The asset-backed commercial paper (ABCP) market, which started modestly as a way for banks to move assets off their balance sheet, using special purpose vehicles known as conduits, is today among the most innovative and complex financial sectors, often supporting entirely synthetic transactions. But its very success is arousing concern among some close observers. The market's role in shifting risk, often to exploit anomalies in the regulatory treatment of the banks' capital, looks distinctly uncertain when the rules change in three years time under current proposals.

For now, the deals keep pumping out. According to the US Federal Reserve Board, the ABCP market has grown at a compound average annual rate of more than 40% in the US since 1994, to reach $710bn (in outstanding issuance) by the beginning of November (some late big deals will push the figure to a lot higher by the end of 2001). Asset-backed issues now account for more than half of the $1440bn US commercial paper market. Lehman Brothers, one of the leading dealers in the market, says some 56 of the world's largest 100 commercial banks have now set up ABCP conduits, taking the total of such vehicles to around 300 (some banks have several conduits).

European ABCP

In Europe too, the ABCP market is expanding smartly, although from a very low base. Some market participants predict the pace will accelerate further as the euro helps create a pan-European investor base and securitisation becomes generally better understood. At the moment, however, it is somewhat unclear what constitutes the European market, as many deals are generated by banks in Europe, but funded in the US market. Of the roughly $140bn of ABCP deals generated in Europe, around 85% have been sold to US investors, which is a measure of the depth and liquidity of the market in that country.

Another big boost to the market came last month in a classic deal from Dutch bank ABN Amro, which launched a a12.5bn synthetic securitisation of assets from its own loan book. The complex deal involved buying credit default swaps, financed chiefly through the bank's Amstel conduit. It was the biggest ever such European deal, with over a12bn of highly-rated asset backed bonds refinanced by commercial paper and the lower rated asset backed bonds sold into the euro bonds market.

There are several factors behind this rapid expansion. But not least is what Lehman coyly refers to as the "heightened focus of European and US banks on risk-based capital". Lehman promotes ABCP programmes as a tool to help the banks improve "balance sheet and capital management", and achieve more "efficient lending".

A rather blunter explanation comes from one of the first participants in the market, who is no longer involved. "The asset-backed CP market provides two kinds of arbitrage," he explains. "Firstly, there is a tenor arbitrage, as long-dated assets are financed by short-dated paper. It is cheaper to borrow money for 90 days and keep rolling it over, than to borrow for five years. Secondly, there is regulatory arbitrage. Assets on the bank balance sheet incur a capital charge of 100% if the tenor is over a year, irrespective of whether they are triple-A or sub-investment grade.

"If the top-quality assets are taken off the balance sheet and held by a conduit, which finances them through the CP market, the capital charge is eliminated," says the former market participant. "This is what has really allowed the market to grow."

Lateral benefits

There are other benefits, too. Initially, the so-called multi-seller conduits - with names such as Kittyhawk, Tulip and Great Lakes - were set up by banks to purchase, from their corporate clients, streams of good-quality trade receivables that could be funded in the CP market. This not only reduced the capital tied up by the bank's lending to the corporate client; it also enabled the client to obtain cheaper financing. The banks, meanwhile, collected a stable fee income for sponsoring and administering the conduits (called because assets go in one end, and CP comes out the other).

As a market for the highest-quality borrowers, with maturities ranging from one day up to 270 days, CPs have advantages over other markets. To begin with, as a private market, CPs offer the corporate client "simpler execution. There are no roadshows and no prospectuses," says Steve Gandy, head of asset securitisation at Bank of America, in London.

There is also no disclosure of the client's name, so it does not lose its scarcity value in the capital markets. "The ABCP market now generally trades well below Libor [London interbank offered rate], because it is recognised as a very safe liquid product," says Mr Gandy. This is why it is so attractive to blue-chip borrowers or, at least, the borrowers with good quality receivables that form the collateral for the ABCP.

Market growth

But since Citibank created the first multi-seller conduit - now known as Ciesco - in 1983, the market has sprouted in many directions. The range of assets that are now purchased through conduits has grown markedly, becoming ever more exotic, while banks are creating vehicles to house their own investments, as well as the conduits for their clients. Trade receivables now account for just 24% of all assets in these vehicles, according to Goldman Sachs (the rating agency Fitch reckons the figure is even lower, at 13%). Other assets now regularly purchased through conduits include credit card payments, car loans, equipment leases and mortgages. At the more exotic end, even anticipated settlements from tobacco lawsuits have been used as collateral, as well as England Premier League football club receipts.

