Conduits and special investment vehicles
(SIVs) allow companies and banks to take on
off-balance-sheet debt. These vehicles
usually hold highly rated,
short-term debt that offers a higher yielding
alternative to ultra-safe Treasury debt. Banks use
the low-cost proceeds to buy longer-term debt such
as auto-loans, credit card loans, or mortgages to
profit from their high cash flow. Banks that have
stakes in the conduits have provided ''liquidity
back-stops'', promises that the vehicles’ debts
will be paid by the banks when they come due even
if the vehicles are not able to pay them.
Banks are reluctant to consolidate the
distressed vehicles because it would have to put
the liabilities on bank balance sheets, thus
restricting lending. Also, allowing conduits or
SIVs to fail could damage a bank's reputation and
might even create financial systemic risk if
investors should lose faith and stop purchasing
commercial paper altogether. This creates possible
scenarios where banks must lend the distressed
vehicles money in the hope of riding out a storm
or take substantial immediate losses.
The
trillion dollar commercial paper (CP) market that
raises funds for the purchase of assets ranging
from home mortgages to car loans seized up in
August this year just as more than half of that
amount was coming due. Unless the issuers continue
to find new buyers to roll over the maturing debt,
hundreds of hedge funds and home-loan companies
will be forced to draw on bank loans or sell some
US$75 billion of debt at fire sale prices every 90
days, which would drive prices further down in a
market where investors have already lost $44
billion. That would hurt the 40 million individual
and institutional investors in money market funds,
the biggest owners of CP. The money comes
predominantly from retirement funds. Let that be a
warning to those who advocate the privatization of
social security.
Ottimo Funding Ltd, whose
name means ''excellent'' in Italian, started
selling its $2.8 billion of mortgage bonds at the
end of October after failing to roll over
financing in the CP market. Many of Ottimo’s
securities were backed by option adjustable-rate
mortgages (ARMs). Borrowers with option ARMs are
permitted to make low initial interest payments
for the first few years, causing loan balances to
grow. Monthly payments can later more than double.
The securities auctioned were rated AAA
and backed by Alt-A mortgages, a credit class
above subprime made to borrowers with good credit
scores who opt for unusual terms, such as reduced
income documentation or delayed principal
repayment, without enough visible assets to offset
the risk, such as sufficient cash in the bank. The
sale of Ottimo securities did not generate enough
cash to fully repay investors who had bought
short-term debt from the fund that was now
maturing.
Ottimo, created six months
earlier by Stamford, Connecticut-based $20 billion
hedge fund manager Aladdin Capital Management,
extended the maturity of its asset-backed
commercial paper (ABCP) in August after being
unable to roll over the debt. Investors in
short-term CP issued by Ottimo and similar funds
fled to safety in US government bonds after losses
linked to subprime home loans began to spread.
S&P in August cut Ottimo's credit rating to C,
the second-lowest ranking, from AAA.
The
threat of a fire sale of assets by investors that
also rely on the shrinking market for ABCP
prompted US Treasury Secretary Henry Paulson to
broker talks that may lead to the creation of a
$80-100 billion fund by Citigroup Inc, JP Morgan
Chase & Co and Bank of America Corp.
The fund would buy securities from
so-called structured investment vehicles, or SIVs,
to prevent them from dumping their $320 billion of
holdings and further roiling credit markets.
But Ottimo is not considered a SIV. Its
bonds are backed by mortgages to people with
credit scores of 708 and higher, compared with
scores for subprime loans that average less than
620. The company's CP has an A1+ rating from
S&P and P1 from Moody's Investors Service, the
highest available.
Aladdin was not forced
to immediately shutter Ottimo because the company
exercised an option to extend the maturities on
its CP, providing 30 to 45 more days to find
buyers. No issuer had extended maturities in the
12-year history of the asset-backed market until
Ottimo. Two other issuers, Luminent and a unit of
Melville, New York-based American Home Mortgage
Investment Corporation did so in the last two
weeks of October. More than $100 billion of
extendible CP is still outstanding.
