Asset-backed commercial paper program
[1] Like banks, ABCP programs provide market liquidity and maturity transformation services.
Initially, ABCP conduits were primarily sponsored by major commercial banks as a means of providing trade receivable financing to their corporate customers.
Over the past decade, ABCP programs have grown to serve a wide variety of needs such as: asset-based financing for companies that cannot access the commercial paper market, warehousing assets prior to security issuance, investing in rated securities for arbitrage profit, providing leverage to mutual funds, and off-balance sheet funding of bank assets.
[5] Above all these service types, ABCP programs are commonly used by banks to free up their regulatory capitals by moving the seemingly safe assets off their balance sheet.
[1] At that time, ABCP was the largest money market instrument in the United States, following by Treasury Bills with about $940 billion outstanding.
At the beginning, sponsor banks have enough liquid to pay off these liabilities, but lack of market confidence can create a subprime mortgage crisis.
In August 2007, the French bank BNP Paribas halted withdrawals from three funds invested in ABCP and suspended calculation of net asset values.
Even though defaults on mortgages had been rising throughout 2007, the suspension of withdrawals by BNP Paribas has a profound effect on ABCP market.
[2] ABCP programs regularly roll over their liabilities and use proceeds from new issuances to pay off maturing commercial paper.
Sponsor types range from large U.S. commercial banks to non-bank institutions, like mortgage lenders and asset managers.
Non-bank institutions, such as mortgage lenders, finance companies, or asset managers, also sponsor a considerable share of the market.
Hence, there is a possibility that full liquidity guarantees expire before the asset-backed commercial paper matures.
This form of guarantees is weaker than full credit, but from the bank's side, they can move these assets off the balance sheet.
SIV guarantees were primarily used by commercial banks and other financial institutions to cover high quality assets.
[1] The asset types that conduits invested in are mostly asset-backed securities (ABS), residential mortgages, commercial loans and CDOs.
Originally, banks set up ABCP conduits to finance only safe assets off-balance sheet.
ABCP conduit provides a way to free up regulatory capital, and thus achieve higher efficiency.
However, due to no capital requirement for off-balance sheet assets, ABCP conduits also induce excessive risk taking.
Therefore, banks optimally take on more risk because it does not care about the losses that occur in those states of nature when it goes bankrupt.
Most conduits minimize their credit risk by holding a diversified portfolio of high quality assets.
Most traditional ABCP programs are sponsored by commercial banks that provide explicit liquidity support.
By using off-balance sheet funding, commercial banks exploit regulatory capital arbitrage opportunities.
But unlike the credit arbitrage programs, SIVs do not have explicit agreements with their sponsoring banks for committed back-stop liquidity lines covering all their short-term liabilities.
CDOs are similar to SIVs in structure, but are not actively managed and tend to rely on explicit but only partial liquidity support.
The majority of single-seller conduits mainly fund credit-card receivables, mortgages, mortgage-backed securities, or auto loans.
These loans are generally closely managed by the bank, and have a variety of covenants designed to reduce credit risk.
[2] Before the 2008-09 financial crises, the global financial system "manufactured" risk-less assets, totaling over $1.2 trillion, by selling short-term ABCP to risk-averse investors, predominantly U.S. money market funds, and investing the proceeds primarily in long-term U.S. assets.
Governments and central banks responded with unprecedented fiscal stimulus, monetary policy expansion and institutional bailouts.
