Fixed Income Research

Asset-Backed Commercial Paper Conduits and Their Impact in the ABS Markets
February 20, 2001
Brian Hargrave 212-526-8311

SUMMARY
I Asset-backed commercial paper (ABCP) conduits have emerged as a major investor class in AAA and AA oating-rate ABS products. Traditionally used by banks to increase regulatory capital efciency, these structures are receiving increased attention from the money management and insurance communities as a means of increasing assets under management.

The author would like to thank Arthur Chu and Jin Chang for their assistance in the preparation of this report.

Publications: L. Pindyck, A. DiTizio, B. Davenport, W. Lee, D. Kramer, S. Bryant, J. Threadgill, R. Madison, A. Acevedo.
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INTRODUCTION
The asset-backed commercial paper (ABCP) market was established in the early 1980s as an off-balance sheet nancing solution. Historically, banks have deployed multi-use conduits as a regulatory capital efcient means of meeting their customers nancing needs. For example, short term trade receivables have traditionally been a large asset class for conduit nancing. More recently, the application of conduits in nancing highly rated securities portfolios has grown dramatically. At a conceptual level, asset-backed commercial paper conduits issue debt and use the proceeds to invest in structured assets, as shown in Figure 1. The conduits liabilities principally take the form of asset-backed commercial paper (as well as medium-term notes and/or subordinated debt, in the case of certain conduits), while the assets may be in whole loan form (i.e., mortgages, credit card receivables, trade receivables), or in the form of ABS products. The purpose of this paper is to examine the structure and strategy of securities conduits, whose proceeds are primarily invested in ABS products. ABCP conduits have become an important factor in the nancial markets in general, and particularly so in the ABS market. Their relevance to ABS investors can be summarized as follows: 1) ABCP conduits have emerged as a major investor class in oating rate ABS products. They are, therefore, an important component of any investors view on the future of this particular market segment. 2) ABCP conduits offer investors a unique strategy for increasing assets under management by accessing the consistent and stable U.S. commercial paper market. 3) The securities conduit structure relies almost exclusively on investments in highly rated (AAA and AA) assets. This strategy is consistent with those in the market seeking to limit credit exposure, while still achieving attractive returns on equity.

Figure 1.

ABCP Conduit Conceptual Diagram

Cash Cash ABCP Conduit ABCP Structured Assets Asset Markets

CP Investors

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Traditionally, ABCP conduits have been used by banks as a tool to improve regulatory capital efciency. Increasingly ABCP conduits are being used by non-bank entities, such as money managers, as a means of aggregating assets under management. In this application, the conduit sponsor receives the net spread between the securities portfolio and the all-in cost of funding in the ABCP market. We will discuss both of these structures later in this paper. ABCP conduits have grown tremendously in recent history. As shown in Figure 2, ABCP outstandings in the U.S. have grown by 46% annually since 1994, to the present level of $642 billion. By contrast, the total commercial paper market, also shown in Figure 2, has grown by 18% annually over the same period. At present ABCP represents 40% of the $1.6 trillion commercial paper outstanding. The historical growth in ABCP can be attributed to two fundamental forces. First, from an issuer perspective, the previously mentioned regulatory capital efciency has led to strong interest from bank issuers. Secondly, from an investor perspective, the extraordinary growth of money market investment funds has created enormous depth and liquidity in the commercial paper markets. These factors, combined, have created an environment which has fostered the strong growth of ABCP conduits.

Securities Conduits: Investing in Highly Rated Floaters

ABCP conduits represent a signicant and growing consumer of both rated securities and whole loans. In Figure 3, we show S&Ps estimate of the breakdown of assets funded in ABCP conduits. Based on current U.S. ABCP outstandings of $642 billion, as well as investments funded through non-U.S.

Figure 2.
$ bn
1800

Growth of ABCP Relative to Total Commercial Paper Market

U.S. ABCP 1500 1200 900 600 300 0 1994 1995 1996 1997 1998 1999 2000 U.S. Unsecured CP

Source: Federal Reserve data.

