The crisis in the US$2trn-plus commercial paper markets on both sides of the Atlantic could lead to a fundamental change in the structure of the global investor base and to yet more difficulties for the world's banks at a time when they are already exposed on multiple levels.
Unless conditions in the euro and US asset-backed CP markets, which total some US$1.15trn, quickly return close to the levels that prevailed a few weeks ago, the market will soon see a drastic shrinking in the amount of money held by extendable ABCP conduits, structured investment vehicles (SIVs) and SIV-lites.
Even bank-sponsored multi-seller conduits may soon begin to wither away in light of changed economic circumstances. The implications for the structured finance markets of the shrinking or disappearance of a large section of its investor base are stark (see Structured Finance).
Such vehicles will not disappear just because of forced liquidations of entities containing now hard to sell structured finance product – though liquidations have started and will only accelerate – but, more fundamentally, because the business models of such entities will cease to make sense.
Last week, many extendible ABCP conduits, SIVs and SIV-lites could only issue CP – when they can issue at all – at levels of 25bp–40bp over Libor for 364-day paper.
But many such vehicles are only earning some 15bp–20bp on their assets. Clearly, those numbers add up to a losing proposition and, if the levels at which they fund don't return closer to Libor flat, they will have no option but to shrink as they reduce leverage and eventually close down.
Paradoxically, this problem is more acute for entities that invest largely in lower yielding, safer assets and rely on huge levels of leverage to make a decent overall return. That lack of yield makes them particularly exposed if they have to borrow at the current levels for long.
For vehicles with lower levels of leverage and bank conduits, the maths may not be as stark, but the issues are the same: more expensive borrowing mean that their fundamental business model of taking advantage of the spread between where they borrow and the return they get on their investments may no longer be compelling.
The future for such vehicles is entirely dependent on how quickly the CP markets return to levels that prevailed a few weeks ago. Unfortunately, many bankers and investors think that the prospects of a return to normality are slim.
"Pricing of asset-backed CP will not return to the levels that existed before because this crisis has clearly demonstrated that the assumptions about the riskiness of such assets were wrong," said an analyst.
"The sub-prime crisis and then the recent illiquidity shows that CP is much riskier than everyone thought – that new reality will have to be priced in."
Investors are increasingly wary of buying CP issued by SIVs and SIV-lites – even very short-term paper – because of the danger of being caught out if any such vehicle failed.
"No one wants to be the one left holding the baby when one of these things goes down. You would just join the pool of creditors hoping to get money back. That's not a good risk for Libor plus 40," said one fixed-income professional.
Doomsday?
It is all too easy to see how such vehicles could collapse. A typical SIV-lite may be leveraged 10 times. If a two-year duration security widens 80bp, the loss would be US$1.60 on each US$100 of paper, which means a mark-to-market loss of 16 points.
That would trip enhancement triggers inherent in such vehicles and force a liquidation.
It is just as easy to envisage a doomsday scenario involving many such vehicles going bad at the same time because they are all holding similar assets and have triggers set at similar levels.
If that were to happen, it would lead to an avalanche of structured finance paper being dumped on an already illiquid secondary market with obvious – and potentially disastrous – consequences.
Illiquidity in the CP markets was heightened by a particularly vicious circle: banks are hoarding cash precisely because they know that the bank credit lines they have written to SIVs and conduits may now have to be used.
Another factor that reduced demand for CP is that banks and other investors had less incentive to buy CP because the huge spike in Libor levels last week and the week before meant that they could earn a decent return in the interbank market.
The nervousness about buying CP issued by such entities was underlined last week by the fact that while some US$60bn of euro-CP matured, only US$20bn–$25bn was rolled over. The situation wasn't as bad in the US market but in neither market had spreads returned to the levels that prevailed in July.
To make matters worse, the amount due to be rolled in August is significantly lower than in every other month of the year, bar December.
Both issuers and investors seek to avoid having notes come due in the traditionally thin August period and there will be an upturn in paper maturing in September.
How much unwinding?
Research released last week by UBS's securitised products team in the US predicted that in the end some US$50bn–$75bn of liquidations related to CP unwinds will take place.
"The weaker structures in the commercial paper market [will] disappear," the researchers predicted. They suggested that there will soon be fewer extendable ABCP facilities which rely on overcollateralisation, SIVs and SIV-lites.
But they believed extendable ABCP facilities that depend on a market value swap (where a swap counterparty takes out the CP holder at par before the end of the extension period) and bank sponsored multi-seller conduits will continue to play a major role in the market.
Maybe. But it is arguable that the long-term future of such bank mediated vehicles is also bleak simply because their economics no longer truly make sense if the spread between what they earn on their investments and what they pay on their CP isn't large enough.
It is certainly unlikely that any bank would countenance the reputational damage that would follow from letting an associated conduit go to the wall. In the event such vehicles got into trouble or no longer made sense, it is likely that banks would take them back on balance sheet and fund them internally.
That would nonetheless be extremely bad news for bank shareholders as such entities would have turned from being money-earners to a drain on the resources of banks, particularly as banks that were forced to take such a move would see a rise in their own cost of funds.
One step that banks may consider – and some rumours suggest that this is already taking place – is buying the CP issued by their own conduits in order to prop them up. Analysts said that banks that did this would not have to disclose such actions publicly, but would have to tell the appropriate regulators.