The asset-backed commercial paper (ABCP) market has ended several years of stalled growth and resumed its progress toward $1 trillion in total outstanding amount. The next few years will bring more challenges, and opportunities, for ABCP conduits and their bank sponsors. The implementation of Basel II's revised bank regulatory capital requirements will change the economics of bank-sponsored conduits. The likely effects on arbitrage conduits, which invest primarily in rated securities, can be shown most clearly. The sponsors of these vehicles can use a number of new and developing structural features to reduce the capital costs and to preserve and enhance the economic benefits of these vehicles.

In a typical ABCP conduit structure, a bank or other financial institution (or occasionally a non-bank financing company or asset management company), informally called the sponsor, arranges for a special purpose entity (SPE) to be organized, to establish a programme for issuing short-term notes primarily to institutional investors in the capital markets, and to enter into liquidity facilities, credit enhancement agreements, interest rate and currency exchange transactions (if needed) and other arrangements designed to assure timely payment of the notes at maturity. The conduit, or an associated SPE, uses the proceeds of the notes to purchase or otherwise acquire interests in receivables, securities or other financial assets, including asset-backed securities (ABS). Typically, the sponsor acts as administrator of the conduit's activities, arranging its issuance of ABCP, negotiating its transactions with sellers of financial assets, and monitoring and managing those transactions. Often, the sponsor (or an affiliate) provides the conduit's credit enhancement facility and all or most of its liquidity facilities, and interest rate and currency swaps. In the case of a securities arbitrage conduit, generally the assets are debt securities, including ABS, with high credit ratings, which have a longer term and slightly higher yield than the ABCP.

Basel II effects

Basel II, by providing different methods of calculating risk-based capital for rated versus non-rated exposures, special rules for ABCP conduit exposures, and different percentages for differently rated exposures, will change the incentives for banks to hold or originate assets in ABCP conduits.

It will reduce the capital cost of holding some assets and therefore reduce the incentive for conduits to hold those assets. For example, highly rated asset-backed bonds will generally carry a much lower capital charge than under the existing rules.

Conversely, Basel II will greatly increase the capital cost of holding some types of assets, including lower-rated and unrated asset-backed exposures. Other things being equal, banks will want to limit their exposure to those assets for capital purposes, and this might increase incentives for ABCP conduits or other SPEs to hold those assets.

The capital cost of liquidity facilities (with some exceptions), and possibly credit enhancement, will be increased. In a fundamental change (at least for non-US banks), all liquidity facilities provided by banks to ABCP conduits, even short-term commitments, will carry some capital charge (other than market disruption only eligible liquidity for standardized banks). For banks that will use the internal ratings-based (IRB) approach (including all the large ABCP conduit sponsors), a bank's capital charge for a liquidity facility covering assets held in an ABCP conduit will effectively be the same as if the bank held those assets directly, regardless of the tenor of the facility and whether it includes an asset quality test. Also, capital costs of subordinated exposures such as credit enhancement facilities will in some cases be much higher than under the existing rules. These changes will tend to reduce the benefits for banks of placing assets in ABCP conduits rather than holding them directly. They will also prompt bank sponsors to find ways to reduce both the amount of liquidity and credit enhancement facilities required and the regulatory capital cost of those facilities.

For IRB banks, commitments under securitization liquidity facilities will be treated as having a 100% credit conversion factor regardless of the tenor or nature of the commitment. The amount of risk-based capital required would not depend on whether the commitment is subject to an asset quality test or otherwise qualifies as an eligible liquidity facility or on whether the commitment has a term of more or less than one year. Instead, liquidity facilities will be differentiated from credit enhancement according to an external credit rating, corresponding internal rating, or supervisory formula measure of credit risk to the facilities arising from the securitization structure and the characteristics of the underlying assets.

