The asset-backed commercial paper market, which is still less than a third of the size it was before the financial crisis, may be set to shrink even further.
When the commercial paper market seized up in 2007, money market funds (MMFs) - by far the biggest buyers of ABCP - sustained significant capital losses that were absorbed by the funds' sponsors.
But in 2008, when large money market fund the Reserve Primary Fund "broke the buck" as the result of its exposure to debt issued by Lehman Brothers, investors panicked. In the days that followed, nearly $200 billion was withdrawn from prime money market funds - about 10% of the sector's invested assets. This led to severe funding pressures for issuers of commercial paper.
These funds, which remain ABCP's biggest buyers, continue to face challenges that make future investor appetite in the product somewhat precarious.
On the one hand, the latest regulatory effort to ensure the safety of MMFs and prevent future "runs" on these products, threaten to reduce their appeal to investors, and,in doing so, to reduce MMF's appetite for ABCP.
On the other hand, MMFs must learn to cope with the shrinking universe of tier-one-rated ABCP investment opportunities. Moody's Investors Service downgraded several large banks, including two major sponsors of ABCP, Citibank and Royal Bank of Scotland (RBS). Both banks had their short-term debt rating lowered, to 'P-2' from 'P-1', on June 21.
The ratings of ABCP programs are directly correlated to the banks that sponsor them. So it came as no surprise when Moody's subsequently downgraded to 'P-2' the ratings of seven U.S. programs backing commercial paper as well as four U.S. programs backing letters of credit. The move affected approximately $37 billion of commercial paper.
Additionally, the downgrades impacted $30 billion representing three European programs sponsored by RBS and roughly AUD$ 1,608.35 million ($916.85 million) and Ã‚Â£162 million ($251.8 million) of ABCP backed by RBS' Australian unit.
ABCP is short-term senior secured debt that can be backed by a variety of assets. Banks use it to provide low-cost funding to clients that could not issue their own commercial paper. Full and timely payment of ABCP is of paramount importance to buyers, and Moody's rates the paper solely on the risk of default, rather than expected loss.
The biggest determinant of the risk of default is the creditworthiness of the bank pledging to provide liquidity, rather than the quality of assets in the conduits.
Money market funds hold only the highest-rated securities; Rule 2a7 of the 1940 Investment Company Act severely restricts the percentage of assets they can allocate to Tier II investments (those rated P-2 or A-2). That doesn't mean money market funds are obliged to unload ABCP supported by Citibank and RBS; for now, both banks, and the programs they support, still have 'A-1'or 'P-1' short-term debt ratings from the two other major rating agencies, Fitch Ratings and Standard & Poor's. But these funds may think twice about holding split-rated debt, forcing banks to pay a substantial yield premium.
"There have been few instances where programs have existed in a second-tier manner, whereby their short- term ratings were in that tier status, but by and large that has not been maintained for very long," said Deborah Cunningham, chief investment officer for global money markets at Federated Investors, one of the country's biggest money market fund managers with approximately $370 billion in MMF assets.
"As long as you are looking at sponsor downgrading, and potentially program downgrading, those programs with sponsoring banks that go into a second-tier status draw a bold line in the sand - once it's crossed, funding will go from a lot to a little," Cunningham said.
Even with a more select and limited number of Tier I sponsor banks, however, Cunningham is confident that the bank downgrades will not cause the ABCP market to completely crumble; although it may certainly put downward pressure on the amount of paper outstanding.
A source at an ABCP issuer offered another reason money market funds might shy away from split-rated paper: The fund managers may be mindful that holding paper rated Tier II by Moody's could put pressure on the funds' own triple-A ratings.
Citibank and RBS were contacted for the story but declined to comment on how the downgrades would affect their ABCP holdings.
According to the Investment Company Institute (ICI), MMFs funds held $121 billion in ABCP as of February of this year. This would indicate that they accounted for roughly 39% of the $310 billion of ABCP outstanding.
A source at an investment bank said this figure may understate their importance to the ABCP market. "Money market funds are not only the biggest buyers, they also buy the biggest chunks," he said.
Some market participants put the figure even higher. Lewis Cohen, a partner at law firm Clifford Chance, said money market funds represent upward of 50% of the ABCP market's buyer base.
The average taxable money market fund held 5% of its portfolio in ABCP in the week ended June 22, according to iMoney.net. That was down from 6% a year earlier, before Moody's initiated its review of major banks, and 9% in June 2007, before the financial crisis. Total assets in these funds were $2.245 trillion that week, which means these funds held approximately $112.25 billion of the paper.
