Asset-Backed Commercial Paper
How ABCPs Nearly Destroyed the US Economy
Asset-backed commercial paper is short-term debt backed by collateral. Commercial paper is another word for a 45 to 90-day loan. Corporations with very high credit ratings can issue commercial paper without any collateral. Companies use them to raise capital they need immediately.
Unlike commercial paper, ABCPs are backed by collateral. The collateral is the future payments made on auto loans, credit cards, and invoices. Companies use ABCPs to borrow money now in return for these expected future payments. Mortgages are not used to back ABCPs because they are long-term debt, not short-term.
In January 2018, there were $246 billion in outstanding U.S. ABCPs. Auto loans backed 30 percent of it. That's followed by 25 percent in trade receivables and 7 percent credit card receivables. All others were each less than 5 percent of the total. These include commercial loans, consumer loans, and equipment finance.
How ABCPs Work
An ABCP is a type of collateralized debt obligation that is sold on the secondary market. Financial institutions, such as banks, sell ABCPs. The bank must set up a special purpose vehicle that owns the assets. The SPV protects the asset in case the financial institution goes bankrupt. It allowed the bank to hold the property in the SPV "off-balance sheet." That gave the SPV the freedom to buy the type of assets to meet the investors' needs. The bank didn't have to meet its capital requirements or other regulations in the SPV.
ABCPs were created in the 1980s to provide more liquidity in the economy. They allowed banks and corporations to sell off debt. That released more capital to invest or loan. That allowed ABCPs to expand U.S. economic growth. By 2007, there were $1.2 trillion issued in the United States and $250 billion in Europe.
ABCPs are safer than long-term corporate bonds because they are short-term. There is less time for something to go wrong. The companies that issue the ABCP are high quality. That makes it unlikely they would default in just a few months. Many ultra-safe investors invested in ABCPs and unsecuritized commercial debt.
The downside of ABCPs was partly due to the SPV structure. Since the bank and the SPV were separate firms, they were protected from the other's default. That gave banks a false sense of security. They didn't have to be as disciplined in adhering to strict lending standards.
Banks also didn't have to collect on the loans when they become due. Instead, the underlying loans were sold in the secondary market. They became the problem of other investors. That was another reason banks didn't adhere to their normal strict standards.
How It Affects the Economy
Asset-backed commercial paper affected the U.S. economy in a way similar to mortgage-backed securities. Like MBS, the collateral was a package of loans.
During the financial crisis, investors were clobbered with MBS defaults. They then became concerned about the credit-worthiness of ABCPs, even though supposedly-safe commercial paper stood behind the ABCPs. They assumed that the ABCPs had bad loans, just like the mortgage-backed securities that contained subprime mortgages.
Worry grew to the point it even affected the money market funds that invested in ABCPs. On September 17, 2008, money market mutual funds were attacked by an old-fashioned bank run. Panicked investors withdrew a record $144.5 billion from money market accounts. That was 20 times greater than the $7 billion typically withdrawn in a week. They couldn't raise enough cash to meet the withdrawals. The ABCP market had disappeared.
Things were so bad that the Primary Reserve Fund "broke the buck." That meant it couldn't keep its share price at the traditional one dollar. If money market instruments had gone bankrupt, businesses would have shut down within weeks. Grocery stores wouldn't have the cash to order food. Truckers wouldn't have the money to pay for gas. Farmers wouldn't have the cash to water their fields. The Primary Reserve money market run in 2008 almost triggered the collapse of the U.S. economy.
The Federal Reserve stepped in to guarantee the ABCPs. It lent money to its banks. It ordered them to buy the ABCPs from the money market funds. That gave the funds enough cash to pay for the redemptions. That went on from September 22, 2008, to February 1, 2010. It took two years for investors to regain their confidence.