By Dan Wilchins - Analysis
NEW YORK (Reuters) - Trouble is mounting in the $2.2 trillion commercial paper market, and further deterioration could trigger problems for banks that would rival what they’ve suffered from the subprime crisis.
While the problem could still subside, and there are no signs of a full-blown panic, at least five issuers of asset-backed commercial paper have had trouble refinancing that debt when it matured, forcing them to make investors wait before getting repaid. The asset-backed notes now makes up half of all commercial paper.
Most recently trustees for a Canadian asset-backed commercial paper issuer on Tuesday said it could not find the funds to repay investors in their outstanding asset-backed commercial paper.
Generally, trading in asset-backed commercial paper is choppier than it was before the isolated problems hit, and there is some danger that investors will be less willing to buy the paper, which offers only slightly higher returns than other forms of commercial paper, traders said.
If troubles among issuers spread, investors could suffer, but so could banks, which are most likely to be on the hook if issuers cannot sell new asset-backed commercial paper.
“Asset-backed commercial paper problems could be much worse than what we saw in the subprime market,” said Josh Rosner, an analyst at independent research firm Graham Fisher in New York.
In some cases, banks may have sold bad loans to commercial paper issuers, which would only magnify trouble in the market, experts said.
Rosner was a long-time critic of subprime mortgage lending practices and foresaw many of the difficulties in that market, and if he’s right about asset-backed commercial paper problems, bank earnings could suffer further after already getting hit by exposure to mortgages. Loans used to finance acquisitions might be hard to parcel out to other investors.
Many investors and dealers downplay the extent of potential problems in the $1.15 trillion asset-backed commercial paper market. The type of commercial paper that is struggling, known as extendible ABCP, makes up a relatively small portion of the total. The Canadian ABCP market is also relatively tiny, and plays by different rules than the U.S. market.
The broader ABCP market is still liquid, supported by solid collateral, and should perform well if other markets continue to suffer and investors put cash into money market instruments, dealers and investors told Reuters.
“The whole market has been tainted by a few deals. We see it as an opportunity to add to our positions,” said Patrick Ledford, Chief Investment Officer at money market fund The Reserve Fund, which has some $67.5 billion of money market assets under management, late last week.
And conventional unsecured commercial paper is doing fine. Its performance may only improve as jittery investors pull assets out of riskier markets and put them into safer instruments.
Generally, when ABCP matures, it is refinanced with new commercial paper.
If it cannot be refinanced, banks pay back investors and seize the collateral, assuming the performance of the entire portfolio of collateral has not declined too much.
With extendible ABCP--where most of the trouble in the U.S. has been found--if the paper cannot be refinanced, the issuer has the option to extend the maturity of the debt until a particular date.
Investors continue to receive interest during the extension period, and may in fact receive extra interest.
Dealers estimate there is about $160 billion of extendible ABCP outstanding in the United States, or nearly 15 percent of the total ABCP market.
In the U.S., at least three extendible deals have recently had to extend for the first time in the product’s decade-long history. Standard & Poor’s said on Tuesday it may cut ratings on extendible commercial paper issued by three other entities known as conduits.
Issuers in Europe and Canada have also faced difficulties. Germany’s IKB Bank had the eighth-largest ABCP program in Europe, the Middle East, and Africa as of the end of May, and was forced to move bad subprime assets from its conduit onto its balance sheet, analysts said. German banks clubbed together to give IKB more capital.
Some analysts see these cases as a taste of more to come. Some dealers may have put bad loans into these conduits as a way to offload them to investors, said Graham Fisher’s Rosner. When investors wake up to this fact, they may be reluctant to buy ABCP, leaving banks on the hook.
Several dealers said that was an unlikely scenario. Banks’ credit groups and rating agencies carefully monitor the collateral that is placed into ABCP funding vehicles, and generally it is of high credit quality, one dealer said.
But Michael Parker, chief executive at Evergreen Collateral Consulting LLC, said that he has seen asset-backed commercial paper deals that have bought assets like equity bridge loans, or loans made to private equity firms help finance the equity portion of leveraged buyouts. Often, the trouble comes from smaller banks that are just starting their conduits.
“When you’re small, and you have to build mass quickly, sometimes you put strange assets into the conduit,” Parker said.
Rosner noted that rating agencies failed to detect bad debt for bonds backed by subprime mortgages, and lightning could strike twice.
“We’re seeing a big adjustment in the cost of capital, and that could make it uneconomic for many to play and leave banks holding a lot of losses,” Rosner said.