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Asset-Backed Commercial Paper (ABCP) is a form of commercial paper that is collateralized by other financial assets. Commercial paper is a type of short-term loan instrument that businesses and financial institutions issue to raise money for their daily needs. Commercial paper is often sold at a discount to its face value and has a maturity of less than a year.
ABCP is secured by a variety of assets, such as trade receivables, loan receivables, auto loans, credit card debt, student loans, or residential mortgages, as opposed to normal commercial paper, which is unsecured and only supported by the issuer's credit rating. The issuer or a sponsoring bank establishes a special purpose vehicle (SPV) or conduit, a distinct legal organization, to receive these assets. The SPV issues the ABCP to investors and makes loans or purchases of the underlying assets with the money from such transactions. From the cash flows produced by the assets, the SPV uses the ABCP's interest and principal payments.
The primary benefit of ABCP is that it gives the issuer access to more affordable and adaptable finance than other short-term funding sources. The issuer can eliminate the assets from its balance sheet and lower its leverage ratio by transferring the assets to an SPV. The ABCP's maturity and interest rate can also be customized by the SPV to accommodate investor preferences and market conditions. Depending on the caliber and diversification of the underlying assets, the SPV may also issue different tranches of ABCP with various risk-return profiles.
The primary risk associated with ABCP is its exposure to the credit and liquidity risks associated with the underlying assets. The SPV might not have adequate cash flow to repay the ABCP investors if the assets fail or lose value. Furthermore, the SPV might not be able to roll over or refinance the ABCP at advantageous terms if market circumstances worsen or investor confidence drops. This could lead to a liquidity crisis for the SPV, forcing it to either sell the assets at a loss or look to the issuer or sponsoring bank for outside assistance.
ABCP made up around 11% of the U.S. commercial paper market in 2007, before the global financial crisis. Unfortunately, many ABCP programs failed or suffered major impairments as a result of exposure to subprime mortgages and other toxic assets after the crisis. Although at a much lower level than before, the ABCP market has recently recovered. Around $227 billion, or roughly 6% of the market for commercial paper, was outstanding in ABCP in the United States as of June 2020.
Several businesses and financial institutions rely heavily on ABCP as a source of short-term funding. Compared to other types of commercial paper, it has a number of advantages, including off-balance sheet treatment, greater flexibility, and cheaper cost. Yet, it also carries considerable hazards, including credit, liquidity, and reputational risk. When purchasing ABCP, investors should therefore carefully assess the value and performance of the underlying assets.
