Friday, August 17, 2007

Commercial paper market: hidden time bomb?

Like most of us, as I try to comprehend the latest facts about the sub-prime mess, I sort of rub my eyes and scratch my head like a country bumpkin just arrived in the big city who’s innocent, unsophisticated mind can hardly comprehend all the big lights, tall towers, and fast operators. The latest piece of the SPM (sub-prime mess) has me gaping wide mouthed in awe. “Golly Ma, never thought I’d live to see the day!” This has to do with what, once upon a time, was about the most boring and uncomplicated market there was: commercial paper. Well, it ain’t boring anymore and it’s complexity has reached byzantine levels. Over the last couple days, as I read about problems with commercial paper, I was surprised but didn’t fully grasp the import and simply took it as an indication that the subprime unraveling had entered a potentially explosive new phase. But then I read about KKR in the same sentence as commercial paper. Say what? That got my attention. Then on Friday I read about “asset-backed CP” and “bank conduits” and I became curious and did some more reading. I don’t claim to understand all the ins and outs of this thing (like who does?) but the gist of it is becoming clear.

Banks, investment banks, hedge funds, and PE firms have been issuing commercial paper as funding for carry trades. They put in capital of $100, borrow $2,000 in CP, and invest the proceeds in higher yielding stuff: CDOs, MBS (including sub-prime) and other ABS. So, sports fans, this is why we are all rushing to call our Schwab brokers and blowing out our cash sweep accounts and other money market funds as though they were leveraged Egyptian equity funds. The (ex-)masters of the universe were using the commercial paper market – formerly a way for quaint old fashioned “companies” to get short term funding – as financing for leveraged carry trades. Now some of these conduits (also known as SIVs, structured investment vehicles) may be related to the bank’s operations (e.g., a bank makes mortgage loans and then sells them to the off-balance sheet conduit) but I suspect that a lot of these vehicles – like that for KKR – were just another way to play the ponies – er, execute investment strategies. They look suspiciously like off-balance sheet credit hedge funds. Btw, remember the last time the world read about off-balance sheet vehicles in connection with severe market dislocation and potential bankruptcy? Begins with E and rhymes with moron. This also bears more than a passing resemblance to the S&L bankruptcies in the early nineties: funding long term assets of questionable quality with short term deposits.

Well it all started with a tiny German bank with the funny name that no one had ever heard of, that was one of the first shoes to drop week before last. IKB Deutsche Industriebank was in fact one of these “bank conduits” set up expressly for the purpose of investing in MBS, financed by CP. Then we learned early last week that the entire Canadian ABCP market needed a bailout:

Several third-party issuers of ABCP, traditionally regarded as a safe investment because it is backed by assets like home and car loans, have warned this week of trouble raising money to repay debt that is maturing. They had asked banks for funding lifelines, but several have refused…

What started out as defaults in the risky U.S. subprime mortgage market has widened to concerns about debt markets in general, including Canada's ABCP market, in particular that segment operated by non-bank or third-party players, estimated to be worth C$40 billion.

The remaining C$75 billion segment of Canada's ABCP market is mostly operated by the country's big five banks and looks set to escape the credit squeeze…

The group's proposals include an agreement to roll third-party ABCP for a 60-day standstill period. Signatories will not pursue liquidity calls, or make new liquidity calls for 150 days after the standstill agreement.

In the longer term, the players propose converting all outstanding third-party ABCP into term floating-rate notes, which will pay interest monthly or quarterly. "Existing liquidity facilities will therefore not be necessary and will be canceled, and all outstanding liquidity calls will be revoked," the group said.

But others cautioned that the proposal was just postponing the problems until later when the notes fall due.

"That's just a stopgap," said Paul Gardner, principal, and portfolio manager for the equity and fixed income portfolios at Avenue Investment Management.

If you are the manager of a Canadian money market fund that holds this paper, you’ve got to be pretty unhappy.