More significantly, debt securities are increasingly purchased by the conduits, often in the form of collateralised bond obligations or collateralised loan obligations. Fitch calculates that such securities now account for some 25% of conduit assets. In some cases, securities are simply added to the mix of assets in the multi-seller conduit.

In others, separate vehicles are created exclusively for a bank's securities portfolio. Known as securities arbitrage vehicles, they offer banks the same kind of off-balance sheet benefits in relation to regulatory capital, as the general type of conduit. Some banks have taken this process a step further and established securities investment vehicles (SIVs), which are structured rather differently and have many of the characteristics of an investment fund. In addition, some of the larger banks are now actively marketing the off-balance sheet advantages of their conduits (particularly the arbitrage variety) to the smaller, second-tier banks that do not have the expertise or the business volumes to create conduits of their own. This mostly involves the second-tier banks putting their business through an existing conduit.

Third-party conduits

But a few banks, and specialist institutions such as Chicago-based Liberty Hampshire, will create and administer a conduit for other banks that want to offer conduit services to clients, but do not have the expertise, or want the bother, of arranging it themselves. Loosely termed "renting a conduit", such activities - whether using another bank's conduit, or outsourcing the running of it - are increasingly becoming another key facet of the ABCP market.Dresdner Bank, for example, launched a "product" in July, which involves renting space in its conduits to regional European banks that "want the regulatory capital and funding benefits of originating pools of assets into a conduit, rather than through its own balance sheet", explains London-based Forbes Elworthy, who is heading the marketing effort for the product. Banks that are too small to create a conduit of their own, may want the economies of scale from renting space in an existing conduit. "You do not get efficient funding in the conduit market with issuance of less than $1bn, and it is also hard to amortise the fixed costs of setting up the conduit. So it may not pay a bank with a $200m pool of securities," he says. These securities - the main asset involved, here, is debt securities - might instead go through Beethoven, a Dresdner conduit that is a combined multi-seller and securities arbitrage type. Dresdner, which has more than $20bn in its four main conduits of this type, as well as its SIV called K2, has received three mandates since July from banks choosing to take advantage of the new "product" says Mr Elworthy.

ABCP failings

Despite all the evident success of the ABCP market, there are some uncertainties on the horizon. In part, these relate to the new Basel Capital Accord, which will regulate - from 2005 - how much capital the banks in the leading industrial countries must set aside to cover exposures, such as credit risks. Unlike the present Basel Accord, which is a blunt, one-size-fits-all instrument, the new accord will be more closely related to specific degrees of risk. The proposed changes will reduce some of the present benefits of the conduit.

The reason that conduits command the highest credit ratings from the rating agencies is, first, because they are substantially over-collateralised (relative to the amount of CP issued); second, they enjoy additional credit enhancement, such as a letter of credit; and third, they are fully backed by a liquidity facility. This facility is not supposed to be insurance against a borrower's default, but a guarantee that investors will get paid in the event that the CP market is severely disrupted, and paper cannot be rolled over when it falls due. (This applies much less to SIVs, which use different mechanisms to maintain liquidity.)

As regulators have been persuaded, until now, the liquidity facility is what the banks claim it to be; it bears no regulatory capital charge. It is, however, a grey area that banks are often reluctant to talk about.

In many circumstances, the liquidity facility "becomes a direct credit substitute", says a former ABCP market participant. "The banks will always deny this because to admit it would undo the very favourable regulatory treatment that they have obtained for [conduits] in the past 10 years," he adds. Tony Lowes, head of Citibank's conduit business in London says: "Any time you have an extension of funds, you have credit exposure, whether you call it liquidity or credit enhancement. However, it is very rare for these facilities to be drawn down and losses have been extremely small."

Changing the rules

The regulators are aiming to change the rules. Under initial proposals for the new Basel Accord, liquidity facilities would have faced a 20%, regulatory capital charge after 2005. More recent drafts of the new rules have dropped the 20% figure, and it remains to be seen what capital charge will eventually be specified, although it is likely to be lower than proposed.

