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PD16
Asset Backed Commercial Paper
Lessons in risk management to be learned
Stuart Wason
June 19, 2008
ABCP Conduit
• An ABCP conduit is a Special Purpose Vehicle
(SPV) that issues commercial paper and uses the
proceeds to purchase assets such as
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Trade receivables
Credit card receivables
Auto and equipment leases
Mortgages
Other types of assets
• The payments that are collected from the
purchased assets are used to redeem the
commercial paper at maturity
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Simple ABCP Transaction Structure
asset
Seller
cash
ABCP
Conduit
securities
Investors
cash
assets
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ABCP Conduit
• In recent years, many ABCP conduits
purchased longer-term assets such as:
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Mortgage-backed securities (MBS)
Commercial loans
Collateralized Debt Obligations (CDOs)
Collateralized Loan Obligations (CLOs)
• By the end of 2006, a number of
conduits had been created to act as
“arbitrage vehicles” in which the conduit
purchases longer term, higher yielding
assets in the public fixed income market
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Asset Collateralization Structure
asset
Seller
securities
SPV
cash
assets
Investors
cash
Credit
guarantor
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ABCP Market Structural Issues
• Lack of transparency
– Investors received only basic or minimal
information as to what assets they were really
buying
– In most cases, the only information available was
in the form of rating agency reports which
outlined the asset class composition of the
program, not the actual description of the
underlying assets
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ABCP Market Structural Issues
• Asset / liability mismatch
– Programs are founded upon funding of long-term
assets with short-term debt (ABCP)
– To address this, conduits relied upon the liquidity
providers to support the repayment of notes if
access by the conduit to funds becomes an issue
– There was a lack of transparency in respect of
who provided what support to which tranche or
structure
• This information was only available to the
conduit and the rating agency
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Liquidity facilities
• “Global Style”
– Liquidity provider backstops the conduit in times of
liquidity stress
• “Canadian Style”
– Rely on a broadly defined “market disruption” clause
as the trigger for liquidity support
Bank sponsored conduits were largely supported by
global style facilities provided by large domestic
banks, while Canadian style arrangements were in
place at non-bank sponsored conduits, often provided
by international banks
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Simple ABCP Transaction Structure
asset
Seller
cash
assets
ABCP
Conduit
securities
Investors
cash
Bank
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Rating ABCP
• Moody’s and Standard & Poor’s refused
to rate Canadian non-bank sponsored
ABCP because they carried “Canadian
style” and not “global style” liquidity
guarantees
• DBRS did rate these securities and was
the only public source of information
about them
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Rating ABCP
• Moody’s and Standard & Poor’s appear
to have been correct
– When the non-bank sponsored ABCPs
experienced severe liquidity problems their
claims on their liquidity providers were not
honoured because it was claimed that since the
bank-sponsored structures were still sound, a
general market disruption had not occurred
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The troubled asset class
- U.S. subprime mortgages
• In the early years of this decade, small
banks and mortgage brokers began to
issue residential mortgages with very
low (subprime) interest rates for an
initial period but renewable at
considerably higher rates (~10% or
more)
• Underwriting standards weakened and
mortgages were issued for 100% or
more of the property’s value
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The troubled asset class
- U.S. subprime mortgages
• The issuers did not intend to hold the
mortgages
– The mortgages would be securitized
– The issuers received fees for the issuance and
would receive fees for administering the loans
• The issuers had little or no incentive to
require borrowers to have a good credit
record
– Many loans were made to poor credit risks
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The troubled asset class
- U.S. subprime mortgages
• As mortgages came up for renewal at
considerably higher interest rates and
monthly payments, many borrowers
defaulted
– The tendency to default was increased by the
fact that many borrowers had virtually no equity
in their homes
– Since major Canadian non-bank sponsored
ABCP was heavily invested in U.S. subprime
mortgages, once news of the increasing defaults
surfaced in mid-2007, the market for these
assets dried up.
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Problem: Investors
• ABCP was purchased based upon ratings alone,
with little or no understanding of the underlying
assets
• Difficult to determine exactly who holds these
assets
– Some regulated FI’s certainly held them
• Some exposure came from being middle-men
– Reputation risk
– Exposure to credit guarantors of the basic
securitizations
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Problem: Accounting
• Fair value accounting relies upon deep
and liquid markets existing
• What do we do when markets dry up?
• Models are not an acceptable alternative
since there is little sound basis for the
assumptions needed
Markets are not always rational!
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Risk Management
• Limits on asset classes and exposures
• Look to underlying assets, understand
the risks
• Evaluate the security of counterparties
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Securitization of Insurance Risk
• Establish a special purpose reinsurer
• SPRV receives premiums, pays claims
• SPRV’s capital supplied by outside
investors
• Major issues
– The ownership and structure, including capital
structure, of the SPV,
– The degree of risk transferred
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Insurance Securitization Structure
Insurer
Mortality
risk
bonds
SPV
reinsurer
Reserve
relief
Investors
cash
premiums
claims
policies
Credit
provider
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Insurance Securitization
• The creditor is effectively an unregulated
reinsurer
• The underlying assets are opaque to
most investors
• Certain tranches could be packed with
substandard lives – potentially as toxic
as subprimes
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Insurance Securitization
• Very active market in the U.S.
– Primarily driven by a desire for reserve relief,
particularly under Guideline XXX
• No such structure as yet in Canada
– OSFI has received three applications
– Two were denied and one was withdrawn
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Discussion