Regulatory and accounting changes that have been implemented, and proposals under consideration, have been primary drivers behind many of the recent innovations in the ABCP market. As ABCP conduit sponsors make adjustments to their programs in order to maintain off-balance-sheet treatment, manage regulatory capital, or minimize the cost of third-party liquidity facilities, Standard & Poor's has evaluated the impact of those changes on the credit quality of commercial paper issued.
In addition, Standard & Poor's has issued credit assessments that address the risk borne by credit enhancement and liquidity facility providers to ABCP programs. These credit assessments have been used in the syndication of liquidity, for internal risk management purposes, and to support the bank's position in discussions with regulators. The pace of innovation is likely to accelerate as the effective date for Financial Accounting Standards Board's FIN 46 draws near. Absent program amendments, FIN 46 threatens the long-term economic viability of many ABCP programs. Although the market's direction currently is uncertain, it is clear that market participants will be working overtime to find solutions that will allow sponsors to continue to receive off-balance-sheet treatment while maintaining the credit quality of commercial paper notes.
Historical innovation and adaptation
The ABCP market essentially started as a "fully wrapped" market with both credit and liquidity risks being borne by liquidity banks. Investor comfort with ABCP and other short-term instruments, combined with the phenomenal growth of money market funds and the introduction of partially supported programs in which liquidity banks only funded against performing receivables, were responsible for the significant growth of the ABCP market.
The majority of ABCP programs, traditionally, have relied on committed liquidity facilities to ensure timely payment to investors. But over time, the cost of that liquidity has trended up, and third-party liquidity has become a scarce resource. Scarcity of liquidity was often cited as a factor constraining the growth of the ABCP market. The search for alternative forms of liquidity led to the expansion and use of extendible note programs, or secured liquidity notes programs, and asset-backed medium-term notes (MTNs).
The small decline in ABCP outstandings during the past year, as well as the growth of existing programs combined with the establishment of new programs in 2002, has led to the extendible note programs accounting for roughly 8% of total ABCP outstandings. Banks with large credit card securitization programs were among the first to issue extendible notes to efficiently tap into a new source of funding. Standard & Poor's rating analysis was adjusted to include an analysis of both the credit quality of the receivables and repayment speeds. By leveraging the portfolio's inherent liquidity provided by the rapid paydown of receivables, the banks were able to issue 2a7 eligible notes with significantly reduced third-party-provided liquidity facilities relative to traditional ABCP programs.
The analysis of these types of instruments on a cash flow basis enabled reliance on internal liquidity as a source of repayment instead of committed liquidity lines. Analysis of Eureka Securitization PLC (Eureka), a multiseller CP conduit and MTN program, enabled Citibank to further reduce its reliance on bank-sourced liquidity and instead look to the liquidity inherent in over 50 trade receivable pools, such that the mix of external and internal liquidity will, in the event of a commercial paper market disruption, still allow Eureka to meet its obligations in full and on time.
The analysis conducted by Standard & Poor's included a review of historic portfolio performance and a review of the sponsor's cash flow tracking systems. After amending the Eureka program, Citibank was able to reduce its reliance on external liquidity by as much as 40%. Part of the motivation for reducing reliance on traditional bank-provided liquidity facilities included proposed changes in the Basel Capital Accord that would require banks to hold capital against liquidity facilities.
Assessing liquidity bank risk
A growing number of liquidity banks and conduit sponsors are requesting Standard & Poor's risk assessment of the true risk being taken by liquidity banks. The more sophisticated liquidity banks find that the risk assessment helps in the syndication and supports internal credit departments' approval processes or in determining the appropriate pricing for the risks being taken.
For the most part, banks signing a liquidity agreement with a conduit are comfortable advancing loans on the balance sheet to the originators seeking financing through the ABCP conduits. Consequently, the analysis often entails determining the ultimate recovery of loans or advances made rather than timely receipt of interest and principal. For example, the analysis may involve calculating dilution and commingling risk, the two most common risks being taken by liquidity banks. Alternatively, if there is some degree of additional risk being taken by the liquidity banks, they may want confirmation of the exposure for determining the appropriate regulatory capital charge.
Meeting new capital
guidelines
On Nov. 29, 2001, the U.S. Treasury Dept., Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, and other "agencies," published guidelines for determining risk-based capital for the credit risk being taken by U.S. banks on their recourse obligations, residual interest, and direct credit substitutes provided by them. Among the risk-based capital rules published, the Fed introduced the "ratings-based approach" for determining the appropriate capital. Under this approach, the amount of regulatory capital required is a function of the ratings assigned to the exposure being taken.
An increasing number of recent pool-specific risk assessments completed by Standard & Poor's are providing credit enhancement and liquidity facility providers with a more refined analytical basis for capital allocation under the new guidelines. Standard & Poor's has also undertaken the analysis of the programwide credit enhancement (PWCE) for some sponsors for the purpose of determining regulatory capital as outlined in the Nov. 29 ruling mentioned above.
For the most suitable risk assessments to be completed, entities requesting the assessments should be prepared to answer the following questions:
* Are you looking for a risk assessment to the first dollar loss, similar to a rating, or an ultimate recovery assessment?
* Is a credit assessment of at least investment-grade sufficient for your purpose, or is a more precise assessment required?
* Is a survey of transactions sufficient or do you want every exposure quantified?
The answers to these questions will determine the scope of the analysis. The proportion of risks being taken by the conduit and the liquidity banks in any given conduit transaction can vary on a deal-by-deal basis and Standard & Poor's analysis is flexible enough to take into account the transaction structure and business strategy.
On a related note, at least one major conduit sponsor has been preparing to comply with the new Basel Capital Accord issued by the Basel Committee on Banking Supervision that sponsors the international framework for setting minimum capital standards. The undertaking involved moving away from transactions that are fully enhanced by liquidity banks to partially supported structures where liquidity funds only for performing receivables.
The Financial Accounting Standard Board's (FASB) deliberations in 2002, and the implementation of the limited time within which viable restructurings consistent with the sometimes nebulous guidelines issued in January 2003 have to be implemented, has understandably distracted some sponsors from focusing on Basel.
Determining expected losses
To determine the primary beneficiary of a Variable Interest Entity (VIE), as defined in FIN 46, the first level of analysis involves calculation of expected losses and then comparing it to the equity investment at risk. According to FIN 46, the primary beneficiary (the entity that has to consolidate the assets of the VIE, in this instance the ABCP conduit) is "the party that absorbs a majority of the expected losses, receives a majority of its expected residual returns, or both, as a result of holding variable interests, which are ownership, contractual, or other pecuniary interests in an entity."
In the ABCP context, there is a wide range of distribution and dispersal of risks between the seller/originator of the receivables, the liquidity banks, and the different levels and types of credit enhancement to cover losses. Historically, the average loss experience has been negligible for the industry.
To the extent market participants are in need of objective third-party analysis, Standard & Poor's is uniquely qualified to determine and verify the pure expected loss calculations as clarified by the FASB given the depth of its knowledge of the ABCP conduit programs, as well as its research and analytical capabilities. Credit assessments may also be used to a greater extent to support appropriate capital allocation for those banks that may consolidate conduit assets onto their balance sheets.
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