According to a report issued by Moody's Investors Service, the largest change in the asset-backed commercial paper program mix over the past year has been in the securities arbitrage segment, which is also the fastest growing segment of the market.

Annika Sandback, vice president and senior analyst at Moody's, shed some light on exactly what these programs are and how they function.

"Securities arbitrage programs are asset-backed commercial paper programs that are set up strictly to purchase asset-backed securities," Sandback explained. "Rather than purchasing trade receivables or credit cards, they purchase asset-backed securities and they issue asset-backed commercial paper in order to fund those purchases. The spread between the rate they have to pay on the commercial paper to commercial paper investors and the rate they receive on those asset-backed securities is an arbitrage."

A total of 39 new ABCP programs were established in 1999 in both the third and fourth quarters. Securities arbitrage programs accounted for 11 of these and were responsible for 36% of the 68 ABCP programs established in 1999. Currently, there are several new arbitrage programs floating along the Moody's ratings pipeline.

Presently, there are three types of securities arbitrage programs in the marketplace: limited-purpose investment companies (LiPICS), market-value ABCP programs, and credit-arbitrage ABCP programs. All three programs are alike in that they invest in securities portfolios but also have varying characteristics.

Although growth in these programs is speculated - with several banks looking to set up arbitrage programs - Maureen Coen, managing director at Moody's, does not anticipate record growth numbers like those were seen last year.

"Growth will not be like it was in 1999, I project, because A) many banks already have securities arbitrage programs and B) potentially some of the arbitrage may be eliminated because of the BIS capital-adequacy revisions," Coen said. "Some of the capital arbitrage will be taken away potentially by the proposed regulations."

Fundamentals of the Programs

Right now the way the programs work, Coen explained, is that the issuers invest in assets that are rated Aa2 or higher. As a result of the highly rated assets, no program of credit enhancement is required, saving the issuer money. If the bank provides the credit enhancement, it has to hold capital against that.

These programs also have 100% liquidity, Coen said, but right now liquidity is not attractive to capital. With these programs there's no capital that's held against them. If the bank held these Aa2 or higher-rated assets on its balance sheets, currently under the BIS regulations they would have to hold capital against them. What happens is they put them into the conduit, keeping the holders of the conduit on their balance sheets and they get what Coen calls "an economic return".

From the investor standpoint, transactions done through these programs tend to trade a little bit wider, so the yield picks up, Coen said.

But nothing is risk free.

Coen explained that an asset can go from a double-A rating to a Aa1 rating in over 270 days. If an asset is Aa2 today and goes down to single-A, the banks have a choice of either taking that asset out of the portfolio, putting up credit enhancement or letting the program wind down.

"If they take the asset out of the portfolio, there is no more risk," she said. "If they put up credit enhancement, hopefully the risk is mitigated by credit enhancement and if they let the program amortize the investor is exposed to that single-A asset for 270 days; if it deteriorates further below Caa1, the investor is going to have a loss."

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