank and appointed the Federal Deposit Insurance Corp. (FDIC) as receiver. The regulators determined that NextBank severely understated chargeoffs, and as a result, would deplete all or substantially all of the its capital, rendering it under-capitalized and unable to meet the demands of its depositors in the normal course of business without federal assistance. In July 2002, following months of fruitlessly trying to find a buyer for the portfolio, the FDIC shut down NextCard's portfolio of 800,000+ thousand accounts, rendering the cards useless.
Another troubled credit that found its way into several ABCP conduits, involved a securitization of vocational student loans originated by Student Finance Corporation (SFC). The issue involved a dispute between MBIA Insurance Corp. (MBIA) and Royal Indemnity Co. (Royal) over Royal's obligation to pay under insurance policies it issued guaranteeing repayment of student loans originated by SFC, which secure eight MBIA-wrapped securitizations, and allegations of SFC's fraudulent inducment of Royal to issue such policies. MBIA agreed to honor its financial guaranty on the securitizations irrespective of Royal's refusal to honor its obligations. Several ABCP conduits had exposure to non-MBIA-enhanced pools which we removed following Royal's refusal to pay on its policy.
Troubled transactions were either removed from the respective ABCP programs by way of liquidity funding mechanisms, or were fully credit enhanced, ensuring that all related CP was paid in full. Though all of the above conduit transactions contained rating agency mandated performance triggers, it is important to note that many of the affected transactions involved fraud or allegations of fraud which are beyond the scope of credit ratings. Given the overall size of the ABCP market, the number of transactions funded, the current economic environment, and the regulatory pressures to uncover any additional fraudulent financial reporting, the potential exists for further reverberations from corporate exposures in ABCP conduits.
ECP Gains Momentum
The ECP market experienced explosive growth in 2002 as evidenced by outstandings of Eur 46 billion as of July 31, 2002 compared to Eur 27 billion at year-end 2001. These figures take into account all ECP issued in the Euro market, whether denominated in Euros, U.S. dollars, pounds sterling or Japanese yen. However these figures exclude the fast growing asset-backed billet de tresorerie (BT) market in France, given this market's different investor base and the special regulatory treatment afforded to BT by French regulators.
The growth of the ECP market has been attributable to the launch of several new European-administered programs, and to the increased viability of the ECP market for both multi-currency issuers and investors. Conduits sponsors are recognizing that the spread differential between funding in the U.S. market vs. funding in the euro market has narrowed, and also that funding foreign-currency denominated assets with similarly denominated CP removes significant hedging costs. To take advantage of the increased market acceptance, many European conduit administrators seek to place between 30% to 50% of their CP outstandings within the European investor community.
Another impetus of the market's growth has been the inclusion of additional European assets in conduits. In particular, European corporate entities are increasingly accessing conduit financing for working capital needs. Additionally, Fitch has seen an increase in the number of smaller deals (less than Eur 75 million) during 2002, suggesting that the securitization message is reaching small and medium size companies in Europe as well.