Even so, some regulatory charge on liquidity facilities will raise the cost of operating conduits and reduce some of their attractions, says New York-based Ira Powell, head of asset-backed CP origination for Goldman Sachs, one of the top three CP dealing houses, along with Lehman Brothers and Merrill Lynch. In addition, it looks likely that loans to top-rated companies, or investment in their debt issues, will incur little or no regulatory capital charge after 2005 (against the current undiscriminating 100% charge), under the new Basel Accord. This will reduce the incentive to remove such assets from bank balance sheets."These two factors will both work in the same direction, and imply a lower requirement for conduits. They will make some marginal deals uneconomical," says Mr Powell. "This will not, though, eliminate all the incentive for doing these deals."

Some banks do set aside economic capital against their liquidity exposures. But economic capital is a measure of how the banks themselves perceive the risks involved in particular business lines and is, inevitably, much less than regulators seem likely to require. In the case of top-notch conduit assets, the economic capital assigned is only a tiny percentage of the contingent liquidity liability, and nothing like the 20% initially proposed under Basle II. If a capital charge on liquidity eliminates some marginal conduit deals, this may not be a bad thing, according to Bank of America's Steve Gandy. "A capital charge on a contingent liability will apply a little more sanity to this market because many European banks do not even assign economic capital against their liquidity exposures. They price their transactions very thinly. This provides crazy competition," he says.

Hitting the ceiling

Meanwhile, the sheer scale of the liquidity now needed after several years of rapid ABCP market growth is also becoming a problem for some banks. Some have "effectively been capped out", says a market observer, suggesting that they have reached a ceiling, set either by external or internal regulators, for such activities. In earlier days, the banks that created conduits were able to syndicate out part of the liquidity facility to other banks. But now that most of the large commercial banks have their own conduits, they are reluctant to use their balance sheet supporting rivals in this way.

"Some banks are undoubtedly running up against [liquidity facility] limits", says Goldman Sachs' Mr Powell. "But many of these [limits] are being set by internal treasury people, rather than national regulators," he adds. Mike Nawas, European head of asset securitisation at ABN Amro, one of the three biggest conduit sponsors and arrangers - along with Citibank and Bank One - concedes that supporting conduits with liquidity facilities is increasingly becoming a constraint, leading to higher pricing for conduit securistisation transactions. Liquidity is not for free," he says. But ABN Amro, which had $43bn in outstanding ABCP in its conduits at end-March 2001, is not being obliged by external regulators to slow down, he says. "It is something we assess for ourselves in relation to our overall balance sheet management." Adds John Bottorff, head of North American securitisation at Dresdner Bank, in New York: "Liquidity capacity is a scarce resource. You have to decide what is the most efficient use of economic capital. Do you want to use it all up supporting conduits or divide it between various businesses? Of course we are finding this a constraint. Everybody is."

CRA scrutiny

Although the ABCP market is viewed as deep and liquid, the speed of growth is prompting the credit rating agencies to watch it more closely. The contingent bank liquidity commitments may not match the total $700bn of issuance outstanding (the SIVs, for example, do not require as much bank liquidity as other conduits), but it could amount to 90% of the outstanding paper. Certainly, it has got to the point where one rating agency has its bank analysts and structuring specialists working more closely together in assessing the market. At the same time, the constraints imposed by the high liquidity support required for conduits - and the associated capital charges expected from 2005 - is prompting banks and CP dealing houses to search for new technologies to reduce or eliminate these impediments. "The large banks cannot provide liquidity in infinite amounts. They need to find new ways to continue to grow their business without increasing the liquidity they provide," says Jim Peterson, head of European origination for ABCP at Lehman Brothers in London.

Liquidity initiatives

One approach came from Citibank a year ago when it restructured its Eureka multi-seller conduit for European corporate receivables. Citibank, which has nine multi-seller conduits, funded by some $58bn of ABCP issuance, managed to create a structure comprising receivables with such inherently high liquidity that it no longer needed 100% support from a separate bank liquidity facilities. The liquidity cover has been reduced to around 70%, with the endorsement of the rating agencies.

Lehman is also working on structures to reduce greatly the amount of the liquidity facility needed. Last December, it was helping to create a conduit for a UK bank that required no facility at all, and would be entirely synthetic. Several other, similar conduits are said to be in preparation. Pressure for ever greater capital efficiency and the anticipation of Basel II rules are today spurring big changes in the ABCP market. Whatever risk framework is finally produced by the Basel regulators, the market looks set to try to stay ahead of them.

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