Mike Krasner, managing editor of iMoney.net, said fund managers had plenty of warning about the potential for bank downgrades, since Moody's put them under review in February. He expects that managers who are inclined to reduce their exposure as a result have probably done so by now. "It might have been different if the move was a surprise," he said.
Krasner likened the impact of Moody's bank downgrades to S&P's downgrade of the U.S. government in August 2011, which left the Treasury market split-rated.
Another factor working in ABCP's favor is that money market funds do not have a lot of other attractive places to put their money to work. Federated's Cunningham said ABCP still compares favorably to other eligible short-term instruments.
"When you look at the ABCP market versus unsecured commercial paper, versus unsecured bank CDs [certificates of deposit] and versus other types of short-term instruments that are available, ABCP offers extreme amounts of diversification, huge amounts of support from sponsor banks or similar third-party ways of support within the program," she said.
ABCP's Shrinking Numbers
ABCP programs first appeared in the mid-1980s. Initially, banks used the conduits to provide trade receivable financing to their corporate customers. In the 1990s, total assets hovered around $450 billion. But in the early part of the last decade, these programs evolved to serve a wider variety of needs, such as asset-based financing for companies that could not access the term market, warehousing of assets prior to term securities issuance, investing in rated securities for arbitrage profit, providing leverage to mutual funds and off-balance-sheet funding of selected assets.
Assets skyrocketed from $600 billion in June 2006 to $1.15 trillion in June and July 2007, before credit markets seized up.
As of June 20, ABCP outstanding stood at about $310 billion on a non-seasonally adjusted basis, according to figures reported by the Federal Reserve. This is a 74% drop from the July 2007 peak.
The broader U.S. commercial paper market, including unsecured commercial paper and ABCP, has also contracted. As of June 20, total outstanding was $994.7 billion, on a non-seasonally adjusted basis, according to data from the Federal Reserve. That's down 55% from the July 2007 peak of $2.19 trillion.
The market has also become mostly a U.S.-dollar one. Approximately 80% of the global ABCP market rated by Standard & Poor's is issued in U.S. dollars.
The rating agency explained in its June Global ABCP market review that European- and Australian-based conduits issue ABCP in U.S. dollars because of the U.S. market's abundant liquidity and broad investor base.
As of o f year-end 2011, U.S. dollar-denominated ABCP comprised 97.5% of ABCP issued by the North American-based conduits S&P rates; 54.1% of ABCP was issued by European-based conduits, and 17.2% of ABCP was issued by Australian-based conduits.
Outstandings in the European ABCP market, on the other hand, remain very low. S&P said in its June report that year-end figures for 2011 show that issuance from European-based conduits has decreased 17.4% to $133.8 billion from $162.0 billion, which is 32.5% and 37.2% of global rated ABCP outstandings, respectively.
The U.S. ABCP market might be even smaller today if not for the fact that some European banks have shifted their issuance here because there isn't much of a European ABCP investor base.
Michael Dean, a managing director at Fitch, said that European banks have to deal with the SIV fallout that left much of its investor base afraid to be part of even the multi-seller conduits that make up most of market issuance today.
"Many of the SIVs were based in and active issuers in the European market," he said. "In the aftermath of the crisis, many of the traditional multi-seller ABCP programs got painted with the same brush as [SIVs] in the European ABCP markets and since have been issuing in the U.S. markets."
Since the financial crisis, banks have increasingly consolidated their ABCP programs on balance sheet. This phenomenon has been driven by Basel II risk weight capital requirements. "Banks recognize that there is no longer any advantage between using a conduit and using your own balance sheet," Dean said.
In mid-2010, for instance, one of the largest ABCP conduit sponsors, Bank of America, consolidated funding for its conduit platform into a single vehicle. The decision reflected changes to regulatory capital and accounting requirements. At the time of the decision, the outstandings in the bank's conduit stood at about $12 billion, although they have been substantially wound down at this point.
Today BofA continues to serve its clients through a variety of lending solutions including asset-based lending, the bank's emailed statement to ASR said.
BofA had only enough deposits to fund its normal conduit assets. This made the decision to consolidate its programs, to eventually shut down its ABCP operations and to fund the assets on balance sheet instead an easier one, explained a source who is on the sponsoring bank side of the ABCP market.
