Asset-backed commercial paper issuance could pass the $1 trillion mark in 2006 while outstandings are expected to increase 10%, according to an econometric model generated by Standard & Poor's and a recent survey of nine leading conduit sponsors.
Several factors seem to be driving the growth, including new structural features, corporate funding requirements, a low interest-rate environment as well as accounting, legal and regulatory issues.
Commercial paper (CP) remains cost efficient for both borrowers and lenders.
"Originators can get cheap financing with sub-Libor ABCP rates," said Manjeet Kaur, a credit analyst at S&P. "And investors are putting a substantial portion of their large supply of investible cash into the CP market."
The economic backdrop
As the economy enters a more expansionary phase, corporations need funding again for new investments.
"In 2002 and 2003, inventories were still high and companies could not put money to work," said Andrew Jones, managing director at Dominion Bond Rating Service. "As levels of retained earnings begin to recede, general financing needs arise."
The vibrancy of the residential mortgage market in 2005 helped establish warehousing conduits. Few dare to predict the course of RMBS issuance. But with talk of an inevitable eventual slowdown in RMBS, could we see a dampening of ABCP going forward?
The auto finance sector, on the other hand, will probably continue to rely on ABCP for the foreseeable future.
"Despite the parent companies' trouble, their securitizations have been doing well," Kaur said.
Growth in the repurchase market and extendable notes has reduced bank liquidity costs for conduits, which can run 15 to 30 basis points. Repos have benefited from recent changes in bankruptcy law and developments in structural features have helped fuel extendables.
"You can minimize expenses with structures that allow liquidation of collateral, or with fast-paying assets that generate cash flow during the extension phase," Kaur said.
The Bankruptcy Code extended a safe harbor provision last year to include repo mortgages, having previously only covered government debt. It had been necessary to create additional bankruptcy remote SPVs to ensure that the collateral would not belong to the broker/dealer's estate. Conduits no longer need to find sufficient Treasuries. They can instead put a lien on the mortgages, liquidate collateral and use the proceeds to pay off the noteholders if a seller files.
"A two-step structure can be replaced with a one-step structure, so mortgage companies can transfer assets directly," said Tim Mohan, a partner at Chapman and Cutler.
Extendables are proving to be popular since they deliver a slight pickup in yield in return for investors' willingness to hold them up to the second maturity date, in the event of some disruption. This fast-growing market has also reined in liquidity costs, thanks to innovations in cash flow analysis. New tools describe how much cash flow can be collected during the collateral liquidation period.
"Mortgages are very liquid, have value and the market is very deep, so why do you need liquidity if you can sell off the assets?" Jones asked.
Kaur said that if cash flow generated during the extension phase will cover 80% of the required principal and interest, only the remaining 20% must be met by third-party liquidity. When market value programs use the extension period to liquidate the collateral, S&P analyzes various factors that might contribute to the decline, such as the depth of the secondary market, interest rate movement and spread volatility.
CDOs and synthetics
Synthetics and CDO-like vehicles that employ multiple swaps are increasingly issuing commercial paper. Some CDOs are issuing senior tranches at better rates, creating short-term paper that can be bought by money market funds.
"The market for financial service companies has broadened," said Felicia Watson, a partner at Orrick Herrington. "Hedge funds, with their huge proliferation on the scene, could be either buyers or issuers of CP."
Watson said that as the market has matured, it has become more willing to "move down the credit curve," since conduits are accepting a wider range of assets. Lower quality credits are compensated by insurance, credit enhancement or pricing. There was no appetite for non-investment grade paper 10 years ago, she said.
"CP is even being used as a bridge arrangement on distressed receivables," Watson said. "It can be used to fund a distressed portfolio on a temporary basis during a reorganization period."
"Over the past year, certain account and regulatory issues have become more settled, enabling sponsors to focus their attention on deal flow," Mohan said. "We are having more conversations with clients about how to get deals done, now that they are less worried about accounting constraints."
GAAP accounting rules dictate that ABCP conduits must be consolidated by sponsors who retain their risks and rewards. U.S. regulators have developed permanent capital requirements for bank liquidity facilities with a minimum capital charge of 80 basis points. New rules under Basel II have also lifted some clouds. They provide for an internal assessment approach to risk-weighted charges for each category, as long as conduits can get approval from their national regulators.
"Banks are getting more comfortable about using that approach," Mohan said.
Also, never discount old fashioned cross marketing.
"Banks never looked at ABCP as a big profit center, but it is a way to maintain a total client relationship," Jones said.
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