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ABCP and U.S. and Euro asset-backed MTNs, we estimate that total conduit investments in rated ABS product are in excess of $150 billion. Securities conduits continue to grow relative to other conduit asset types, as demonstrated by Moodys estimate that securities conduits made up 41% of newly established programs in the year 2000. Conduit portfolios generally contain minimal duration exposure, typically investing in oating rate securities. Hedging costs minimize the economic viability of many xed rate investments. For our purposes, the liabilities of the conduit, that is the asset backed commercial paper, can be thought of to trade near LIBOR at on a net basis. These oating rate liabilities, typically funded with a term of less than 90 days (maximum maturity of 270 days), are highly correlated with movements in LIBOR. The net exposure of oating rate ABS and LIBOR based liabilities results in a long position in spread duration. However, spread movements generally have no impact on conduit economics as securities conduits employ a buy and hold investment strategy. This strategy is commonly adopted to achieve off-balance sheet treatment under GAAP accounting, in the absence of substantive third party equity. To illustrate the historical spread relationships between the assets and liabilities of a conduit, we analyzed historical spreads on a representative conduit portfolio. In doing so, we assume a constant asset allocation, AAA and AA securities holdings, and an average life of four years. In Figure 4, we show the historical spreads on this portfolio, as well as the actual historical spreads in the ABCP market. The net spread on the portfolio has remained relatively stable in the

Figure 3.

Assets Held in ABCP Conduits, as of September 30, 2000.

Other Assets 9%

Trade Receivables 26% Credit Cards 17% Mortgages 12%

Securities 16%

Equipment Loans/Leases 9%

Auto Loans/ Leases 11%

Source: S&P estimates.

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Figure 4.
60 50 40 30 20 10 0 -10

Historical AAA/AA Securities Conduit Performance

Assets ABCP (A-1/P-1) Net Spread

11/97 1/98 3/98 5/98 7/98 9/98 11/98 1/99 3/99 5/99 7/99 9/99 11/99 1/00 3/00 5/00 7/00 9/00

Source: Lehman Brothers estimates.

30-40 bp range since the 1998 market dislocation. In addition, this chart illustrates the relative strength of the ABCP market in the midst of the 1998 dislocation. Aggregate information for the securities holdings of ABCP conduits is not available. However, in Figure 5 we describe an example portfolio which we consider to be representative (note that this is the same portfolio used in Figure 4). One common thread across securities conduits is the preponderance of high quality assets. Typically 80 to 90% or more of the securities conduits holdings are AAA rated, with the remainder rated AA. This high quality asset portfolio generally allows the conduit to operate without requiring incremental program credit enhancement to be posted under a dynamically sized credit enhancement facility, provided that the assets maintain their credit quality. This high portfolio credit quality is a key to the regulatory capital efciency of the typical securities conduit. Consequently, the rating composition is generally similar across conduits, however the aggressiveness with which the conduit pursues spread in excess of LIBOR determines the mix of collateral type and average maturity of the securities held in the conduit. Our example portfolio, composed almost exclusively of AAA securities, would yield approximately LIBOR + 30 bp in the current market environment. It is worth noting that ABCP conduits generally do not hold corporate bonds, both because AA and higher securities in this sector trade too tight relative to funding costs, and due to the historically greater event risk associated with this sector.

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Figure 5.

Example AAA/AA Securities Conduit Portfolio

Security CDOs Credit Cards HELs CMBS RRBs Aircraft* Auto Other Allocation 30% 25% 20% 5% 3% 7% 5% 5% 100% LIBOR Spread 48 bp 15 25 23 45 50 19 25 30

*Note all spreads are for AAA securities, except Aircraft which are for AAs as AAAs are generally not issued.

