After years of relentless decline, asset-backed commercial paper may be on the verge of a comeback.
ABCP is a tool that banks use to warehouse assets for their corporate customers until they can bundle those assets into a securitization. At the height of the crisis, banks sponsoring conduits that issued ABCP had trouble rolling over the paper as investors shunned the instrument, largely a result of certain conduits’ heavy exposure to subprime mortgages.
The volume of outstanding asset-backed commercial paper has been on the decline ever since, having peaked at $1.2 trillion in July 2007. The drop has been precipitated by a combination of low interest rates, a slow economy, regulatory anxiety and lingering associations with the financial crisis.
The vast majority of ABCP are bank sponsored and either fully or partially supported by the sponsor in the event of defaults. The instruments are short-term — typically well under 270 days. They compete with other form of bank funding, certificates of deposit, regular deposits and other kinds of commercial paper, which haven’t suffered quite as much as ABCP in the crisis aftermath.
But there are reasons to believe ABCP is finally turning a corner.
An economy on the rebound and greater regulatory clarity are two leading catalysts. Another is the prospect of rising interest rates. Players said that with longer-term rates hovering at historical lows for the past several years, the demand for short-term debt to fund longer-term assets — basically what much of ABCP does — has been low as well. Once rates do increase, the spread between shorter term and longer-term rates is likely to widen, making it more attractive to fund assets via commercial paper.
In a late-December report, Moody’s Investors Service said that it had already registered an uptick in ABCP outstandings, even though more widely-used data published by the Federal Reserve have yet to show a clear trend upward.
Moody’s put the total at $213.8 billion as of September 2014, up 1.3% from a year earlier. This was the first time the agency registered an increase over the course of a year since the financial crisis.
The Federal Reserve had outstandings at $230.9 billion on a nonseasonally adjusted basis at the end of 2014, an uptick from the previous few months. But the figure dropped a bit again to $228.1 billion at Jan. 14.
Though less sanguine than Moody’s, Fitch Ratings and Standard & Poor’s see areas of growth within ABCP as well.
“[In] some of the larger, more established multiseller programs, you could see outstandings increase, but there will not be significant growth,” said Kevin Corrigan, senior director at Fitch Ratings.
Multiseller programs, most of which are bank-sponsored, fund a variety of assets; whereas single seller programs are used to finance a single asset.
Analysts at Standard & Poor’s also expect some banks that sponsor ABCP programs to boost outstandings, although analysts there believe there could still be some dip in the aggregate figure. Bank-sponsored conduits make up the bulk of the market.
Last year saw the exit and wind-down of a number of ABCP conduits, as the headwinds facing the market proved too much for some. Among the ones closing their doors was Ford Credit Auto Receivables Owner Trust, a single-seller conduit administered by Ford Motor Credit, which had roughly $17 billion outstanding at its high point in 2008-2009.
Deutsche Bank also either closed down or reduced outstandings of some conduits in the second half of 2015, a possible reaction to Moody’s downgrade of a number of the ABCP programs the German bank sponsors to P-2’ from P-1.’ Among downgraded U.S. programs were Gemini Securitization, Montage Funding, Monterey Funding, Northern Pines Funding, Aspen Funding, Newport Funding, Saratoga Funding Corp., and Sedona Capital Funding Corp.
The downgrade came on July 30. And within a couple of months, Okanagan Funding Trust, which is Canadian, repaid all of its commercial paper in full. Monterey and Montage — which were “feeder conduits” into Gemini — closed down in the fall as well. As feeder conduits, they bought assets from, and issued paper to, Gemini.
Moody’s dunked the conduits’ ratings in tandem with the bank’s long-term debt and deposit ratings, which fell to A3’ from A2.’ The credit strength of a bank-sponsored program is linked to that of the corresponding bank.
According to Moody’s, as of Sept. 2014, Deutsche had already reduced the outstanding of the four U.S. ABCP programs it rates to $8.45 billion from $13.73 billion a year earlier.
Fitch’s ABCP surveillance shows that, between June and November 2014, outstandings of Gemini Securitization alone fell to $1.5 billion from $6.5 billion. But others conduits have not shrunk as much. Over the same period, Newport declined to $600 million from $700 million and Aspen to $1.2 billion from $1.3 billion.
A Deutsche bank spokesperson did not return a request for comment.
But some new ABCP conduits also started up last year, while older ones boosted their outstanding as demand for funding certain assets rose — the torrid origination of auto loans helped on this count — and regulatory uncertainty began to wane.
Among programs launched in 2014 were Great Bridge Capital, a multi-seller conduit managed by Guggenheim Treasury Services, and Multi-Borrower Funding, a conduit administered by Credit Suisse that funds derivatives
Two active foreign banks include the Bank of Tokyo Mitsubishi and Royal Bank of Canada. The former had $14.28 billion Moody’s-rated outstandings at Sept. 2014, up from $12.51 billion a year earlier, while the latter grew to $20.56 billion from $15.73.
