Tangled in regulations: ABCP aims to restore respectability

Asset-backed commercial paper today is a more staid, respectable and client-driven beast than before the crisis. But it has been caught in a tangle of regulation designed for other asset classes, and the industry stills depends on precarious US money market demand. Owen Sanderson reports.

  • 28 Sep 2011
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As a cornerstone of the much-maligned shadow banking system, ABCP still carries the taint of pre-crisis hubris. SIVs and conduits are often dismissed in the same breath as vehicles that won’t return, a part of the banking system that flourished in the frothy, flush environment pre-crisis, but never again.

It is also falling foul of regulations structured with US subprime RMBS in mind — a common complaint for all ABS bankers, but with ABCP, the contradictions are glaring.

"We’re still seeing a lot of size go through, but it’s in a period of maintenance rather than expansion," says Emma-Jane Fulcher, head of ABCP conduits at Fitch. "Banks are committed to the business, but there’s a lot of regulatory uncertainty ahead."

Article 122a of the European Union’s Capital Requirements Directive II (CRD II) is probably the worst offender. Its main provisions are risk retention — skin-in-the-game — and provisions on disclosure, transparency and investor due diligence.

"Challenges for the conduit business are a subspecies of difficulties for the whole ABS industry," says Salim Nathoo, structured finance partner at Allen & Overy. "But conduits seem to have been forgotten in the drafting process. The rules have weird applications when you translate to the conduit world."

To satisfy risk retention, an originator, sponsor, or original lender must hold 5% of a securitisation (any structure with tranched risk, according to the CRD II definition). It may not affect ABCP conduits, based on guidance issued by CEBS (now the European Banking Authority) at the end of last year. But the uncertainty is still weighing on the market.

"It looks like ABCP will not fall within the risk retention rules," says Fulcher. "Securities in securities conduits will already have a retention, and for multi-seller conduits the rating of the underlying is held as commensurate with the CP — they aren’t treated as a standalone transaction."

The parts of 122a dealing with investor due diligence may be even harder to manage. Forcing investors to do due diligence before lending 30 day money is likely to cripple the economics of ABCP, though as many buyers are US money market funds, article 122a will not apply.

"Conduits today are black boxes," said Nathoo. "That will have to change, but conduits aren’t set up to disclose all the assets they may be funding. That can cut across asset classes, so it represents much more of a challenge than other revolving structures like master trusts."

The unpalatable alternative to due diligence and full disclosure is continued reliance on the rating agencies. But this may be much more justified in short term markets than for term funding — ABCP serves as a park for liquidity, and is explicitly not a long-term investment.

Existing conduits will not have to comply with the Article 122a rules until January 2014, in line with grandfathering rules for the term markets. But the new rules will still hamper banks aiming to expand or develop the business.

Bank backing

The solution may lie in the restructuring of conduits to rely more on the credit of banks themselves — the ultimate black boxes.

Since the crisis, European conduits have been moving towards fully supported structures, effectively giving investors a secured bank exposure. LBBW, for example, replaced its partially supported vehicle Lake Constance with the fully supported Weinberg last year.

HSBC and Commerzbank both opted to convert existing trades within their conduits to fully supported — they amended transactions in Regency and Silver Tower, respectively, at the beginning of August.

This can work two ways. Some investors dislike fully supported programmes, arguing that it makes more sense to simply buy bank CP at better levels, since the programmes are effectively bank risk with undisclosed assets behind. However, issuing ABCP accesses different lines — even if an investor is full on a bank name, they may be able to buy the paper issued by that bank’s conduit.

Providing more support to deals also underlines the commitment banks have.

Kate Grant, head of conduit securitisation at Lloyds Banking Group, says: "Within LBG, conduit finance is considered a growth business as it is an important financing product for corporate treasurers as they look for flexible, diversified funding tools/sources."

This view is echoed by Nathoo, who says that banks are allocating more and more capital to their conduit business.

"Banks have had little opportunity to grow them during the crisis, although they continued to fund right through the credit crunch," he says.

The pre-crisis business of the arbitrage conduits — lending long in securities format and borrowing short in CP format — has not re-emerged in the same form, taking global outstandings down from $1.1tr in 2006 to around $400bn today.

But the remaining conduit business has been stable at that level since the crisis, although almost entirely dependent on dollar demand. The conduit business today is about short term assets sourced from relationship clients.

"ABCP is a financing product offered by banks to fund client business — it is offered as an option for a corporate treasurer, who sees the benefits it provides to finance receivables ledgers," says Grant.

Trade receivables, insurance receivables, and auto lending are the most common forms, and corporate finance bankers offer conduits as another alternative funding source to treasurers.

The auto business in particular feeds through to conduit activity, says Nathoo. "Auto companies are coming off the back foot," he says. "They are raising more finance, and that can mean more activity for conduits. A number of conduits have stepped up their activities recently."

Future funding

For the conduit business to grow, it may need to wean itself off reliance on US investors — which will need a big shift in the euro-dollar basis as well.

"Euro denominated ABCP has almost disappeared," says Fulcher. "Funding European assets by selling dollar CP is much more cost-effective and the market is larger. You can get tighter spreads and pick up a few basis points on the FX-hedging as well."

European banks want the return of a big euro denominated market. Some banks have even been funding ECP conduits entirely through liquidity facilities while continuing to sell assets into the conduit — simply waiting for the return of a vibrant European market.

Worries around European bank CP, as well as the broader sovereign crisis, have passed the ABCP markets by. US money market funds may be cutting their exposure to European bank CP, but there is little difficulty selling conduit paper.

"Don’t look at the turmoil in the term markets as a guide to conduit activity," says Nathoo. "US money funds might be worried about European banks, and might ask for more spread, but ABCP conduits are highly structured secured funding. There is a preferential claim on the assets and then on the bank itself."

Wider banking regulation will also shape the future of ABCP conduits, with different structures on the table to deal with capital and liquidity regulation.

"There may be some new repo programmes, and some programmes are looking at issuing callable or puttable CP to deal with the money market fund regulations," says Fulcher.

The Basel III liquidity coverage ratio proposals assume a full draw on all ABCP liquidity facilities, and no cashflows from assets when figuring out what liquidity will be drawn down in a 30 day period. Banks will then be required to hold enough liquid assets to cover this full amount.

Callable, extendable and puttable ABCP are all options to deal with these requirements, while also satisfying money market fund regulations on asset maturity. A conduit can issue longer dated CP to extend its liabilities beyond the 30 day horizon of the liquidity coverage ratio, but call ahead of maturity to satisfy the money funds.

This is not foolproof — if the market expects the call (as defined by the Basel draft), then the LCR numbers have to be calculated to call. But it could mean more innovation in the conduit business. So the remaining conduits have a bright future, in spite of the regulatory worries on the horizon.

Market participants remain optimistic that ABCP, in its post-crisis, wholesome and client-driven form, will dodge the worst of the regulatory worries. Maybe this will involve putting sensible flesh on regulatory bones, or maybe it will be careful structuring to work well in a new world.

Banks that can get a political hearing should also have an easy time selling ABCP to politicians. Financing trade receivables and auto loans is the sort of feel-good financing that supports the real economy. Even if they do not understand what a conduit is, they will understand cheaper auto finance for the electorate.

Jitters in the vanilla CP market around European banks could also play into the hands of the conduit business. As spreads start to look wider and execution more volatile, more banks will try to steer client funding through their conduits.

European banks seeking term funding have already started leaning more heavily on secured funding — the strong year in covered bond and private term repo markets prove that much.

A little more certainty and a wider investor base, and ABCP could be just the support they need at the short end.
  • 28 Sep 2011

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