Structural Details: Source of Regulatory Capital Efciency

Expanding upon our conceptual denition of an ABCP conduit in the introduction, a more accurate picture of the ABCP structure contains more moving parts. To understand these additional parts we turn rst to the rating agency approach to ABCP. The ABCP issued by a conduit is generally targeted to be rated at least A-1, P-1, and/or F-1 by S&P, Moodys and Fitch, respectively, to achieve a competitive funding cost. The ratings are derived from a combination of the portfolio credit quality, the amount of credit enhancement necessary to bring the portfolio credit quality to at least a AA level for the life of the liabilities, and the availability of liquidity support to address the maturity gap between the short-term liabilities and the longer term ABS portfolio. To achieve the desired rating, the conduit must employ structural support to address these factors. In Figure 6 we illustrate a more complete picture of a securities conduit. The additions to our conceptual diagram in Figure 1 are the structural support shown at the top of Figure 6, as well the sponsor who retains the economics of the program by capturing the net spread of the portfolio. Excess spread is typically captured via a swap arrangement in which the sponsor receives all portfolio proceeds and pays out the cost of funds and expenses, retaining any excess proceeds. As previously discussed, the conduit typically maintains a minimal duration exposure with hedging support required to offset the duration of any xed rate assets. The liquidity support and credit enhancement programs merit a more detailed discussion as they are the source of regulatory capital efciency in the conduit structure, and consequently the primary drivers of the growth of ABCP conduits. Liquidity Support Program liquidity support is put in place to address the maturity mismatch of a conduits assets and liabilities. As previously discussed, conduit liabilities are funded in the commercial paper market with a maturity typically less than 90 days,

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Figure 6.

Securities Conduit Structure

Liquidity Support

Credit Enhancement

Hedging Arrangement

ABCP Investors

ABCP Conduit

ABS Market

Sponsor

and with a maximum of 270 days. Conduit assets, for our purposes consisting of securities of various terms, are generally of longer maturity. Liquidity support, in effect, provides backstop protection for the ABCP by standing ready to fund performing assets and thus ensure timely repayment of maturing ABCP. This support is typically provided by a bank sponsor rated at least as highly as the desired conduit rating or by a highly rated third party, and is provided via a loan facility or asset purchase agreement sized to 100% of the face amount of ABCP. From a provider perspective, typically a bank, the liquidity facility receives favorable treatment under current regulatory capital rules (see the sidebar discussion of proposed regulatory changes). When structured with a 364-day term and a funding out for defaulted assets, the contingent obligation does not require regulatory capital to be held against it. This feature of the liquidity support facility is the principal source of regulatory capital efciency in the ABCP conduit structure. Credit Enhancement In a securities conduit, program-wide credit enhancement is designed to protect the ABCP from the impact of non-performing assets, which are not covered owing to the funding out in the liquidity support agreement. The amount of credit enhancement required for a given security is determined by the rating agencies, and is a function of the credit rating of the assets. A bank provider of credit

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enhancement, under current regulatory capital rules, would risk weight the credit enhancement at 100% and therefore be required to hold 8% Tier I capital against the enhancement. However, in the current environment incremental program credit enhancement is generally not required if the assets in the portfolio are rated AA/Aa2 or higher, as the assets in aggregate have already been structured to a AA or higher default probability over the life of the ABCP liabilities. This characteristic of the credit enhancement provides the second source of regulatory capital efciency in the ABCP conduit structure. We note that many banks manage their liquidity and credit exposure to ABCP conduits by allocating economic capital, even in the absence of regulatory capital requirements. However, the AAA/AA rating of the ABS portfolio generally results in an economic capital allocation that is signicantly less than the current 8% Tier I regulatory capital assessment. The credit enhancement, combined with liquidity support, represents a dynamic trigger designed to protect the ABCP investor. In the event a portfolio security is downgraded below a specied level (generally AA/Aa2 or AA-/Aa3), the conduit will be required to arrange credit enhancement within a short period (generally 5 to 10 business days), or liquidity support will be drawn. In the event of an asset default (or a deemed default, dened as a downgrade to CCC or below), the funding out of the liquidity support agreement with respect to that asset is tripped, and program credit enhancement, if available, is drawn to repay ABCP investors.