And then on Thursday we learned that KKR wasn’t satisfied making 2 & 20 on $20 billion LBO funds so they set up KKR Financial Holdings. KKR owns 12% of KKR Financial Holdings which in turn owns two entities called, KKR Atlantic Funding Trust and KKR Pacific Funding Trust.

According to the WSJ:

The two issuers raised money with $500 million in equity backing from KKR Financial and invested in mortgage securities based on a debt-to-equity ratio of about 20 to 1, said the people familiar with the situation. Such mortgages might fetch only 90% or less of their face value now, these people said.

KKR Financial's strategy for KKR Atlantic and KKR Pacific was to issue highly rated commercial paper at low short-term rates and invest in triple-A mortgage securities, which paid slightly higher rates. However, the strategy depended on the ability to resell the mortgages on short notice, while demand has dried up unexpectedly.

So who else is playing this game? Who else has a highly leveraged credit hedge fund masquerading as a boring old fashioned CP issuer? Well, everyone it seems. The Journal reports that the huge increase in ABS CP issuance is

primarily due to growth in conduits, bank affiliates that issue paper and use the borrowed money to invest in securities, which back future borrowing…

A number of large banks operate some of the world's biggest affiliates, or conduits, including ABN Amro Holding NV and Fortis NV in the Netherlands, the U.K.'s Barclays PLC and Royal Bank of Scotland Group PLC, and Germany's Deutsche Bank AG. Big U.S. operators include Citigroup Inc., Bank of America Corp., and Wachovia Corp., according to a Morgan Stanley report issued Thursday…

The conduit issues commercial paper and uses that money to buy longer-term bonds that pay higher interest rates than the conduit is paying on its debt. The conduit issues a steady stream of paper to invest and repay past borrowings. The bank behind the conduit harvests asset-management fees and investment profits.

And it isn’t “just” every large bank in the world, in a separate article, the Journal reports that:

Hedge funds, private-equity firms and investment banks have played a major role in this expansion by setting up companies that borrow by issuing commercial paper and then invest the money, sometimes in the types of mortgage-related securities that have proliferated in recent years.

As the value of those securities has become unclear -- and the companies holding them come under pressure -- the commercial paper they have issued has come into question, as well.

The immediate focus of concern has been a variety known as asset-backed commercial paper, a form of financing that has been hit by a downturn in the value of collateral such as subprime mortgages, which have been damaged by rising default rates. The amount of asset-backed paper has grown in recent years, soaring 48% to $1.13 trillion today from $765 billion two years ago, according to data from the Federal Reserve.

Kind of makes you shake your head in dazed wonderment at this funny old world. Okay, let’s step back and think about what we know at this point:

One, there is a Trillion dollar-plus commercial paper market backed by ABS, some of which are residential US mortgage paper. Goldman estimates only about 10% of the assets are MBS but count me skeptical. I seem to recall more than a few Goldman backed IPOs so they may not be the place to go for unconflicted analysis.

Second, that the great majority of large global banks were doing this. The Europeans seems to have been the biggest. According to the Economist:
One of the busiest in these markets is Deutsche Bank, Germany's biggest bank. In a March filing with America's Securities and Exchange Commission it estimated its maximum exposure to loss from structured products at €2.3 billion ($3.1 billion). But it will not, indeed cannot, put a number on its exposure now. It is the same at other big European banks, such as Royal Bank of Scotland or HSBC.

