Everyone expected a lot of US sub-prime mortgages to go sour and everyone knew that leverage in the LBO market was getting ridiculously high. But the liquidity crisis that hit the ABCP market in August was something that almost no one saw coming – and was greeted with panic and bafflement in equal measure. "We sat down early in the month and said ‘How far can this thing spread?’" reveals an ABS veteran. "We knew that the short-term money markets would be impacted, but it seemed that the entire ABCP investor base getting up and walking on 30-day paper was something that just could never happen."
So why did it? There must be a pretty good reason for the markets to get to the stage that banks will not even lend overnight to each other. Many see the problems in ABCP (and structured investment vehicles, SIVs) as the result of a chronic dearth of transparency. "When CP investors were trying to see what was in the conduits the information was so vague that they just panicked," says an observer. "If you are simply told that the exposure to CDOs is X – but you are not able to find out what type of CDOs these are or what is backing them – then you will assume the worst and run."
Thus anything involving a three-letter acronym – be it ABS or CDO – became toxic overnight. As Matt King at Citi noted on August 16: "The main fear becomes fear itself... Of course there is no fundamental reason why the ABCP buyers should take fright – the assets themselves are generally sound and most of the banks are very well capitalized – but the greater the fear in the system, the greater the potential for problems."
Those problems led the ABCP market to evaporate at an alarming rate. According to UBS, US dollar ABCP outstandings were down by $48 billion for the week ending August 15, down $77 billion for the week ending August 22 and down $59 billion for the week ending August 29. The yield on 30-day CP went from hovering between 25 basis points and 75bp to an astonishing 356bp on August 20 (by August 28 it had come down to 155bp). "The market moved beyond mathematical reason and into emotion," said Douglas Connor, CP trader at UBS in a conference call on August 30.
IKB’s inability to provide committed liquidity to its Rhineland Funding conduit certainly spooked CP investors across the board. And despite the fact that problems in the Canadian market were largely the result of a now-defunct structuring peculiarity, by the end of August they remained far from comfortable. "Paper is still trading but not at the size, speed or duration that is was before," says Connor. The main problem was that curves had gone completely flat, so there was little incentive to go out further than a week or two. But in this environment the structural differences between programmes has suddenly become very important – and tiering will be very evident in the months to come. "The market has gone back to people rolling their sleeves up and deciding which structures are good and which are bad," says Connor.
Given that German banks hold approximately one-fifth of outstanding liquidity lines to ABCP conduits ($250 billion according to Fitch), it is no surprise that the first two vehicles to run into trouble were German (Rhineland Funding and Sachsen LB’s Ormond Quay). The effect of not only a funding crunch on the liability side but having to mark to market on the asset side (when that market has disappeared) means that others will likely follow. Indeed, at the end of August there were signs of stress in other, more aggressively structured, ABCP programmes.
Providing 100% – or even more in some cases – liquidity to an ABCP conduit can be an expensive business. Under Basle II these lines can be risk weighted up to 20% so the market has spent the past couple of years devising ways in which to reduce liquidity requirements. One of these is to issue extendible CP – that for a higher yield can be extended in a period of market disruption. The idea is that if CP funding is disrupted the extension period can be used to sell assets – bringing liquidity back into line again. This line of thinking doesn’t look quite so smart in the recent environment, where not only is CP squeezed but also there are no buyers for the assets that the conduit is forced to sell.
Extendible ABCP programmes have proved very popular with mortgage originators, and by the beginning of September eight such vehicles had been forced to extend their CP. They are backed by American Home Mortgage; KKR and Deutsche Bank; Luminent Mortgage Capital, Aladdin Capital; Lord Securities and Conduit Management Corp (Australia) and Thornburg Mortgage. How these programmes fare will in part depend on whether they rely on a market value swap or purely on overcollateralization. If there is a market value swap in place, investors are protected as the liquidity provider makes up any shortfall between market and asset prices. However, investors in programmes that rely on overcollateralization depend on asset sales to achieve liquidity and so could run into trouble. The KKR/Deutsche Bank, Aladdin Capital, and Thornburg Mortgage programmes are structured in this way.
The expen-SIV option
The liquidity freeze in the CP market very quickly shone a bright light into a usually dark corner of the structured finance market – that of the structured investment vehicle.
The most obvious distinction between ABCP conduits and SIVs that the market has leapt upon is that conduits tend to have 100% liquidity support and SIVs as little as 10%. But the two are very different: a SIV is a very much more expensive proposition than an ABCP conduit and takes far longer to establish. There are roughly 30 SIVs in existence following a surge in activity in the sector over the past couple of years. But the sheer cost and infrastructure required to manage a SIV have checked the growth of the market.