Accounting and regulatory changes may be casting a shadow over the future of the European asset backed commercial paper market but new innovations and strong investor demand look set to ensure its continued success. Duncan Kerr reports on a year of new developments in the asset class.
When Tulip Funding Corp, ABN Amro's A-1+/P1 rated multi-seller asset backed commercial paper (ABCP) conduit, issued extendible commercial paper in March last year it became the first borrower in the EuroCP market to do so and investment bankers in London and New York heralded the deal as a breakthrough development.
The extendible note, which was sold to European investors by ABN Amro and Goldman Sachs, provided investors with an innovative alternative to plain vanilla issuance in the EuroCP market.
Tulip's note not only emphasised the extent to which the European asset backed CP market has evolved in recent years, but it was also an example of the efforts borrowers made in 2004 towards programme innovation, coerced as they were by the changing regulatory environment.
?The ABCP market in Europe is starting to enter a new era of innovation,? says Jon Ford, executive director in euro money markets and medium term notes at Lehman Brothers in London. ?The changing regulatory environment is provoking new programme structures and products to come through in the form of credit enhancement and alternative liquidity sources such as extendible CP, synthetic programmes using credit default swaps, repos, market value and total return swaps.?
Ahead lies a formidable array of regulatory initiatives, each of which threatens part of the habitat in which ABCP has evolved. The asset class has been the principal driver behind the growth in new deal issuance and the rise in total outstandings in the EuroCP market over the past three years.
In October last year, European ABCP outstandings hit a new high of $116.5bn ? equivalent to about 25.5% of the $456bn of total outstandings in the EuroCP market. However, although the entire market appeared to grow in that month ? with 70% or $4.25bn provided by the ABCP segment ? the total increase was almost solely down to the appreciation of the euro.
The immediate challenges for the ABCP market concern consolidation ? how ABCP programmes should appear on the balance sheets of their sponsors ? and capital, specifically how much regulatory capital banks will need to allocate to cover their links with ABCP programmes or conduits.
The three main prongs of regulatory upheaval are the US Financial Accounting Standards Board's new FIN 46 ruling on ?variable interest entities', the Basel Committee on Banking Supervision's forthcoming new capital accord (Basel II) and the International Accounting Standards Board's still unresolved treatment of consolidation and derecognition under its IAS 39 and SIC 12 measures.
Extendible CP, such as that issued by Tulip, is one of the methods conduit sponsors are exploring to reduce liquidity costs, given the expected 20% capital charge expected for undrawn liquidity lines under Basel II ? to be introduced at midnight on December 31, 2006.
By selling instruments ? the maturity of which can be extended ? conduit sponsors are asking investors to shoulder the burden and the sponsor's freedom not to repay at maturity reduces the need for bank liquidity.
But the product is not intended to actually be extended and in ABN Amro's case, the primary motivation for introducing the extendible product was to better manage the bank's CP maturity profile.
?We have around $60bn ABCP outstanding in ABN sponsored conduits in the US and Europe,? says Rob Koning, head of conduit administration at ABN Amro in Amsterdam. ?Extendible CP allows us to be more flexible in the event of a market disruption, so we wouldn't have to draw all $60bn liquidity in one week.?
Extendibles allow ABN to spread its maturity profile, following a market disruption, to up to 364 days from its usual tenor of one month. But the bank also hopes, in time, to use extendibles to reduce its liquidity burden.
?Extending CP automatically gives you time to liquidate a portfolio, reducing the need for 100% outstanding liquidity,? says Koning. ?In 2005 we will probably start discussions with the agencies to bring down our liquidity.?
The exact reduction of liquidity rating agencies will allow depends on the inherent liquidity of the assets in the vehicle. Assets such as residential mortgages, which can be sold relatively easily, can carry a liquidity charge as low as 5%-10% of the principal. For a trade receivable pool the minimum liquidity requirement is unlikely to fall below 40%.
For the moment, however, CP will still be backed by 100% liquidity. If ABN decides to extend CP, the notes will step up to 25bp over one month Libor during the extension period, and liquidity support must be increased accordingly.
In the US ABCP market ? where extendible CP was introduced in the late 1990s ? there is about $80bn of extendible CP outstanding from a total asset backed CP market of around $700bn and there has still not been an extension to date. The extendible CP offers a pick-up in the 2bp-5bp area over A-1/+P1/F1 levels in the US.
And although the product is new to European ABCP investors, market participants are confident that there will be demand for the product, given the extra yield it offers combined with the remote risk of an extension.
?It makes sense for investors as long as they understand what they are buying and how the repayment structure would work,? says John Delaney, head of European money market origination at Goldman Sachs in London. ?In a low nominal yield environment something that gives an extra couple of basis points is going to be appealing.?
