Understanding Asset-Backed Commercial Paper Program

Asset-backed commercial paper is a type of short-term debt instrument that's used by companies to raise funds for their daily operations. It's typically backed by a pool of assets such as accounts receivable, inventory, or loans.

Companies like GE Capital and General Motors Acceptance Corporation (GMAC) have used asset-backed commercial paper to raise funds. These companies create a pool of assets that can be used to back the commercial paper.

This type of commercial paper is usually sold to investors through a trust or a special purpose entity. The trust or entity then issues the commercial paper to investors, who lend money to the company.

Commercial paper is a type of short-term debt instrument that allows companies to raise funds by issuing debt to investors.

It's typically a low-risk investment option, as it's usually backed by high-quality assets.

Commercial paper matures within a short period, usually ranging from a few days to a few months.

This makes it an attractive option for companies that need quick access to cash.

The underlying assets used to back commercial paper can include a variety of financial assets, such as trade receivables.

These assets are often pooled together to create a diversified asset pool.

The cash flows from these assets are then used to pay the investors of the commercial paper.

This arrangement allows companies to borrow money at a lower cost than traditional loans.

By issuing commercial paper, companies can avoid taking on long-term debt and maintain their financial flexibility.

Asset-backed commercial paper (ABCP) programs are typically structured with a conduit or special purpose vehicle (SPV) at their core. The conduit is a separate legal entity created by the sponsoring financial institution, which purchases and securitizes assets into an asset pool to back the ABCP.

The conduit finances the assets by selling ABCP to outside investors, such as money market funds or retirement funds. This allows the sponsoring institution to manage its balance sheet more effectively and potentially improve its financial ratios.

The assets backing the ABCP are usually a mix of asset-backed securities, residential mortgages, commercial loans, and CDOs. Most of these assets are AAA-rated, with some being unrated assets generated by the sponsor financial institution. A ratings agency jointly judges the assets to have a low risk of bankruptcy.

The asset origins are mostly from the United States, Germany, and the United Kingdom. The maturity of the ABCP is typically between 1 to 270 days, with an average of 30 days.

The SPV plays a crucial role in the ABCP program, providing a layer of protection for investors by insulating them from the bankruptcy risk of the sponsoring institution. The SPV also provides off-balance-sheet financing for the sponsoring institution.

Here's a breakdown of the typical asset composition of ABCP programs:

Note that the exact composition may vary depending on the specific program and the assets used.

The Asset-backed Commercial Paper (ABCP) market is a vital component of the short-term funding market, providing a source of funding for institutions like banks, corporations, and financial institutions.

The ABCP market involves a variety of participants, including issuers, investors, and rating agencies. Issuers are typically financial institutions that sponsor the creation of the Special Purpose Vehicle (SPV) and the issuance of the ABCP.

Money market funds, corporations, and other institutional investors can invest in ABCP, seeking a return on their short-term cash holdings. The rating agencies provide credit ratings for the ABCP, which can influence the demand for the paper.

A decrease in demand for ABCP can impact the ability of issuers to raise short-term funding, highlighting the importance of a stable and functioning ABCP market. The interaction between participants can impact the market's stability, with downgraded credit ratings leading to decreased demand for the paper.

Asset-backed commercial paper (ABCP) programs offer a way for institutions to obtain short-term funding and for investors to earn a return on their cash holdings.

The primary benefit of ABCP is that it provides a source of short-term funding for institutions and higher yields compared to other short-term investments, such as Treasury bills.

ABCP can offer higher yields due to the higher risk associated with the underlying assets.

However, there are also risks associated with ABCP, including credit risk, liquidity risk, and market risk.

Credit risk refers to the risk that the issuer of the ABCP will default on its payment obligations, which can be influenced by the quality and performance of the underlying assets and the financial health of the issuing institution.

Liquidity risk refers to the risk that an investor will not be able to sell the ABCP in the secondary market at a reasonable price.

Market risk refers to the risk that changes in market conditions, such as interest rates or economic conditions, will negatively impact the value of the ABCP.

While ABCP can be a safe investment for outside investors, the asset holdings of ABCP conduits are not transparent, and uncertainty about asset values can create risks.

ABCP programs do not have explicit deposit insurance provided by the government, which can increase systemic risk of the financial system and impose huge risk on the broader economy.

Excessive risk taking and regulatory arbitrage can also occur with ABCP programs, leading to high leverage and high risk.

Conduits use four different types of guarantees to provide insurance to outside investors, ranked from strongest to weakest: full credit guarantees, full liquidity guarantees, extendible notes guarantees, and guarantees arranged via structured investment vehicles (SIV).

These guarantees expose banks to different levels of risk, with full credit guarantees being considered equivalent to on-balance sheet financing. In practice, full credit guarantees are infrequently used by financial institutions that have to satisfy bank capital requirements.

Full liquidity guarantees are similar to full credit guarantees but only require the sponsor to pay off maturing asset-backed commercial paper if the conduit assets are not in default. This form of guarantee is weaker than full credit but allows banks to move these assets off the balance sheet.

The ten largest sponsors of conduits as of January 2007 are listed below:

Conduits can generate significant risks for the sponsor, including the risk of roll-over risk, which is the risk that a conduit cannot refinance maturing commercial paper.

The sponsor of a conduit plays a crucial role in managing assets and providing liquidity. They can be a large U.S. commercial bank, a non-bank institution like a mortgage lender or asset manager, or even a foreign bank.

In 2007, foreign banks sponsored about 40 percent of the market, while non-bank institutions sponsored a considerable share, with programs sponsored by these institutions growing dramatically from 2004 to 2007.

The ten largest sponsors as of January 2007 were:

As the sponsor, they take on significant risks, including roll-over risk, where they may have to assume losses from lower asset values if the conduit cannot refinance maturing commercial paper.

Conduit sponsors use four different types of guarantees, each providing a different level of insurance to outside investors.

The strongest type of guarantee is the full credit guarantee, which requires the sponsor to pay off maturing asset-backed commercial paper independent of the conduit's asset values.

Full credit guarantees are considered equivalent to on-balance sheet financing and expose banks to the same risks as assets on the balance sheet.

In practice, these guarantees are infrequently used by financial institutions that have to satisfy bank capital requirements.

Full liquidity guarantees are similar to full credit guarantees, but the sponsor only needs to pay off maturing asset-backed commercial paper if the conduit assets are in default.

This type of guarantee is weaker than full credit guarantees, but it allows banks to move these assets off the balance sheet.

Extendible notes guarantees are similar to full liquidity guarantees, with the main difference being that the conduit issuer has the discretion to extend maturing commercial paper for a limited period of time.

This type of guarantee is riskier than full liquidity guarantees, making it less desirable for outside investors.

SIV guarantees are also similar to full liquidity guarantees, but they only cover a share of the conduit liabilities, usually around 25%.

This partial insurance is considered weaker than full credit or full liquidity guarantees, but it was primarily used by commercial banks and other financial institutions to cover high quality assets.