ABCP & SIVs

Introduction

Asset backed commercial paper programmes and SIVs are used in structured finance to fund assets. The following is an introduction to what is a complex topic. The risks in individual transactions can only be assessed by referring to their documentation-the devil is in the detail.

Asset Backed Commercial Paper, (ABCP)

Banks and companies have issued short term direct obligations in the form of commercial paper, (CP), in the US and European markets for many years. This is a money market product and usually matures within 270 days.

Over the last decade many financial institutions have sponsored special companies called conduits. These are bankruptcy remote vehicles that issue CP that is backed by some form of asset, hence asset backed CP, (ABCP).

ABCP programmes involve many parties. The institution that originates the programme is the sponsor. The conduit itself is owned by third parties. There is an administrative agent responsible for the daily activities of the programme, a dealer responsible for selling the paper and an issuing and paying agent. There are often third party liquidity providers and credit enhancers. Sometimes the sponsor takes on some of these roles.

Banks have sponsored ABCP programmes in order to finance assets they originate in their normal course of business and assets specifically purchased for the purpose. Sometimes they help clients structure ABCP programmes in return for fee income.

The Assets

The conduit invests in trade debt, consumer loan receivables, secured loans, asset backed securities and mortgage backed securities. The assets are medium dated (2-5 years) and are pooled together, with new purchases replacing maturing assets.

The conduit may have asset quality restrictions in the form of minimum ratings. From an investor's perspective the quality and diversity of the assets can be very important although credit enhancement, (see later), may mitigate risk.

The Liabilities

The conduit funds itself by issuing short dated ABCP in the US and European markets. To attract investor the rating is normally A1/P1.

The timely repayment of this paper is dependent on the ability of the conduit to refinance maturing CP with new CP issuance as well as cash flow matching between assets and liabilities in the conduit.

To ensure investors can expect timely repayment the conduit has a liquidity facility from a high quality bank. This facility normally covers 100% of the CP issued. The rating of the provider must be at least as high as that of the issued CP.

The liquidity facility only covers timely repayments of the ABCP and cannot normally be used to cover credit losses in the conduit.

Credit events are covered by credit enhancement. Credit enhancement can take different forms including third party guarantees, overcollateralisation or reserves for credit losses.

Without credit enhancement many programmes would not obtain the desired credit rating. Depending on the credit quality of the assets credit enhancement can be for 100% of the programme or less. Where credit enhancement is 100% the credit risk is considered to be that of the credit support provider.

To add further protection for investors ABCP programmes also have triggers that stop further issuance of CP subsequent to certain events. Such an event may be the credit downgrade of the CP itself. Under such circumstances the programme is forced to liquidate the assets and repay investors with the proceeds.

A simplified ABCP structure:

How does the ABCP programme make money?

The economics of ABCP programmes are reliant on maturity transformation.The longer dated assets when swapped to give a Libor return will produce a rate that exceeds the short dated funding cost.

Any narrowing of credit spreads on long term assets or any increase in short term issuance costs will have a detrimental effect on the economics of the programme.

Careful asset and liability selection will also enhance returns. Some assets may offer relative value, and some CP markets may provide cheaper funding.

Economies of scale

The programme must pay fees for the provision of liquidity and credit enhancement as well as ongoing fees associated with issuing and paying agents, rating companies, lawyers and advisors. The remaining "excess spread" is then paid to the sponsor normally as fee income. Because of these fixed costs the economics only makes sense when the size of the ABCP programme runs into the billions of dollars.

Structured Investment Vehicles, (SIVs)

SIVs are special companies incorporated by financial institutions. They are leveraged and invest in diversified portfolios of high quality assets. In order to fund this investment SIVs issue commercial paper, (CP), medium term notes, (MTN) and capital notes. The margin or spread between the assets and liabilities leads to profits. Theses are split between the arranger or manager and the capital investor.

The assets

SIVs invest in asset backed securities, (bank originated debt, residential mortgage backed securities, collateralized debt obligations), with a portfolio average rating of AA. Historically these assets have had low default rates and have proved popular with investors because of their relative value. The average life of the assets is 3 to 4 years. In general the assets held by SIVs are considered to be more liquid than those in ABCP programmes.

The liabilities

SIVs issue senior debt, capital notes and in some cases equity. Senior debt comprises the majority of the funding. It can take the form of highly rated MTNs and shorter term ABCP. (In this respect SIVs are considered to have more diversified funding sources than conduits). Ratings are typically AAA or A1/P1, with investors obtaining returns close to or below Libor.

The high rating reflects the quality of the underlying investments, the protection afforded by subordinated capital notes, (see below), and some additional structural features.

Capital notes account for approximately 10% of the SIV's funding. These notes are subordinated to the senior debt and act as a first loss piece. (Investment losses are absorbed by the capital notes before the senior debt). In some cases these notes can obtain a BBB rating making them attractive for some investors.

The use of first loss capital by the SIV contrasts with the credit enhancement found in ABCP programmes. Although similar to ABCP conduits SIVs are probably less connected with bank sponsors for this reason.

