A short-term monetary-market debt instrument collateralized by a package of loans
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An asset-backed commercial paper (ABCP) is a type of commercial paper that is collateralized by financial assets. Commercial paper is a short-term monetary-market debt instrument with a maturity of no more than 270 days. It is usually issued by a large corporation or financial institution to pay for inventories, account payables, and other short-term liabilities.
An ABCP is typically issued by a non-bank financial institutition, such as a conduit or special purpose vehicle (SPV). A conduit or SPV is set up by a financial institution to own the collateral assets from asset sellers. The structure protects the assets in case of the bankruptcy of the financial institution.
A typical commercial paper is unsecured. It is backed merely by the credit of the issuer as a promissory note. Generally, only large companies with high credit ratings are able to issue commercial papers.
The major difference between an ABCP and a typical commercial paper is that an ABCP is backed by collateral. The collateral is the receivables that bring in future payments. The future payments include the repayments on credit cards, collateralized debt obligations (CDO), auto loans, invoices, and many others.
The issuance of AN asset-backed commercial paper can be either a single-seller program or a multi-seller program. A single-seller program includes only one asset seller. A multi-seller program comprises a pool of sellers, which lowers risk through diversification.
Credit enhancement is usually implemented in a multi-seller program. A sponsor or third-party bank can be a credit enhancement provider by providing cash reserves or guarantees. In addition to credit risk, liquidity risk is also a concern of ABCP. A liquidity provider may also be involved in the issuance by providing the funds to meet the ABCP payments under certain circumstances.
Placement agents are usually investment banks. They are responsible for providing the instruction of issuance and selling ABCP to investors. The process also includes screening for qualified investors. An ABCP issuance program generally includes two to three placement agents.
Investors pay for their ABCP purchases to the conduit, and the conduit repays the investors through the placement agents. The repayments to the ABCP investors are collected from the principals or interests from the underlying receivables.
Compared with typical commercial papers and long-term debt instruments, ABCPs offers several advantages, as listed below:
The nature and quality of the collateral assets of an ABCP are important factors that determine the credit risk. Although a pool with multiple asset sellers and different types of assets offers the benefit of diversification, assessing the risk for a new or complex composition of assets can be especially difficult.
In addition to the collateral, the overall credit risk of an ABCP program also depends on its credit enhancement facility. Complex terms in the credit enhancement contract also make it more difficult to assess the overall risk.
The timing mismatch between the cash flows from the receivables and the payments to ABCP investors is also a concern. For example, mortgages should not be used as collateral for ABCP due to their long-term nature. The entire future payments are still uncollected from the mortgage when the ABCP matures. The timing mismatch causes liquidity risk and makes it important to employ a liquidity provider in an ABCP program.
Another concern of ABCP is that the expected future payments of underlying receivables are packaged and sold to investors in the secondary market. The risks regarding cash flow collection from the assets are transferred to ABCP investors from banks. It causes a problem that the banks may not keep their typical strict standards on risk assessment.
Before the 2008 Global Financial Crisis, many commercial banks set up SPVs to issue ABCPs. They sold the ABCPs to invest in long-term, high-yield securities. When the crisis took place, the default of mortgage-backed securities (MBS) caused significant damage to the economy.
As ABCPs are also collateralized by a package of loans, such as MBS, the investors’ confidence in the creditworthiness of ABCPs also deteriorated, despite its nature as a commercial paper. Panicked investors withdrew massively, which led to a bank run. The liquidity shock forced the affected banks to liquidate their long-term investments immediately, even at significant losses. The crisis thus intensified.
To learn more about asset-backed papers and explore your career options in capital markets & securities trading, download our Capital Markets & Securities Analyst (CMSA®) program brochure, below:
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