Asset-backed Commercial Paper: Pros and Cons

How ABCPs Nearly Destroyed the U.S. Economy

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Companies use ABCPs to fund their day-to-day operations. Photo: The Image Bank/Getty Images

Definition: Asset-backed commercial paper (ABCP) is short-term debt backed by collateral. Like other forms of commercial paper, banks issue ABCPs for three months or less. Companies use ABCPs and other money market instruments to raise the capital they need immediately.

Unlike commercial paper, ABCPs are backed by collateral. These are usually future payments on auto loans, credit cards, and invoices.

Companies use ABCPs to borrow money now in return for these expected future payments.

In 2014, there was $250 billion in U.S. ABCP outstanding. Auto loans back most of it (30%). That's followed by 25% in trade receivables and 7% credit card receivables. All others are each less than 5% of the total. These include commercial loans, consumer loans, and equipment finance. (Source: "A Primer on Asset Backed Commercial Paper," Wells Fargo. Understanding ABCP, BlackRock)

How Do ABCPs Work?

An ABCP is a type of collateralized debt obligation (CDO) that is sold on the secondary market. It's like a mortgage-backed security in that the collateral is a package of loans. Mortgages are not used to back ABCPs because they are long-term debt, not short-term.

ABCPs are only sold by financial institutions, such as banks. The bank must set up a Special Purpose Vehicle (SPV) that owns the assets. The SPV protects the property 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. That would turn out to be both a blessing and a curse.

(Source: "A Primer on Asset Backed Commercial Paper," Wells Fargo.)

Advantages

ABCPs were created in the 1980s to provide more liquidity in the economy. They allow banks and corporations to sell off debt, which frees up more capital to invest or loan. ABCPs drove U.S. economic growth in the five years leading up to the financial crisis. In fact, by 2007 there was $1.2 trillion issued in the United States and $250 billion in Europe.

ABCPS have many of the same advantages of commercial paper, or short-term corporate debt. Both are safer than long-term corporate bonds. The companies that issue the commercial paper that back the ABCP are high quality. That makes it unlikely they would default in just a few months. Many ultra-safe money market funds invested in ABCPs and unsecuritized commercial debt.

Disadvantages

The downside of ABCPs is that they free the bank from having to collect on the loans when they become due. That's because the underlying loans are usually sold off in the secondary market before then. They become the problem of other investors. This may make banks less disciplined in adhering to strict lending standards. Like mortgage-backed securities that contained subprime mortgages, ABCPs may have less than AAA-quality loans.

This could make them more susceptible to default. 

How It Affects the Economy

Asset-backed commercial paper affected the U.S. economy in a way similar to mortgage-backed securities (MBS).  During the financial crisis, investors worried about MBS defaults became concerned about ABCPs. The problem was that no one could determine the value of the underlying assets. Even though ultra-safe commercial paper stood behind the ABCPs, investors grew concerned. Worry grew to the point it even affected the money market funds that invest in ABCPs. 

Starting 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 with 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.See Primary Reserve Money Market Run.

The Federal Reserve stepped in to guarantee the ABCPs. They lent money to their banks, ordering 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.  (Source: ABCP MMMF Liquidity Facility, Federal Reserve, February 5, 2010.)