Because of the increased credit risk an investor in capital notes receives a higher coupon, (Libor plus 25 to 50 basis points). The investor also receives a proportion, approximately half, of the SIVs profit, this may increase the investor's return by 1%-2%. The remaining profit goes to the SIV arranger.

Some SIVs have three a tranche structure. Beneath the capital notes there is a subordinated first loss equity piece that lays claim to the SIV's profit.

A simplified SIV structure:

How does the SIV make money?

There are four ways the SIV makes money:

Maturity transformation: The SIV invests in assets that have longer maturities than the liabilities. Normally this strategy will benefit the SIV. The longer dated assets when swapped to give a Libor return will produce a rate that exceeds the short dated funding cost.
Asset selection: By carefully selecting the assets the manager can increase the investment return whilst retaining the ratings on the SIV's liabilities.
Liability selection: The SIV can issue CP and MTNs in both the US and European markets. Sometimes one market offers cheaper funding and careful selection can keep costs to a minimum.
Leverage: The capital notes are leveraged. Every dollar of capital is subordinate to several dollars of senior debt. The more senior debt the capital supports the higher the leverage. Depending on market conditions and restrictions SIVs can be leveraged 10 to 20 times.

Higher leverage means more risk and return for the capital investor.

This is why:

Suppose the SIV has the following assets & liabilities what is the leverage and profit?

Assets: $1,000m ABS paying Libor + 0.25%Liabilities: $100m of capital notes paying Libor + 0.25%$900m of issued commercial paper paying Libor

The leverage is $900m/$100m = 9 times

The net profit is ($1,000m x 0.25%)-($100m x 0.25%) = $2.25m, split between the manager and capital note investors.

Suppose the manager increases leverage issuing more CP, what happens to the return?

Assets: $1,900m ABS paying Libor + 0.25%Liabilities: $100m of capital notes paying Libor + 0.25%$1,800m of issued commercial paper paying Libor

The leverage is $1,800m/$100m = 18 times

The net profit is ($1,900m x 0.25%) - ($100m x 0.25%) = $4.5m

The profit has doubled but the capital investors have twice the risk.

Originally they cushioned losses on $900m now it is $1,800m.

Liquidity

To ensure investors obtain timely repayments SIVs must maintain a level of liquidity. This can be estimated by calculating the largest one cumulative cash outflow anticipated in the following year.

The SIV is then required to hold cash and committed liquidity facilities that are a multiple of this. In general this means that SIVs have committed facilities that amount to 10% of their liabilities. This contrasts with the 100% liquidity associated with ABCP progammes.

Limits on the manager

Rating agencies impose strict limits on the quality, diversity and maturity of assets held by SIVs. They also insist that the SIV is overcollateralised. (The market value of the assets exceeds the debt by a certain percentage).

When asset values fall overcollateralisation is reduced. In order to retain the SIV's ratings the manager must respond by either reducing payments to capital holders or by selling assets. This is a structural protection for investors.

This deleverage process is known as defeasance. Provided it occurs in an orderly fashion it protects investors. If the arranger fails to liquidate sufficient assets the SIV's rating may fall and funding costs increase. This will adversely affecting the economics of the SIV especially the returns of the capital note holders.

A downgrade or reduction in overcollateralistion may also trigger pay down. This is where the assets of the SIV are liquidated and senior debt is repaid on it's scheduled maturity date.

If the SIV is unable to make these payments on a timely basis it is insolvent. Steps will now be taken to rapidly sell the assets with the senior investors receiving repayment on a pro rata basis. Capital investors may experience losses on some or all of their investment.

Why SIVs?

For arrangers this is money market business. You can create and sell short term assets. The higher the volume the more you make.

Some banks manage up to $100bn in SIVs possibly generating income of $250m pa.

The senior debt from SIVs has been sold as high quality paper underpinned by an investment portfolio with a stable credit history and low default rates. The close monitoring by rating agencies and the defeasance process has added to investor confidence.

Some investors have felt that the profit participation shared by the capital notes make them good investments too.

Whether this area of structured finance can be accurately valued by quantitative models is open to question. The old adage of caveat emptor remains.

How are events in 2007 linked to ABCP programmes and SIVs?

It is a fact that credit spreads, (what you got paid for taking credit risk), continued to narrow between 1998 and 2007.

To obtain the same return banks and investors bought more assets and/or relaxed lending criteria.

The sub-prime crisis in the US market triggered a number of questions in financial markets:

Is the credit cycle on the turn?
How well distributed is the credit risk?
How do structured products really work?
What exposure do individual banks have?
Are structured asset valuations to be trusted?
Are rating agency assessments accurate?

The net effect has increased uncertainty and risk aversion. Investors have purchased Treasury bills and banks have been reluctant to lend to each other.

Falling liquidity has meant that ABCP programmes have had to pay higher interest rates to refinance or draw down on liquidity facilities provided by banks.

The true extent to which banks are underwriting both the liquidity and credit risk of these vehicles is difficult to determine.

If asset prices fall further forced liquidation by ABCP programmes and SIVs may create a downward spiral in asset prices until confidence returns. How long that will be remains to be seen.

Central bankers fully aware of the implications have provided ready access to temporary liquidity but at the same time they are reluctant to relax their medium term interest rate objectives.

First published by Barbican Consulting Limited 2007