Recent and ongoing changes in the accounting consolidation rules applicable to SPEs will require bank sponsors to consolidate many ABCP conduits on the banks' balance sheets. In the US and some other countries the bank regulators have indicated that such balance sheet consolidation, by itself, will not result in the bank's being required to hold capital against all the conduit's assets. Under Basel II for IRB banks, as mentioned, a bank holding an asset on its balance sheet and a bank providing a 100% liquidity facility covering the asset should in principle have the same capital charge. However, the relationship of accounting rules to risk-based capital charges in most countries (excluding the US) has yet to be clarified, and banks with more limited exposures to conduits will still want to avoid consolidating those conduits.

Conduit sponsor responses

In response to these changes, conduit sponsors will find it beneficial to modify the structure of new and existing ABCP conduits, and particularly securities arbitrage conduits. As they aim to reduce the amount of liquidity and credit enhancement facilities required to maintain the ABCP credit ratings, sponsors will also seek to reduce the cost of a given amount of liquidity or credit support by:

• providing such support in new forms that require lower (or no) risk-based capital;
• choosing the conduit's asset portfolio so the bank can calculate risk-based capital according to a more favourable method (for example, using the internal assessments approach (IAA) rather than the supervisory formula); and
• choosing assets with low risk weights.

Subject to the above goals, conduit sponsors may seek to acquire capital-heavy assets from other banks, where the conduit can hold those assets more efficiently.

Changes in liquidity and credit support

ABCP conduit sponsors can reduce the capital cost of liquidity and credit enhancement facilities in a number of ways by reducing the required liquidity facility amount reducing the required credit enhancement amount, and using forms of liquidity and credit support that require less capital.

The can reduce the required liquidity facility amount. More and more conduits are designed to require less than 100% liquidity support from traditional bank liquidity facilities. They do this by extending the tenor of the conduit's issued securities and by investing in liquid assets that can be turned into cash in time to pay the securities at maturity.

Many ABCP conduits now issue, or are able to issue, extendible commercial paper (extendible CP), which does not have to be fully backed by external liquidity facilities. Extendible CP (and its cousin callable CP) usually has an expected maturity date of six to nine months and a final maturity date of up to about one year from the date of issue. It is normally paid on its expected maturity date but, if it is not (and a conduit liquidity coverage test is met), it will be extended to its stated final maturity, while bearing interest at a floating rate reset monthly. The conduit's assets need to be such that if the notes cannot be rolled over and are extended, the assets can be liquidated in time to pay the notes at maturity. This type of liquidity is well suited to conduits, such as residential mortgage warehouse vehicles, that invest in a uniform and liquid type of collateral, and to securities arbitrage vehicles, which have highly rated and liquid assets. The extension feature typically adds two or three basis points to the discount or interest rate on the notes.

Some conduits reduce their liquidity facility requirements by issuing medium-term notes (MTNs) to finance certain assets. For MTNs, the rating agencies require liquidity to cover interest and other debt service costs but not, as for ABCP, the principal amount and interest to accrue until maturity. A number of multi-seller ABCP conduits are capable of issuing MTNs, but few have done so. Some securities arbitrage conduits are being set up to issue MTNs, adopting one of the features of structured investment vehicles (SIVs).

A few conduits are adopting a new type of instrument known as extendible MTNs, a hybrid between the commercial paper and MTN markets. An extendible MTN typically has an initial maturity of about one year from date of issue, and bears interest at a floating rate reset monthly. On the first interest payment date after issue, or after a previous extension, the investor (not the issuer) may elect to extend the maturity by one month, so the remaining maturity is again one year. This extension can be repeated for a maximum term of up to five or six years. The interest rate margin is increased in each year the note remains outstanding, so the investor has an incentive to extend the maturity. The instrument is designed to qualify as short-term debt so that money market funds and similar investors can buy it, but to provide the issuer with medium-term funding. The investor gets a higher yield than it would get from ordinary commercial paper, and the issuer pays a lower yield than it would pay on ordinary MTNs. To date, most extendible MTN issuers are banks and other finance companies. ABCP conduits can also issue them, if they can satisfy rating agency requirements on liquidity coverage tests and hedging of interest rate and currency risks.

