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4 PATHOLOGY OF
DEBT PART 4: Lessons
unlearned By Henry C K Liu
structures for many ABCP conduits
very expensive. What had been a zero capital
charge will become a capital charge of up to 8% of
the outstanding exposure. In the US, the Board of
Governors of the Federal Reserve System, the
Federal Deposit Insurance Corporation, and the
Office of Thrift Supervision have also specified
new sets of capital requirements for ABCP.
In Europe, various national regulators and
the EU will be
specifying capital levels for
European banks. One major impact is that US ABCP
program bank sponsors are required to hold
risk-based capital against liquidity facilities
that have maturities of less than one year. A 10%
credit conversion was applied to all of these
liquidity facilities until September 30, 2005.
Further to this date, conduits are required to
pass certain asset-quality tests in order to
maintain the 10% credit conversion; otherwise they
would be subject to 100% credit conversion. This
is one reason why partially enhanced, market-value
securities arbitrage programs have grown in leaps
and bounds in recent years. Basel II will
potentially change this and result in similar
capital requirements for liquidity facilities
within Europe. As of year end 2004, securities
arbitrage and SIVs accounted for approximately 25%
of the total ABCP market.
The impact of
these regulatory changes will be far-reaching,
further increasing the cost of liquidity
provisions. However, the proposed Basel Accord is
also expected to provide additional downward
pressure on the spreads of high-rated assets,
removing the arbitrage opportunities for these
conduits as their funding costs move closer to the
spreads on the assets. It is not expected to drive
these vehicles out of the market, but rather
enforce the need to restructure and adopt many
alternative funding and liquidity management
techniques.
On June 26, 2004, the Basel
Committee on Banking Supervision released its
revised framework for the capital adequacy of
banks. International Convergence of Capital
Measurement and Capital Standards (Basel II)
substantially revises the 1988 Basel Capital
Accord.
Under Basel I: A $100,000
commercial loan with AAA credit rating would
require an $8,000 capital charge while the same
loan with a B credit rating would require the same
$8,000 capital charge.
Under Basel II: A
$100,000 commercial loan with AAA credit rating
would require US$370 while the same loan with a B
credit rating would require up to a $42,000
capital charge.
The logic is that capital
requirements should increase for banks that hold
risky assets and decrease significantly for banks
that hold safer portfolios. Basel II creates
incentives for banks to move risky assets to
unregulated parts of the holding company, and to
transfer risk to investors through securitization.
Banks have a strong incentive to undertake
regulatory capital arbitrage to structure the risk
position of a group of loans in a manner that
allows it to be reclassified into a lower
regulatory risk category compared with the Basle
8% standard. Securitization is the key tool used
by large banks to engage in such arbitrage.
Credit derivative vehicles
(CDVs) Credit derivatives have been
responsible for a sea-change in global investment
management practices. A number of SIVs have been
approved to engage in synthetic trading. Other
firms are also focusing on synthetic trading
adopting the ways of the SIV.
Similar to
an SIV, a CDV has its assets reviewed by the
agencies on a regular basis to ensure economic
capital levels are capable of supporting their
business volumes. The high rating provides the
firm with an extraordinary competitive advantage
in terms of counterparty creditworthiness.
Qualification requires intensive monitoring of
market and credit risks integrated into their
asset and liability management process. These
firms must also report risk exposures and limits
on a very frequent basis to the rating agencies.
One such vehicle is Primus, which is an
AAA-rated structured credit vehicle established as
a dedicated seller of single-name CDS protection.
Recently, Primus has moved into portfolio credit
derivative trades, namely tranched CDS.
Hybrid vehicles With the ongoing
convergence in the market, more hybrid-type
vehicles entered the market. In August 2005, BSN
Holdings Ltd launched an innovative ABCP program
that engaged in securities arbitrage and lent in
the repo market. The US$20 billion ceiling
program, Chesham Finance, resembled conventional
securities arbitrage conduits and structured
investment vehicles in that it could buy a wide
variety of short- or long-term securities rated at
least AAA or AA. However, the vehicle would not be
required to maintain a bank liquidity support or a
capital base. Asset-liability maturities would be
managed to an exact science through a system of
repaying maturing CP by issuing paper exactly
matched to its assets and monitoring this using
SIV-like cumulative net cumulative outflow (NCO)
tests. Additionally, this might include using
extendible CP and call and put options on the CP
to ensure perfect matching. In addition, Chesham
was approved to lend to highly rated
counterparties under reverse repos.
Structured lending vehicles Bear
Stearns' Liquid Funding Ltd, a $1.7 billion (MTN)
ceiling program, was among the first vehicles to
use reverse repos and total return swaps as
collateral. Although it has been referred to as
SIV-like, its motivations are very different.
Whereas SIVs look to arbitrage the spread between
long-dated assets and short-term liabilities,
Liquid Funding seeks to provide borrowers with a
secured source of long-term funds as an
alternative to the unsecured and repo markets.
Due to prohibitively costly regulatory
capital charges, many repo desks are reluctant to
provide deals with maturities exceeding one year.
Liquid Funding seeks to bridge this gap with its
innovative program of rated notes. It most
resembles an SIV in that it achieves a high rating
for its notes through a battery of tests,
including NCO analysis and a capital adequacy test
incorporating market value risk. In addition, its
collateral portfolio is marked to market on a
daily basis. Liquid Funding is labelled a
structured lending vehicle (SLV) under Moody's
SFOC rating classification.
Another SLV
entrant was US$10 billion ceiling Atlas Capital,
launched by Wachovia Capital Markets that
leveraged SIV and market-value CDO technologies to
provide a flexible funding and warehousing
platform for its clients' investments. On the
asset side, Atlas engaged in reverse repo and
total return swap activity as part of its charter.
It issued MTNs, CP and repos to fund pools of
investments that could either be leveraged for
asset managers or hedge funds, or warehoused for
asset managers who have plans for a CDO launch but
were waiting for more favorable market conditions.
In an interesting twist, Atlas' clients selected
the assets that were purchased with the proceeds
from the debt issued.
The importance of
the commercial paper market A crisis in the
commercial paper market, which normally is an
arena of high safety, spooks investors of all
levels of risk appetite. The average yield on
overnight asset-backed paper rated A1+, the
highest short-term credit rating by S&P, rose
4 basis points, or 0.04 percentage point, to 6.09%
on Friday, August 24, rising 59 basis points since
August 9.
Fed data show outstanding US
commercial paper fell 4.2% in the second week of
August, the biggest weekly drop in at least seven
years, as investors fled asset-backed debt and
opted for the safety of Treasuries. Short-term
debt maturing in 270 days or less fell $90.2
billion to a seasonally adjusted $2.04 trillion in
the week ended August 24. Commercial paper
outstanding had fallen by $181.3 billion in two
weeks. The retreat told market participants that
the Fed's discount rate cut on August 17 failed to
instill enough calm to draw back investors.
On April 10, 2006, the Federal Reserve
Board made major changes to its CP outstanding
calculations. New outstanding categories were
added, some existing category definitions were
modified, and current and historical CP issuer
information was updated. The historical data for
the new outstanding structure contains data for
January 2001 through the most recently completed
month. The historical data for the old outstanding
structure contains data for January 1991 through
March 2006. Prior to April 10 that year,
asset-backed was considered to be a subcategory of
financial and was not included in total
outstanding. Asset-backed outstanding is no longer
a subcategory of financial outstanding.
Rule 2a-7 of the Investment Company Act of
1940 limits the credit risk that money market
mutual funds may bear by restricting their
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