"The issue with the U.S. banks is that they have such an incredible amount of money in terms of retail and commercial deposits that are just sitting on their books, and they will have to deploy them somehow," said the ABCP issuer source. "So they do not have much need for the conduits."
Foreign banks, on the other hand, are more reliant on the ABCP market because they are essentially more dependent on the capital markets for funding, this person said. That means their ability to raise institutional funds to support liquidity is essentially driven by market appetite. "There is limited appetite for European risk, and it's also down to ratings - if you don't have the rating, you can't issue the product," he said.
European and U.S. ABCP conduits are nearly 100% supported by their sponsors. According to figures from S&P, ABCP from North American-based multi-sellers accounted for 84.6% of ABCP outstanding as of December 2011. The rating agency said that Citigroup/Citibank is now the largest sponsor of ABCP issuers in North America, after a 13.9% rise in ABCP outstanding to $34.8 billion in 2011. JPMorgan Chase Bank, following a large ($9.5 billion) surge in the fourth quarter of 2011, is now the second-largest sponsor (up from fourth in 2011) with almost $32 billion in ABCP outstanding.
It is almost completely a multi-seller market in the region, with the majority of securities-backed conduits being wound down and hybrid conduits significantly reducing their securities exposure.
Nevertheless, banks have remained committed to ABCP because it offers a cheap and diversified source of funding, in particular to institutions that may not have much access to dollar funding, according to Clifford Chance's Cohen.
If these banks couldn't sell ABCP in the U.S., they would have to find that funding elsewhere. "Either they would have to get rid of those assets that they are funding which are business loans to customers or they would have to fund them somewhere else and the question is where do they fund those?" Cohen said. "The ABCP market is a very cheap and practical way for funding assets like trade receivables owed to corporations, which is what most ABCP is these days."
Money Market Fund Reforms
The latest regulatory push to make money market funds safer could also reduce demand for ABCP - not necessarily because it would make ABCP less attractive to money market funds, but because it could prompt an exodus of investors from money market funds themselves.
In testimony before the Senate Banking Committee last month, Securities and Exchange Commission chairman Mary Schapiro warned that, despite regulations passed in 2010, MMFs still pose a systemic risk to the U.S. economy. She said the funds remain susceptible to "runs" by investors, which could potentially freeze short-term credit markets.
That's what happened in September 2008, when Lehman Brothers collapsed and the Reserve Fund saw its share price drop below $1 after writing off debt issued by the investment bank. Typically, MMFs strive to keep their share prices stable at $1; if they drop below this level, managers typically step in to provide support, figuring the cost of lost customers and damage to their reputation outweigh the costs of a bailout. When the Reserve Fund failed to support its share price, investors panicked, withdrawing $200 billion, or nearly 10% of total industry assets, until the Treasury stepped in to provide insurance.
Schapiro told the Senate committee that she asked SEC staffers to examine two options. One would require MMFs to peg share prices to the value of underlying assets - in other words, requiring that funds convert from a stable $1 net asset value to a "floating" NAV.
The other option would be to let funds retain stable NAVs, but add capital buffers and, possibly, redemption restrictions.
Sean Collins, a senior economist at ICI, said floating NAV funds are a non-starter. Certain kinds of institutional investors are subject to guidelines or restrictions that would discourage or prevent them from using floating NAV products for managing their short-term cash holdings. "Our view has been right from the start that the floating NAV won't work," he said.
ICI's concern is that the proposals the SEC seems to be considering would fundamentally alter MMFs, driving investors away from these funds. The impact, Collins said, is likely to be two-fold. "Fewer investors in MMFs reduces the shareholder base so there's less money to invest in things like commercial paper, muni issuances and ABCP," he said. "With fewer investors, there's likely to be industry consolidation, meaning fewer MMFs generally to invest in ABCP and others."
Cunningham, the Federated fund manager, called floating NAV's "a toxic idea that doesn't meet any of the objectives of the market place." She believes that if money market funds are compelled to float their NAVs, the size of the industry would likely be downsized somewhere in the neighborhood of 50% to 75% below the $2.5 trillion in assets it has today.
"Obviously that means that any funding that the industry provides to ABCP issuers would likely be cut in a similar way," she said. "When you look at funding for issuers on the ABCP side of the market, on the corporate side of the market and on the municipal side of the market, those markets would be vastly downsized."
But Cunningham is optimistic that the resistance from the market place and from some regulatory commissioners who would have to vote on the SEC proposal is very high. This makes the likelihood of a floating NAV coming into existence very low.