Asset-Backed Commercial Paper

In the previous articles, we have already read about commercial papers and why they are an important segment of the money market. In most cases discussed earlier, commercial papers were related to unsecured debt. However, this need not always be the case. It is possible for commercial paper to be backed by other securities or assets.

There is a special type of commercial paper called asset-backed commercial paper which is created using other assets as collateral.

In this article, we will have a closer look at what asset-backed commercial papers are as well as the mechanism of issuing these commercial papers.

What are Asset-Backed Commercial Papers?

Asset-backed commercial papers are a short-term money market instrument. This instrument is widely used in most money markets across the world. A large number of companies issue asset-backed commercial papers.

The market valuation of these asset-backed commercial papers issued was more than $250 billion in the year 2021! This is a huge number given the fact that asset-backed commercial papers are a relatively recent phenomenon. They were introduced in the financial market in the 1980s alongside mortgage-backed securities. Even though mortgage-based securities became popular almost instantly, it took some time for asset-backed commercial papers to be accepted by mainstream investors.

In short, asset-backed commercial papers are short-term money market instruments that are not backed by the faith of the issuer. Instead, they are backed by short-term assets such as receivables. The maximum tenure of such securities is one year. However, most securities issued have a maturity period of fewer than 90 days. The assets consist of a pool of receivables such as consumer receivables, auto loans, credit card loans, education loans, consumer receivables, etc.

In most cases, the investors have recourse to sellers’ assets if the cash flow deviates from expectations. Also, it needs to be understood that asset-backed commercial papers can be issued from different types of asset pools.

In some cases, they are issued from single-seller asset pools. This means that all the assets in that pool belong to the same seller and hence the risk may be high. At the same time, it is also possible to have multiple seller asset pools which help create diversification and therefore end up lowering the risks.

How Are Asset-Backed Commercial Papers Issued?

The process of issuing asset-backed commercial papers has been explained in detail in the below article:

1. The process of issuing asset-backed commercial papers is generally started by a high-rated intermediary. This intermediary is generally a bank or a financial institution that has a strong credit standing.

2. The intermediary creates a special purpose vehicle which is bankruptcy remote. This means that this special purpose vehicle will not be negatively impacted by the bankruptcy of the sponsor.

3. After insulating the financials of the special purpose vehicle from the financials of the sponsor, the next step is to buy securities and receivables with the intention of creating an asset pool

4. The asset pools are carefully constructed so that they can meet several types of standards. For instance, these asset pools are constructed in such a way that they meet the standards set by the credit rating agencies. Also, there are some standards and objectives which are set by the sponsors which need to be followed while creating the asset pool

5. Once these assets have been purchased and pools have been created, the pool is then securitized. The resultant securities are sold to different types of investors with the objective of recouping the funds which have been invested in the purchase of these assets.

6. Later, the cash flow from these assets is received and disbursed to the various investors. The end result is that the special purpose vehicle becomes a pass-through entity

7. In most cases, the maturity of the underlying assets and the maturity of the asset-backed commercial paper match. However, if it does not match, then many sponsors tend to roll over these papers. This means that they issue new paper and use the proceeds to pay off the previous investors.

8. For an asset-backed commercial paper to be considered high in creditworthiness, it is required to have the liquidity guarantee by the underlying sponsor or a strong financial party. This is because there is often a maturity mismatch between the assets and liabilities of the asset pool.

   The absence of liquidity at crucial periods of time could trigger a liquidity crunch and even a sell-off. In the absence of such liquidity provisions, it is possible that the sponsors may not be able to pay out the agreed cash flow or even roll over the defect. The end result would be default!

The fact of the matter is that asset-backed commercial paper is a very important segment of the overall money market. However, it is more complex than the other segments. Investors must be aware of the details of complex securities such as asset-backed commercial paper before they make a decision to invest their money in it.