What is Asset-backed commercial paper (ABCP)?

What is Asset-backed commercial paper (ABCP)?

Asset-backed commercial paper (ABCP) is a form of commercial paper that is collateralized by other financial assets. Institutional investors usually purchase such instruments in order to diversify their assets and generate short-term gains.

ABCP is typically a short-term instrument that matures between 1 and 270 days (average of 30 days) from issuance and is issued by an Asset-backed commercial paper program, such as a Conduit or Structured investment vehicle (SIV).

A conduit is set up by a sponsoring financial institution. The sole purpose of a conduit is to purchase and hold financial assets from a variety of asset sellers. The conduit finances the assets by selling asset-backed commercial paper to outside investors such as money market funds or other “safe asset” investors like retirement funds.

The financial assets that serve as collateral for ABCP are ordinarily a mix of many different assets, mostly asset-backed securities (ABS), residential mortgages (RMBS), commercial loans, and CDOs. Most of the assets are AAA-rated, some are un-rated assets generated by the sponsor financial institution, the mixture is jointly judged to have a low risk of bankruptcy by a rating agency.

The asset origins are mostly United States (68%), Germany (15%), and the United Kingdom (10%). Many large institutions heavily invested in these assets because ABCP represented a very attractive investment opportunity: prior to August 2007 this instrument had never encountered difficulties, it benefited from high ratings from agencies and, importantly, institutions had cash assets to invest following a profitable period.

However, in 2007-2008 many of these assets performed poorer than expected, making buyers much less willing to purchase ABCP or rollover.

Summary

  • An asset-backed commercial paper (ABCP) is a type of short-term investment with a maturity date of no more than 270 days.
  • A bank, financial institution, or large corporation typically issues ABCPs, which are notes backed by collateral.
  • The collateral often consists of the corporation’s expected future payments or receivables.
  • These receivables might include payments the corporation expects to collect from loans it has made, such as auto loans, credit card debt, student loans, or residential mortgages.
Asset-backed commercial paper (ABCP) is a form of commercial paper that is collateralized by other financial assets.

Advantages of Asset-Backed Commercial Papers

Compared with typical commercial papers and long-term debt instruments, ABCPs offers several advantages, as listed below:

  • ABCPs provide more liquidity to the market. Sellers are flexible in the amounts and terms of financing through ABCP conduits. They can also adjust the amounts sold based on their changing financing needs.
  • ABCPs, as a short-term debt instrument, come with lower credit risk than long-term corporate bonds.
  • ABCPs are also safer than typical commercial papers. Although commercial papers can only be issued by corporations with very high credit ratings, they are still unsecured. ABCPs are also characterized by high credit ratings, and they are backed by receivables at the same time.
  • The structure of ABCPs provides extra protection to investors. A conduit or SPV can effectively isolate the collateral assets from the risk of bankruptcy of the asset sellers. Credit enhancement and liquidity providers will also provide funds to pay investors in certain circumstances, depending on their contract terms.

Disadvantages of Asset-Backed Commercial Papers

  • Due to the separate nature of ABCP conduits, sponsors can have a false sense of security and may end up not adhering to strict lending standards as they would if the loans were on their balance sheet.
  • As seen in the 2008 Global Financial Crisis, increasingly leveraged, illiquid, hard to value, long-term maturity, or unsecured assets can be used as the underlying collateral. It resulted in the continued treatment of ABCPs as highly-rated products when, in actuality, they carried substantially more risk of default.
  • The ABCP market is predicated by the underlying asset market. If market disruptions occur in the underlying market, it may lead to investors closing out their positions in ABCPs. Thus, under certain market conditions, ABCPs are riskier than traditional, unsecured commercial paper, despite being asset-backed.

Commercial Paper (CP) vs. Asset-Backed Commercial Paper (ABCP)

The primary difference between commercial paper (CP) and asset-backed commercial paper (ABCP) is that commercial paper is not backed by assets. Commercial paper (CP) is a money market security issued by large corporations to raise money to meet short-term obligations. With a fixed maturity of less than one year, the commercial paper acts as a promissory note that is backed only by the high credit rating of the issuing company.

Investors purchase the commercial paper at a discount to face value and are repaid the full face value of the security at maturity. Since standard commercial papers are not backed by collateral, only firms with excellent credit ratings from a recognized credit rating agency will be able to sell commercial papers at a reasonable price. A type of commercial paper that is backed by other financial assets is called asset-backed commercial paper.

A company or bank looking to enhance liquidity may sell receivables to an SPV or other conduits, which, in turn, will issue them to its investors as asset-backed commercial paper. The ABCP is backed by the expected cash inflows from the receivables.

As the receivables are collected, the originators are expected to pass the funds to the conduit, which is responsible for disbursing the funds generated by the receivables to the ABCP noteholders.

ABCP Interest Payments

During the life of the investment, the sponsoring financial institution that set up the conduit is responsible for monitoring developments that could affect the performance and credit quality of the assets in the SPV. The sponsor ensures that ABCP investors receive their interest payments and principal repayments when the security matures.

The interest payments made to ABCP investors originate from the pool of assets backing the security, e.g., monthly car loan payments. When the collateralized paper matures, the investor receives a principal payment that is funded either from the collection of the credit’s assets, from the issuance of new ABCP, or by accessing the credit’s liquidity facility.

Asset-Backed Commercial Papers and the 2008 Global Financial Crisis

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.