The
laws of finance may be bent but cannot be denied
by obscuring the unwinding of obligations through
manipulation to postpone the day of reckoning by
adding more obligations. Ponzi schemes of paying
early creditors with money from new creditors
eventually will fail, with the final bill
increasing in size as time goes on. The reckoning
of the debt cancer presents a choice of facing the
music honestly by excising the invasive malignancy
now or letting it metastasize through the entire
financial system over the painful course of
several quarters and even years and decades. Until
October, investors were willing to buy extendible
CP because it offered higher interest rates than
standard ABCP. Since then, as Wall Street carnival
barkers continue to urge investor to take
advantage of buying opportunities, it has been
time to sell.
Financial
panic Short-term corporate debt yielded
5.75% to 5.95% on average on August 8, compared
with 5.45% for non-extendable ABCP and 5.25% to
5.30% for corporate commercial paper. Since then,
ABCP with a maturity of 30 days or less are
yielding above 6% on average if a buyer can be
found, and corporate borrowers pay about 5.2%,
while three-month LIBOR, or London Inter-Bank
Offer Rate, the interest rate that the banks
charge each other for loans, hovers around 4.89%.
Extendible commercial paper has no market.
Wall
Street is gripped by financial panic and has
stopped funding mortgage bonds, even those that are AAA rated
and backed by prime home loans. Even the Fed's decision
on August 17 to cut the discount rate
50 basis points to 5.75%, its September 18 decision
to cut the same rate another 50 basis points to
5.25% and the Fed Funds rate target 50 basis
points to 4.5%, failed to revive demand for ABCP.
Its October 31 decision to cut the discount rate
another 25 basis points to 5% and the Fed
Funds rate target another 25 basis points to 4.5%
still failed to revive demand. The rate
for overnight borrowing in the asset-backed
commercial paper market soared 0.39 percentage points, the biggest
rise since the September 11 terrorist attacks.
Overnight yields fell 2 basis points to 6.01%
while 30-day paper widened 9 basis points to
6.09%. A basis point is 0.01 percentage point.
The distinction between asset-backed
securities and asset-backed commercial paper is
primarily one of the tenure of the paper -
commercial paper by definition is short-term
funding and is therefore mostly used for
short-term assets such as trade receivables.
ABCP is a device used by banks to get
operating assets such as trade receivables funded
by issuance of securities. Traditionally, banks
devised ABCP conduits as a device to put their
current asset credits off their balance sheets and
yet provide liquidity support to clients whose
working capital needs are funded by the bank. If
the bank wants to release the regulatory capital
that is locked in this credit asset, the bank can
set up a conduit, essentially a special purpose
vehicle that issues commercial paper. The conduit
will buy the receivables of the client and get the
same funded by issuance of commercial paper. The
bank will be required to provide some liquidity
support to the conduit, as it is practically
impossible to match the maturities of the CP to
the realization of trade receivables. Thus, the
credit asset is moved off the balance sheet,
giving the bank a regulatory relief.
So
depending upon whether the bank provides full or
partial liquidity support to the conduit, ABCP can
be either fully supported or partly supported.
ABCP conduits are virtual subsets of the parent
bank. If the bank provides full liquidity support
to the conduit, for regulatory purposes, the
liquidity support given by the bank may be treated
as a direct credit substitute in which case the
assets held by the conduit are aggregated with
those of the bank.
Non-bank entities also
set up ABCP conduits. ABCP conduits can be single
originator or multiple originator conduits. In the
latter case, the credit enhancements (and/or
liquidity enhancements) are found both at the
level of transfer by each originator
(originator-level enhancement) and at the program
level.
The ABCP
market Bank-sponsored ABCP conduits are the
oldest and largest segment of the asset-backed
commercial paper market. As of
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