By American Securitization Forum (abridged)
Over the last decade, market professionals have sought to develop structures that would receive the desired short-term ratings, without including 100% coverage of outstanding ABCP by liquidity facilities. This development has been motivated, in part, by the increased cost, and perceived lack of availability, of traditional liquidity facilities, and also by a desire to develop more efficient program structures.
Industry participants expect that changes to the bank regulatory capital requirements required by Basel II may make liquidity facilities more scarce and expensive. Various structures have been developed involving less than 100% liquidity coverage, i.e., "partial" liquidity, and involving types of liquidity other than bank loan or purchase facilities, i.e., "alternative" liquidity.
In this context, market professionals have sought to develop structures that would harness the inherent liquidity of assets - i.e., the ability to quickly convert such assets into cash. To the extent that cash derived from assets is available at the maturity of ABENs, the dependence on bank facilities can be reduced or eliminated. Underlying assets have inherent liquidity either because they are readily marketable (e.g., mortgage loans), or because they pay off very quickly (e.g., credit card receivables or trade receivables).
ABEN programs which rely on the marketability of underlying assets for liquidity, are called "market value" programs. Programs which rely on the fast paying nature of underlying assets, are called "cashflow" programs. As mentioned above, an issuer may not know in advance that it will not be able to roll all of its commercial paper when due. Although it may be possible to convert the underlying inherently liquid assets into cash quickly, it generally will not be possible to do so without taking at least a number of days. Accordingly, structures needed to be developed to provide time between the date on which the issuer would know it had to obtain cash (i.e., as late as the maturity date), and the date it would be legally required to pay the commercial paper notes.
Hence, "ABENs" are issued with both an Expected Maturity Date (from overnight to up to 30 to 240 days after issuance), and a later legal Final Maturity Date (generally at least 90 days after the Expected Maturity Date, but no later than 397 days after the original issuance date). ABENs are issued with the expectation on the part of both the issuer and the investor that the ABEN will be paid in full on the Expected Maturity Date, although payment in full is not legally due until the Final Maturity Date.
If the issuer is unable to roll or otherwise repay an ABEN on its Expected Maturity Date, the ABEN is said to "extend" to its legal Final Maturity Date, and to "convert" to an Extended Note. During the period between the Expected Maturity Date and the Final Maturity Date (the "extension period"), the issuer realizes the proceeds of the underlying assets, and applies the proceeds to pay Extended Notes on or prior to their Final Maturity Dates. The assets will or prior to their Final Maturity Dates. The assets will be sold, if liquidity is based on the marketability of the underlying assets, or will pay off during the extension period, if liquidity is based on the fast paying nature of the underlying assets.
Market value programs have longer extension periods than absolutely necessary to allow for orderly liquidation of the underlying assets and maximization of proceeds. Cashflow programs generally have longer extension periods than do market value programs to provide sufficient time for the assets to pay off.
A wide variety of asset types are financed in ABEN programs, including residential and commercial mortgages, agency and private label mortgage-backed securities, credit card receivables, auto dealer floorplan receivables, servicer advances and student loans.
What considerations are important for investors in ABENs?
As with asset-backed securities generally, investors make decisions based on assessment of the sponsor of the program, the quality of the underlying assets, the structure of the transaction, the type and amount of credit enhancement, and the identity of enhancement providers. Since transaction structures are complex, it is critical to review offering documents carefully in order to understand the structure, the various sources of enhancement and the specific terms of the ABENs.
The corporate debt ratings and capital market experience of program sponsors varies significantly. Some programs are established by sponsors with corporate ratings and experience in the capital markets and commercial paper transactions. In other cases, sponsors without corporate ratings have launched new programs issuing A-1+/P-1 ABENs.
To compensate for perceived risks, these transactions are typically structured to provide investors with protection against operational risk by requiring a rated entity to perform certain administrative and other functions. The short-term rating of ABEN programs is based on the likelihood that payments of interest or discount and principal will be made by their Final Maturity Date.
ABENs contain various types of enhancement designed to ensure that the proceeds of the underlying financial assets realized during the extension period, together with other available amounts will be sufficient to a rated certainty to pay Extended Notes on or prior to the Final Maturity Dates. The amount of credit enhancement varies greatly, depending upon the assets and structure. For example, in certain programs that finance "AAA/Aaa" rated agency and private mortgage backed securities, no credit enhancement is required and rating agencies assign market value haircuts based on their published methodologies.
In warehouse structures, assets are typically newly originated and are held in the facility for a limited period of time, so delinquencies and defaults are relatively small. Since these structures may hold assets subject to portfolio aging criteria, credit enhancement may be sized based on losses during the period from the Expected Maturity Date to the Final Maturity Date of the ABENs. Still other structures are designed to finance assets held to maturity.
In these portfolio-financing transactions, credit enhancement is generally sized based on criteria for revolving securitized transactions. As of the date of this guide, no ABENs have extended. Nevertheless, investors must understand the risk of extension and be satisfied that they are being appropriately compensated for the risk. This compensation is expressed in the step-up rate, and in addition may be expressed in a purchase price at a premium over a comparable non-extendible note.
At present, there is an active secondary market for Liquidity Notes. However, given the absence of an extension event in the market to date, a secondary market for Extended Notes does not currently exist. In the event of an extension, investors in Liquidity Notes would be subject to market conditions at the time with respect to the depth and pricing of secondary market liquidity. Moreover, as discussed below, ABENs and Extended Notes are subject to transfer restrictions.
Under what circumstances might an ABEN program extend?
ABENs may extend if for any reason the issuer does not roll all ABENs on an Expected Maturity Date. This could happen if due to an unanticipated disruption in general market conditions it is not possible to issue new ABENs on the Expected Maturity Date of maturing ABENs. Causes of an unanticipated disruption in general market conditions may include acts of terrorism or war, natural disasters, and/or systems failures.
An ABEN program could also extend due to a more specific condition, for example, a disruption in the ABEN market, or a disruption in the market for the ABEN sponsor's paper. In addition to unanticipated circumstances, the potential for extension of ABENs depends on the terms of the program. Many programs contain conditions, which if not satisfied, prohibit the issuance of ABENs until the condition is cured.
The existence of such a condition on the Expected Maturity Date of an ABEN would result in the extension of the ABEN, unless the issuer is able to obtain funds from realization on the underlying assets and other amounts available to the issuer to pay in full all ABENs having such Expected Maturity Date (together with any outstanding Extended Notes).
In addition, most programs contain events, often called termination events or wind-down events, which mandate not only stop issuance, but also resulting in the liquidation of the underlying assets and the termination of the program. Upon the occurrence of such an event, it is likely that most if not all classes of ABENs would be extended and funds applied to repay Classes of Extended Notes in the order of earliest Final Maturity Date.
In most programs, all of the program-specific events that could give rise to an extension of ABENs are disclosed in the offering documents, and monthly investor reports provide a means for investors to track the likelihood of the occurrence of such an event. The question may be asked whether there is an option to extend on the part of the issuer. Since program documents do not require the issuer to issue new ABENs to refinance ABENs or to liquidate assets to repay ABENs on their Expected Maturity Dates, such an option is not precluded.
However, investors generally view extension extremely negatively, notwithstanding payment of a step-up interest rate upon extension. Therefore, although an option may exist, there appears to be a strong disincentive for an issuer to allow an ABEN to extend, if such ABEN can be refinanced or otherwise repaid.
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