Putting it All Together: The Regulatory Capital Efciency of Bank Conduits

To illustrate the regulatory capital efciency, we will use a simplied example. We assume a AAA/AA ABS portfolio yields LIBOR + 30 bp (see earlier discussion of asset mix), and that on-balance sheet funding costs LIBOR 10 bp, while the all-in cost of ABCP (assuming the sponsor provides the liquidity facility) is LIBOR at. Looking rst at on-balance sheet funding, the ABS portfolio would require 100% risk weighting and therefore an 8% regulatory capital holding under current regulatory guidelines. With a net spread of LIBOR + 40 (30 bp on ABS portfolio and 10 bp on LIBOR less funding), the portfolio would earn a 5% return on the regulatory capital held. In contrast, the ABCP conduit portfolio would earn a net spread of 30 bp (30 bp on ABS portfolio and LIBOR at funding) which is less than the on-balance sheet example. However, under current guidelines, no regulatory capital holding would be required and thus the return on regulatory capital is unbounded. Returns on economic capital, while not as extreme as those on regulatory capital usage, are nevertheless attractive owing to the relatively low allocation of economic capital to a AAA/AA ABS portfolio. The conduit structure makes LIBOR oater investing economical for nancial institutions, which have historically not been large investors in this market segment. We address proposed regulatory capital changes in the sidebar discussion.

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The accounting and regulatory capital requirements further shape the investment philosophy of bank securities conduits in two respects. First, conduits, as buy and hold investors, can take advantage of spread opportunities in less liquid sectors of the securities markets. Although most conduits hold a core position in highly liquid securities, such as credit cards, they have also emerged as buyers of higher yielding assets such as AAA CDOs. Second, securities conduits are not subject to additional regulatory capital charges for incremental spread duration exposure, since regulatory capital charges are primarily a function of asset quality which drives program credit enhancement sizing. This allows bank conduit sponsors to benet from adding higher spread duration assets to the portfolio.

Structured Investment Vehicles

The bank sponsored securities conduits we have discussed to this point have a capital structure which generally consists exclusively of ABCP; there is nominal equity capitalizing the bank conduit in keeping with their buy and hold investment strategy. Structured Investment Vehicles (SIVs), a more complex structure, are actively managed funds with a signicant layer of equity. A detailed discussion of SIVs is beyond the scope of this paper.

Future Direction: New Structures and Issuers

Sourcing Third Party Liquidity: Driving Structural Innovation Currently, the market for third party liquidity in ABCP structures is tight. Many large commercial banks, who have been the traditional providers of third party liquidity, have now established their own conduits and allocate their capacity for liquidity support to their own programs. The immediacy of funding required in this support, in spite of the lack of a regulatory capital requirement, provides some natural limit to bank appetite for liquidity risk. One innovation that has emerged to address this market dynamic is extendible liability structures, such as Secured Liquidity Notes (SLNs) developed by Lehman Brothers. SLNs, and other forms of extendible liabilities, are recent developments which we expect to exhibit substantial growth from their current level of approximately $17 billion outstanding. SLN programs issue a form of extendible structured liability that requires no third party liquidity support. The ratings of the structure are maintained through a combination of: a) recognition of the liquidity of the highly rated assets in the portfolio, b) utilization of the liability extension feature to delay funding requirements, and c) a 100% notional swap arrangement with a highly-rated counterparty. The swap agreement is generally documented within a banks derivative business, and owing to the absence of an immediate funding requirement has a different liquidity prole than the traditional bank liquidity facility. By harnessing the liquidity inherent in the assets and requiring no third party liquidity support, SLNs can provide a securitization structure that is as efcient as traditional ABCP.