Bank conduit sponsors can also reduce their risk-based capital requirements associated with their ABCP conduits by reducing the amount of capital-heavy credit enhancement facilities they provide to the conduits. One way a bank can do this for a securities arbitrage vehicle is to adopt more sophisticated models, of the type used by CDOs, to assess the programme credit enhancement required for the conduit's assets. Rating agencies are also developing credit enhancement models that are more dynamic and sophisticated than their older credit enhancement matrices for arbitrage conduits. Stop-loss triggers that require an asset to be sold or funded by liquidity when its credit rating is downgraded also help to limit the amount of credit enhancement required.

Apart from reducing the amount of the facilities required, conduit sponsors can reduce their capital requirements by using types of facilities that have lower capital requirements, or that can be provided by non-banks that have lower capital requirements or costs.

• Market disruption only liquidity facilities under Basel II will have a 20% credit conversion factor for IRB banks and 0% for standardized banks. Rating agencies probably will not accept these facilities for a typical multi-seller conduit, as they typically require the liquidity providers to provide funding at any time, not only in a general market disruption, and to bear certain risks of the underlying transaction (other than credit risk of the purchased financial assets). However, these facilities could be used, probably in combination with extendible CP and perhaps other types of liquidity facilities, by securities arbitrage conduits that have liquid assets.
• Market value swaps and total return swaps can be used to provide both liquidity support and credit enhancement. They can be provided by non-banks that do not have to reckon with risk-based capital requirements.
• Repurchase agreements can also be used to provide liquidity and credit support and can be provided by non-banks. Small asset management companies have structured a number of repo arbitrage conduits, which invest in short-term highly rated assets or in other financial assets subject to repurchase agreements, securities lending agreements and other securities finance contracts with highly rated counterparties. The repo agreements effectively take the place of the liquidity facilities in a traditional securities arbitrage conduit.
• Credit default swaps could be used to transfer credit risk to an SPE that issues credit-linked notes to investors, transforming a large portion of the programme credit enhancement facility into a synthetic CDO.
• Banks might be able to hold commitments under derivatives and repurchase agreements, for example, as trading book instruments, which require less capital. The US bank regulators, however, have indicated that they expect a bank's liquidity support to its sponsored ABCP conduit, regardless of form, to be treated as a securitization exposure under the risk-based capital rules.
• A bank sponsor could commit to liquidate the conduit's liquid assets if required at a minimum percentage of par value within a certain number of days, and to indemnify the conduit for any shortfall in value if it fails to do so. This indemnity would be treated as an operational risk not subject to a separate capital requirement.

Examples

The following examples illustrate the calculation of possible risk-based capital savings from using some of the techniques mentioned above. Figure 1 shows a typical ABCP conduit structure and indicates where the different liquidity and credit support techniques would be applied. These examples are meant to illustrate the calculations and not to indicate that a particular kind of transaction will work commercially or that a certain risk-based capital treatment will apply in a particular case. Of course, where liquidity and credit support is acquired from third-party sources, the risk-based capital savings will be offset to some extent by costs of interest or fees paid to the support providers.

Figure 1: Hypothetical conduit structure

Basel I to Basel II

Figure 2 illustrates the change in risk-based capital requirements from Basel I to Basel II for a €5 billion securities arbitrage ABCP conduit that invests in AAA- and AA-rated bonds and ABS, and has 4% credit enhancement and 100% liquidity support for its issued ABCP. (The face amount of ABCP, and so the required amount of liquidity and credit enhancement, would be slightly higher than the corresponding principal amount of assets, but for simplicity these examples ignore that difference.) Under Basel II, the capital requirement for liquidity goes from zero to almost €27 million. Even if the bank can reduce the capital requirement for credit enhancement from €16 million to €8 million by applying a 50% risk weighting under the IAA, the bank's total regulatory capital requirement for the conduit will more than double, from €16 million to almost €35 million.

