The structure of liquidity facilities that are used to cover asset-backed commercial paper issues has been brought to the fore over the past few months as more and more issuers are finding it very difficult to fund their ABCP programmes. Until recently, it had always been assumed that liquidity facilities would not need to be drawn upon, and consequently they were seen as more of a backstop than as a priority component of commercial paper issuance.
But the credit crunch has changed everything. Although issuance has returned in the ABCP market, no one is labouring any more under the illusion that liquidity facilities have no chance of being drawn upon.
Liquidity provision in the ABCP market always covers 100% of the outstanding paper but there is a difference between providing liquidity and providing credit support, a distinction that has not always been recognized by CP investors. Many liquidity facilities are only in place to meet the risk of being unable to roll commercial paper, rather than any longer-term risks. Many were designed this way because it was always assumed that any problems arising in the ABCP market would be short-term.
In the old days, as many are already calling the markets of just a few months ago, ABCP was repaid from the proceeds of further issuance of ABCP. Excess spread levels and cashflows from the underlying collateral paid the coupons. Even after the September 11 terrorist attacks, many people avoided using liquidity facilities. Because of this, liquidity facilities have been structured more and more conservatively by liquidity providers. This has also been partly driven by accounting requirements. In order for assets to remain off the balance sheet, a sponsor needs to take less economic risk. In the past, for example, legal risks involved with structuring a conduit would be covered by the bank providing the liquidity facility on the basis of its own due diligence. It seems that banking regulators, and the banks themselves, believe that these types of risk should now be dealt with under the contractual terms of the ABCP programmes.
This trend can go too far. Before the credit crunch, some liquidity facilities were so loosely drafted that they did not seem to cover anything at all. In these instances the liquidity provider sets the conditions of funding, based on its own criteria. With so much uncertainty, however, ratings agencies are unable to affirm a rating for these issues, which effectively kills a programme.
Before the credit crunch, many investors bought on the basis of rating alone – and ABCP issues that are covered by a liquidity facility are rated on the strength of that liquidity provision in addition to the underlying assets. This can trip up investors, especially when an injection of liquidity is needed but not given because of the intricacies of the liquidity facility’s contractual requirements. Until now, those intricacies have been largely ignored, but not any longer.