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SLNs are issued with an expected maturity of up to 270 days and a legal nal maturity typically at least 90 days after the expected maturity date. If not repaid in full at the expected maturity date, SLNs become extended, at which time the discount amount is capitalized and the notes bear oating rate interest on a monthly basis. The extension may be cured by new SLN issuance within 30 days. For example, an inability to roll SLNs due to abnormal market conditions would not result in wind down of the program if new SLNs are issued within 30 days. If the 30-day cure period passes, portfolio assets must be renanced or liquidated to ensure repayment of SLNs by their legal nal maturity date. Any shortfalls are made up by the swap counterparty who will top-up the proceeds received from asset sales to the amount needed to repay the notes. For example, in a liquidation situation assets sold below par would be topped-up to par by the swap counterparty. The swap counterparty may or may not be responsible for credit related shortfalls due to non-performing assets. Programs in which the swap counterparty does not bear credit risk have subordinated debt that insulates SLN investors from such risk. In Figure 7, we summarize key aspects of bank securities conduits and SLN programs. Money Managers as Conduit Sponsors: Increasing Assets Under Management To a money manager, ABCP conduits represent an alternative means of aggregating assets under management. The sponsor can utilize existing infrastructure and investment expertise to manage the asset portfolio while accessing a new and unique investor base in the CP market . As an example, Alliance Capital Management L.P. recently initiated through Lehman Brothers a $1.5 billion securities conduit program, ASAP Funding, which utilizes the SLN structure. While the regulatory capital incentive does

Figure 7.
Typical Size Assets

Key Characteristics of Conduit Structures

Bank Securities Program Up to $10 bn AA or Higher ABCP Monthly by Administrator 100% Liquidity Facility SLN Program Up to $5 bn AA or Higher SLNs Monthly by Administrator 100% Notional Market Value Swap in lieu of Liquidity Support

Capital Structure Monitoring/Reporting Liquidity Support

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not apply to a money manager, the sponsor is able to increase fee income by adding the conduit to its list of managed funds. The SLN structure, in particular, opens additional opportunities for money managers who are unable to provide liquidity support in the traditional ABCP conduit structure. ABCP and/or SLN conduit issuance by money manager sponsors is consistent with the growing trend of investors using securitization to increase funds under management, through vehicles such as CDOs. One advantage of conduits is that they allow product to be sourced from the much larger pool of AAA/AA ABS, as opposed to the A/BBB pool typically accessed by ABS CDOs. Insurance Companies: Alternative Source of Leverage Insurance company interest in the ABCP conduit structure is motivated at two levels. From a macro perspective, insurers have moved towards managing spread businesses as a means of increasing leverage and therefore ROE, as well as delivering on more aggressive growth targets. From an insurers perspective, ABCP programs compare quite favorably to other funding programs such as Pension GICs, Funding Agreement Backed Notes and most notably Putable Funding Agreements. ABCP programs offer insurance companies the benets of higher quality assets, off-balance sheet operating leverage and in certain cases less liquidity risk. By investing ABCP proceeds in AAA/AA assets, the conduit carries less credit risk than the comparable asset portfolio of a typical on-balance sheet spread management business (with an average rating in the A/BBB range). In addition, the leverage created in the ABCP structure remains off-balance sheet for GAAP accounting purposes, and will likely be viewed as operating leverage by the rating agencies. Finally, liquidity risk in the ABCP conduit is limited to the rollover risk of commercial paper. The liquidity mitigation features of SLNs, compared with ABCP with traditional liquidity support, are attractive in further reducing this risk. For a more detailed discussion of leverage in the insurance industry, see our Insurance Strategies Groups 2001 U.S. Insurance Industry Outlook, January 2, 2001. From an insurers perspective, the regulatory capital incentive for the use of securities conduits is similar in spirit to the bank securities conduit example which we previously discussed. In Figure 8, we illustrate the regulatory treatment of on-balance sheet versus conduit funding for an insurers $1 billion ABS portfolio, assuming an SLN liability structure. Our example assumes regulatory risk-based capital of 0.3% capital against a highly rated asset portfolio and 2.0% against on-balance sheet liabilities. In fact, we assume the insurer will actually hold 200% of both the asset and liability requirements, as most highly rated insurers hold double or triple the minimum regulatory capital required. In the conduit example, we assume the insurer would hold 200% of the 0.3% regulatory capital requirement for the assets. To isolate the regulatory capital impact, we assume

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Figure 8.