More worrying are the exposures of some German Landesbanks. On August 13th DBRS, an international rating agency, noted that rumours had been circulating for a week about the liquidity of some German banks, especially after IKB's state-sponsored bail-out. Part of the problem, it noted, was that investors no longer trusted the ratings of the asset-backed securities that the banks had invested in. And who can blame them. As late as June, Moody's issued a report calling SIVs “an oasis of calm in the subprime maelstrom”.
Third, after the German and Canadian bank bailouts and after the KKR Financial bailout, S&P looked into the whole conduit/ABCP issue and pronounced, confidently, “no problem”:
Standard & Poor's Ratings Services said today that all of its outstanding ratings on the commercial paper (CP) notes issued by U.S. asset-backed commercial paper (ABCP) conduits including multiseller, loan-backed, arbitrage, and single-seller (other than those placed on CreditWatch on Aug. 14, 2007) are not affected by any exposure to U.S. residential mortgage assets that these conduits may have…

Standard & Poor's also believes that liquidity from internal cash flow and existing third-party support arrangements with highly rated banks will serve to effectively manage any disruption to funding resulting from stress in the CP market…

In light of the recent events in the U.S. mortgage markets and in the global ABCP market, Standard & Poor's has reviewed all of its U.S. ABCP conduits and identified those with any exposure to U.S. mortgage assets. A U.S. ABCP conduit can have exposure to U.S. residential mortgage assets directly through an investment in mortgage loans or residential mortgage-backed securities (RMBS), or indirectly through an investment in collateralized debt obligations (CDOs). In its review, Standard & Poor's examined each conduit's portfolio of assets and the structural characteristics of each conduit, including the level andavailability of credit and liquidity enhancement.

Yea… right… so now I’m really worried.

Fourth, the reason that ABCP is rated AAA is because of “liquidity enhancement” or backfunding commitments by the parent bank to step in should the conduit need liquidity. But there seems to be uncertainty as to when and under what circumstances the bank must honor these commitments. As reported in the FT:

Investors in the European financial sector are scrambling to establish how much banks have pledged in credit lines to so-called “conduits” after Sachsen LB became the second German bank to be rescued amid turmoil in the credit markets. The German savings banks association had to take over a €17.3bn credit facility that Sachsen LB had pledged to one of its special investment funds, or conduits, late on Friday…

The rescue was triggered when commercial paper investors refused to refinance Ormond Quay and Sachsen was unable to provide the credit it had pledged. The collapse may raise further questions about the German banking system as it came just a week after the bank said it had “sufficient liquidity” and days after the Bundesbank said the failure of IKB, the German bank bailed out three weeks ago, was an “isolated incident”.

It is likely to trigger fresh concern about European banks’ exposure to the credit market via credit lines to conduits, which face their own liquidity crunch in the asset-backed commercial paper market.

More than 30 European banks run conduits worth about $500bn, according to Moody’s Investors Service, the credit rating agency. The banks include Britain’s HBOS, ABN Amro of the Netherlands, France’s BNP Paribas and several German Landesbanken. US banks such as JP Morgan Chase and Citigroup have also set up European conduits.

Which leaves two big questions we don’t know the answer to yet:

  1. How much of the $1.3 trillion ABCP, if marked to market, is under water?
  2. For those conduits with “impaired assets”, who will ultimately take the hit, the conduit parents or the CP investors?

Perhaps the People’s Bank of China will end up losing billions on AAA rated CP issued by KKR. That may sound too far fetched even by the standards of the current bizarre situation. But it is becoming clear that what we mean by “sub-prime mess” is actually a massive
subterranean labyrinth/ecosystem/carnival – wherein all the major financial entities, be they banks, hedgies, PE funds, are players. This isn’t over by a long shot.

Fyi, Brad Setser's Blog has an excellent post on this topic for more information.


JJ said...

Great story , thanks for the insight

Anonymous said...

I think a large part of the problem has been the CP and ABCP buyers always have looked at the assets the conduits and programs were buying and never understood how the liability side of the balance sheet of these programs worked. The message of any leverage fund must be to use term funding and repo rather than rely on short-term funding.

Lastly, I think SIVs as an investment vehicle are doomed and I expect the sector to disappear in the next 12-18 months as their asset portfolios mature and roll off.


Anonymous said...

your explanation was really helpful, someone needs to create a flow chart with basic terms like commercial paper, mbs, cdo, spv and show how they all created the current crisis.

James said...

This was a pretty good call. Looks like Bernanke has come around to your pov