Extendible note programs have generated considerable interest in the short-term debt market.Lately, a number of stand alone extendible note programs as well as extendible notes issued as part of the short-term debt issued by a single seller asset backed conduit have been rated. This article attempts to address major issues relating to extendible notes as well as highlight some of the features of programs that issue extendible notes.
What Are Extendible Notes?
Extendible notes are short-term instruments. So far, the rated programs have an extended maturity of no longer than 390 days from initial issuance. Bankers tell us the notes have characteristics of both asset backed commercial paper (ABCP) as well as term securities. Like ABCP, they are eligible for purchase by money market investors. Unlike ABCP, liquidity bank commitment to repay investors upon maturity of these notes due to inability or unwillingness to issue new notes, is less than 100%. Extendible notes are largely repaid from the cash flows generated by the assets securing these notes within the 390 day period, much like the money market tranche of term debt.
Why the Recent Surge in Popularity?
From the issuer's perspective, the major benefit of issuing extendible notes is the cost saving from not requiring 100% committed liquidity. Liquidity in this expanding commercial paper market is likely to become more expensive if the latest Bank for International Settlements proposal requiring the assessment of capital for providing liquidity is approved. Investor interest, tempted by the higher yield relative to ABCP, is tempered by reservations about the extension feature of these notes. In effect the investor may be the sole taker of liquidity risk.
Citibank's Dakota Certificates program, in existence for the last five years, issues extendible notes that are backed by credit card receivables. Investor reservation at the inception of Citibank's program has been replaced with a healthy appetite for these certificates given the history of sound performance. Investor acceptance has led to the extendible notes functioning almost like asset backed commercial paper without any need to use the extension feature of the notes as yet.
Lakefront Funding LLC, established by Banc One in 1999, is very much like Citibank's Dakota Certificate Program in terms of the extension feature of the notes and interest on the extendible notes mimicking the payment terms on the certificates. While the structural features are very similar, the incentive for establishing the program is to tap an additional source of liquidity for two of its active ABCP programs - Preferred Receivables Funding Corp. (PREFCO) and Falcon Asset Securitization Corp. (Falcon). Liquidity notes issued by Lake Front do not have pool specific committed liquidity. Rather, they get repaid from collections on the assets that will be purchased by Lake Front from PREFCO and Falcon.
Brahms Funding Corporation is a multiseller, extendible secured liquidity note program (SLN) sponsored by Dresdner Bank AG. It was established this past June. The rating on Brahms' SLNs is based on pool-specific credit enhancements that is commensurate with the program's rating, adequate liquidity from collections of underlying assets in which Brahms invests, appropriate interest rate and currency risk coverage, and pool-specific swap agreements. Such hedges are in place for any specific pool to fully hedge interest rate risk, liquidity risk, currency risk, market value risk and in some cases, credit risk. The hedges are from swap counterparties rated A-1+'.
The new' extendible note programs are experiencing growing pains much like the Dakota Certificates program before them. Issuers and investment bankers are hoping to create a robust market for these notes once the money market investor are sufficiently educated about the extension features and the corresponding risks that they are taking. Investors demand a higher premium on their investment by taking extension risk although the credit risk is in line with a similarly rated commercial paper program.
Criteria for Evaluating Extendible Note Programs
In general, rating criteria for evaluating these programs at Standard & Poor's is aligned with the methodology for rating term securities with the assumption that the extension feature is utilized. The methodology is to stress the cash flows from a credit perspective to analyze full and timely payment of the notes upon the final maturity date. Credit enhancement sizing is asset specific with the use of appropriate rating multiples. From a cash flow perspective, the worst case scenario has to be determined i.e. one in which the least amount of cash is going to be received. The worst case varies by the asset type and the structural features of the underlying transaction, for example amortization events.
This worst case scenario may differ from the one used to size full term credit enhancement. An example of the difference is credit for recoveries for some assets. In a term transaction credit for recoveries on defaulted receivables may reduce enhancement levels. For those same assets such recovery may not come in by the end of the extension period so such credit cannot be given.
Asset types and structures most amenable to extendible note issuance are those with a determinate cash flow because they:
*have a relatively short liquidation
period like trade receivables;
*are currently liquidating or
*need financing for a very short-
period of time, as in a warehousing
Clearly, a greater percentage of committed liquidity is necessary if either the cash flow inherent in the assets during the extension period of the notes is not sufficiently large or is uncertain.
Some programs that issue extendible notes are structured without the use of committed liquidity. These programs rely on the sale of assets to pay off maturing extendible notes. If the transaction is relying on liquidation of assets to repay the extendible notes then the market value criteria is utilized and the sale of the asset is assumed to take place in a highly distressed environment. Centex Home Mortgage, LLC for example utilizes a swap that effectively takes all market value risk associated with the sale of the performing assets as well as the non-credit component of the non-performing loans. There are additional reserves in place to cover any expected defaults on the assets. If the swap is taking market value risk, the swap agreement as well as swap counterparty ratings have to meet synthetics securities criteria.
Legal opinions have to cover all the risks being taken in a term facility and will include true sale, non consolidation and security interest opinions. Those can be the topic of another time or call your friendly rating agency analyst.