However, European investors appear more resistant than their US counterparts to liquidity innovations. ?The alternatives are less good for investors, though expecting 100% liquidity support may become unrealistic,? says one European buyer.
?The quest for more innovative structures doesn't usually tend to be to the advantage of investors,? argues Dierk Brandenburg, senior credit analyst at Fidelity International in London.
That is not a view shared by all. ?I think the structures do work, though there has to be a clear definition of what you are calling liquid assets,? says Brendan Galloway, senior ABS analyst at Barclays Global Investors in London. ?Clearly, there are different levels for different kinds of assets.?
Since ABN Amro and Goldman Sachs placed the first extendible note for the Tulip programme, the EuroCP market has not been galvanised by a flurry of extendible issuance. But where ABN Amro pioneered, other conduit sponsors followed ? particularly in the second half of the year when 11 new asset backed securities programmes closed. And five of them had extendible CP written into their documentation.
ABN Amro brought its first credit arbitrage conduit North Sea Funding in July, while BNP Paribas (Matchpoint Funding), KBC Financial Products (Picaros), HBOS (Landale), JP Morgan Chase (Chariot Funding), NordLB (Hannover Funding) and Sachsen LB (Ormond Quay) closed new conduits in the final half of the year.
One of the most hotly anticipated programmes to come to market last year was Citigroup's new structured investment vehicle, Sedna Finance. The programme marks a departure from previous Citigroup SIVs. Most of the liquidity is being structured as cash deposits ? rather than the bank line ? and it is able to take risk in synthetic format. Some 90% of the liquidity requirement is being held as cash and up to 20% of the risk is taken synthetically.
But the most radical change is in the vehicle's liability structure and operating procedures. Unlike all other SIVs, Sedna Finance has two tiers of paper subordinated to the senior commercial paper and MTN classes ? a single-A rated MTN, protected by rating and capital triggers, and a junior tranche of first loss capital.
?In 2002 we saw a lot of SIV managers struggling to raise sufficient capital,? says Tim Greatorex, head of SIV strategies at Citigroup Alternative Investments in London. ?Sedna is clearly created in the context of that environment, even if because, with Citigroup's placement power and our track record, we didn't have those problems. But if you look at the market over the long term, you can see that a full sized SIV will need $1bn of privately placed capital. Here, hopefully, we can use the wider capital markets for the majority of that sub-triple-A financing.?
From the non-bank sponsors, American Insurance Group brought its credit arbitrage conduit Curzon Funding, while five former investment bankers under the guise of BSN Holdings Ltd established Chesham Finance. The vehicle, which engages in securities arbitrage and lending in the repo market, resembles conventional securities arbitrage conduits and structured investment vehicles in that it can buy a wide variety of short or long term securities rated at least A-1/P1 or AA-/Aa3.
But it differs from those types of programmes in that it has neither bank liquidity lines, like the former, nor a thick layer of supporting capital, like the latter. Chesham Finance Ltd has an authorised share capital of $50,000 and paid-up capital of $1,000, according to Standard & Poor's.
Instead, Chesham will issue paper exactly matched to its assets, using extendible CP and call and put options on the CP to ensure perfect matching. As well as buying securities outright, Chesham can lend to highly rated counterparties under reverse repos. Collateral for these can be rated lower than Aa3/AA-, provided the repos are enhanced to the desired level. Counterparties must be rated at least A-1 and at least A-1+ for repos of more than one month.
Chesham Finance is thought to be unique in its structure. Its establishment was the forerunner for a new wave of non-bank entities setting up programmes and set to emerge in force in 2005.
Hedge funds join ABCP fold
?We've got two hedge funds coming through with new programmes... a very interesting development and one that shows that hedge funds have now woken up to ABCP as a viable option of financing assets,? says John Ford, ECP product manager at Deutsche Bank in London. ?There are also three structured investment vehicles from non-bank sponsors in the pipeline and should be there hopefully in the first quarter of 2005.?
On such hedge fund is Cheyne Capital Management, the London-based fund manager. Cheyne's programme will be one of a very few SIVs to have been launched by independent asset managers rather than banks.
Bankers in London expect more programmes to emerge as hedge funds join the market, along with other select investment management firms and insurance companies. However, they have concerns over the esoteric nature of assets held in the portfolios of some of funds.
?A hedge fund is a very different animal from a big bank setting up a conduit,? says one head of European money markets at an investment bank in London. ?It raises all sorts of issues for intermediaries and it's not clear to us that the intermediaries think hard enough about those issues. I don't know whether investors will embrace it or not. There is a risk that there will be a herd-like mentality to buying paper without the due diligence being undertaken.?