Insurance Company Regulatory Capital Example

On Balance Sheet Funding $1 bn (200% 2.3% capital charge) = $46 mn LIBOR + 20 cost of balance sheet liabilities (L+30 assets) - (L + 20 funding) = 10 bp = $1.0 mn $1.0 mn net spread/$46 mn capital = 2.2% ABCP Conduit SLN Funding $1 bn (200% 0.3% capital charge) = $6 mn LIBOR + 20 SLN cost of funding (L + 30 assets) (L + 20 funding) = 10 bp = $1.0 mn $1.0 mn net spread/$6 mn capital = 16.7%

Regulatory Capital Cost of Fundinga Net Spread

Return on Equity

a Illustrative cost of funds will vary depending on credit rating of insurer for on-balance sheet funding, and size and structure of ABCP program.

that the insurer could fund this portfolio both on-balance sheet or through an SLN structure at LIBOR + 20 all-in. Similar to our previous example, we assume the yield on the ABS portfolio to be LIBOR + 30 basis points. Expressed in terms of return on capital, the on-balance sheet example nets to a 2.2% pre-tax return, while the conduit program returns 16.7% pre-tax. Consistent with the bank example, the benet of the conduit structure in the current regulatory environment is clear. We note that under these circumstances on-balance sheet exposure to AAA oaters is not economical, hence insurers generally move down the credit curve in their actual holdings.

CONCLUSION
With in excess of $150 billion currently invested in the ABS markets and strong growth expected to continue, securities conduits are an important factor for all ABS investors to consider. The investment strategies of conduits are best understood within the context of regulatory and accounting guidelines. Portfolio concentration in AAA/AA assets is driven by the investment parameters of the portfolio manager, as with any on-balance sheet program, and further shaped by regulatory capital requirements for the providers of credit enhancement. Bank conduit tendencies towards less liquid and higher spread duration securities are largely a function of their buy and hold philosophy combined with the lack of incremental regulatory capital charges for assets with higher spread duration. Finally, from an issuer perspective securities conduits represent a unique structure in which leverage can be combined with a highly rated securities portfolio to earn an attractive ROE. Recent innovations such as Secured Liquidity Notes make this market accessible to a growing issuer base which now includes money managers and insurance companies, in addition to more traditional bank issuers.

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REGULATORY CAPITAL CHANGES AND ABCP CONDUITS

At Issue: On versus Off-Balance Sheet Treatment
The regulatory capital arbitrage captured in structures such as asset backed commercial paper conduits exploits two primary regulatory inconsistencies. First, risk weightings for highly rated ABS products held on balance sheet are high relative to other similarly rated securities. Second, liquidity and credit support provided to these structures receives favorable regulatory capital treatment, relative to the risk of such rst loss positions. Broadly speaking, proposals by the FFIEC and BIS are designed to address these aspects of the current regulatory structure, bringing the regulatory treatment of similar risks in-line, regardless of the structure within which the risk is held. Regulatory responses, while issued only in comment form, can be summarized as follows: Ratings based asset risk weightings. The FFIEC and BIS both agree in principal to adjust risk weightings for ABS securities held on-balance sheet. In general, requirements for highly rated assets would be reduced, with lower rated assets actually seeing an increase in capital requirements. For example, FFIEC would reduce AAA ABS to a 20% risk weighting while increasing BB ABS to 200%. Both receive 100% risk weighting under current rules. Consistent treatment of off-balance sheet support. Proposals regarding support for off-balance sheet programs appear to be similar in spirit, although somewhat different in the degree of denition provided. The general objective points to consistency in treatment of the credit leverage of rst loss positions. For example, rst loss credit enhancement provided by a bank currently receives a 100% risk weighting on the amount of the enhancement. New regulations would likely increase the capital held against this position to a dollar-for-dollar basis, recognizing the risk of the entire portfolio. In addition, BIS has proposed a 20% risk weighting for liquidity facilities which are structured with a 364-day renewable term to avoid capital requirements under current rules.

Market Implications
More clarity on the regulatory front is expected later this year, but implementation is some time away. For example, current BIS plans are for 2004 implementation. Hence, the short-term market impact is expected to be minimal.

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