Figure 2: Basel I to Basel II - Hypothetical capital calculation

Synthetic credit enhancement

Figure 3 shows the savings in Basel II required capital if an arbitrage conduit (again, with €5 billion in assets and liabilities, 4% credit enhancement and 100% liquidity) is restructured to leverage its programme credit enhancement into a synthetic CDO, with the sponsor bank retaining a 0.15% first loss position. The retained first loss position must be deducted from capital, resulting in a €7.5 million capital charge, a reduction of only €500,000. The sponsor could achieve a much higher reduction in risk-based capital by having the conduit issue extendible notes or using other means to reduce the amount of required liquidity facilities.

Figure 3: CDS of programme credit enhancement - revised capital calculation

Liquidity from asset sales and sponsor stop-loss indemnity

Figure 4 shows the risk-based capital calculation for a conduit that has no traditional liquidity facilities, but invests in marketable securities, and the sponsor undertakes to sell the assets at a minimum percentage of par within a certain time and provides a stop-loss indemnity for any shortfall on its failure to do so. Assuming the stop-loss indemnity is given operating risk treatment, it will not require the bank to hold any incremental risk-based capital. If the conduit obtains a financial guarantee policy or other third-party credit support and the bank retains only a 1% first loss exposure, assuming that exposure has a low investment-grade credit quality and achieves a 100% risk weight under the IAA, the bank will be required to maintain €4 million of risk-based capital. By eliminating the liquidity facility and reducing the bank credit enhancement facility, the bank's risk-based capital requirement is reduced from almost €35 million to only €4 million. The bank could achieve a similar result if liquidity is provided in the form of a market value swap from a third party not subject to risk-based capital requirements, or by the bank if the bank can hold the swap exposure in its trading book and hedge its exposure.

Figure 4: stop-loss indemnity or market value swap - revised capital calculation

More innovations ahead

These examples show how innovations in conduit technology can continue to deliver remarkable financing efficiencies in a changing regulatory environment. Expect to see wider use of these techniques and more development of new innovations over the next few years.

Author biographies

Jason Kravitt Mayer Brown Rowe & Maw Jason Kravitt is a member of the firm management committee, finance practice leader in the New York office and founder of the firm's renowned securitization practice. Kravitt helped create some of the most significant securitization products used in the capital markets today, including the first partially enhanced, multi-seller, asset-backed commercial paper vehicle in 1989 and the first CLO, Frends in 1988. He is editor of Securitization of Financial Assets, a leading reference in the industry, now in its second edition. Kravitt frequently represents industry groups with regard to securitization regulatory initiatives – for example, the Basel Committee on Banking Supervision's risk-based capital consultative papers, the FFIEC's risk-based capital projects, the FASB's new standards for securitization: SFAS 125 and 140, the FASB's proposed standard for consolidation, and SEC amendments to Rule 2a-7. He is one of the organizers and senior officers of the securitization industry's new trade association, the American Securitization Forum. He holds a JD (cum laude) from Harvard University (1972), a Diploma in Comparative Law from Cambridge University (1973), and an AB from Johns Hopkins University (1969), where he was a member of Phi Beta Kappa. Kevin Hawken Mayer Brown Rowe & Maw Kevin Hawken is a finance partner, specializing in securitization and cross-border transactions, representing commercial paper programme administrators, arrangers, asset sellers, liquidity providers, credit enhancers and rating agencies in transactions involving a wide variety of asset types and jurisdictions. Hawken joined Mayer Brown's London office in 2000 after working in the Chicago office from 1989 to 2000. He was previously with Marks Murase & White in New York (1986 to 1989) and Shearman & Sterling in New York (1983 to 1986). He holds a JD, cum laude, from Georgetown University Law Center (1983) and a BA from the University of Illinois, Urbana-Champaign (1978).