In the same period, a smaller player, Credit Suisse, increased its outstandings to $10.01 billion from $5.19 billion.
A Credit Suisse spokesperson did not return repeated requests for comment.
While JPMorgan Chase and Citibank have voluminous programs — at the top of Moody’s league tables, for instance — it is the foreign banks that face a particular incentive to issue ABCP in the U.S.: fewer alternatives for short-term funding.
Neither JPMorgan nor Citibank returned requests for comment.
“U.S. banks have a deposit base they can tap for funding that foreign-based banks operating in the U.S. typically do not,” said Philip Galgano, lead analytical manager at S&P. ABCP is a useful funding tool for them.”
[Mostly] Out of the Woods
Without a doubt in 2015 ABCP players will be facing far more regulatory certainty than they have in years. Among the rules sponsors are preparing to comply with are Volcker, risk retention and the liquidity coverage ratio (LCR) under Basel III. They also need to be vigilant of changes in the regulations covering money market funds, since these are major buyers of ABCP.
In general, players seem relieved that the final rules in these regs are not as punishing as they might have been.
The Volcker Rule — which prohibits banks from owning certain kinds of financial instruments — has a carve-out for ABCP that is from a conduit that has “100% credit enhancement from a regulated provider with unconditional support” and funds only loans or ABS bought at issuance and not in the secondary market, said S&P in a mid-December outlook report.
Some sponsors have shifted from partial to full support thanks to Volcker but they have another option.
ABCP conduits are considered “covered funds” under Volcker because they rely on certain exemptions provided by the Investment Company Act of 1940 to registering with the Securities and Exchange Commission, namely 3(c)(1) and 3(c)7. Conduits can avoid the covered fund classification by simply relying on a different exception, 3a7 of the same law. According to Moody’s, “a large number” of conduits have already done so.
Galgano says more conduits may follow suit as the deadline approaches, which last December was pushed back a year to July 2016. It remains to be seen how this might impact the mix of assets that are funded by ABCP, because, as he pointed out, with 3a7 comes certain restrictions on the types of assets that can be funded.
For their part, risk retention rules — which ensure issuers have skin in the game by exposing them to potential losses — offer ABCP conduits a few approaches.
In its report, Moody’s said that in fully supported conduits, liquidity providers — nearly always doubling as the sponsor — could easily retain the required 5% of the CP as they already effectively retain 100% of the risk.
Sponsors can retain risk by holding a “horizontal” interest in the most junior tranche;holding a “vertical” slice, that is, 5% of each tranche of the program’s paper; an approach that combines the two; or, particular to ABCP, ensure the conduit’s customers keep the 5% of the assets being funded.
On the face of it, the last option might not seem onerous. However a conduit is only eligible if, in addition to being fully supported, it funds only asset-backed securities bought at issuance. Loans and other receivables are left out. This defeats the purpose of ABCP for many sponsors who use the conduit to warehouse assets for corporate customers until they can be packaged into a securitization.
S&P analysts do not expect bank sponsors of ABCP conduits to avail themselves of the customer-retains-the-risk option precisely because they finance “loans, sales, and purchases of asset pools in addition to ABS.”
Some market participants have indicated that they are looking into the vertical slice approach which seems to be easier and more cost-effective for conduits, said Galgano. Nonbank sponsors and capital market participants not subject to banking capital requirements may be more inclined to utilize the horizontal retained interest particularly for asset classes where retaining equity is already common practice, S&P said in a report.
Designed to ensure banks will have enough funds available to cover its commitments in periods of stress, the LCR has pushed ABCP conduits to allow for the issuance of puttable and callable paper. The idea is to minimize the burden of holding funds under the LCR calculation.
S&P analysts said that a full 22 of the 55 conduits the agency rate have okayed the issue of ABCP that they can call before the 30th day of maturity, reducing the LCR’s impact since in a crisis the sponsor can call its paper for any short-term needs.
Finally, in the money-market fund arena, Moody’s said that ABCP could be affected by a new SEC rule that requires this class of investors to “float their net asset value and allows them to apply liquidity fees and limit redemptions in times of market stress.” The main issue here is that pricing asset-backed commercial paper after issuance is difficult given the lack of a secondary market, Moody’s said.
The agency added that it’s not clear yet what the final result will impact money market fund demand for ABCP over the two-year implementation period that began in July 2014.
As far as the kind of assets that are being funded, the ABCP market should continue to mirror the larger economy, barring certain investment restrictions that might arise from their approach to regulatory compliance.
Last year saw auto loans increase their share of assets funded by ABCP, to 33.9% from 28.9% a year earlier.