Credit’s latest ominous acronyms: SIVs and ABCP

From www.ftalphaville.com

Policymakers and investors have been obsessed in recent years about the potential for a hedge fund collapse to spread financial panic.

But it seems one of the biggest threats to stability stems from the age-old risk of short-term borrowing to fund investments in illiquid long-term products, notes Gillian Tett and the FT’s capital markets team in a Monday article.

In a comparatively obscure corner of the market, regulators are scrambling to understand what is happening in structured investment vehicles (SIVs), a breed of often huge, mainly bank-run, programmes de_signed to profit from the difference between short-term borrowing rates and longer-term returns from structured product investments.

SIVs have proliferated in recent years and control assets worth hundreds of billions of dollars.  Depending on whether they are fully rated by credit rating agencies and on how strictly they have to conform to certain rules, they are known as SIVs, SIV-lites, or conduits. They are typically quite opaque, invest in complex securities and often do not need to be displayed on a bank’s balance sheet.

Pointing to a “mini-crisis” in the commercial paper market, Robert McAdie, global head of credit strategy at Barclays told the FT that “at least half” of the crisis is related to the SIV conduits. These programmes typically invest in credit market instruments, such as US subprime mortgage-backed bonds and CDOs.

The profit for those who run such programmes comes from the fact that the assets pay fairly high yields, while the conduits and SIVs fund their purchases with short-term borrowings in which interest and principal payments are backed by financial assets that are deemed to have stable cash flow. Collectively this so-called “asset-backed commercial paper” — or ABCP — lasts for anything between a few days and a few months before needing to be refunded, the article says.

With billions of dollars of ABCP set to mature on Monday and on Wednesday, there is great un_certainty as to whether this can be refinanced.

In the case of a blip in the market, SIVs and conduits are supported by liquidity facilities from highly rated, mainstream banks - meaning the banks must step in if the SIV cannot raise commercial paper in the normal way, unless the SIVs’ assets suffer significant ratings downgrades. Typically, the credit line provided by the sponsoring bank and a group of others in a syndicate must cover 100 per cent of outstanding commercial paper, the FT article says.These funding lines have rarely been drawn in recent years, due to abundant liquidity in the ABCP market. As recently as mid-June, the European commercial paper market was seeing records levels of issuance.

However, amid last week’s turmoil — and the dramatic intervention by central banks — some investors in the ABCP market started worrying about whether SIVs were also sitting on losses.

The rush to sell structured products by hedge funds facing redemptions and other investors meant those market values that could be ascertained were being marked down heavily. As a result, by mid-July some investors decided to stop buying ABCP paper from SIVs suspected of subprime exposure. The German bank IKB was an early victim.

By early August, the problems in the ABCP market had become so serious that some European banks were preparing for additional calls on credit lines to SIVs. But the banks are also grappling with a backlog of unsold leveraged loans, which is placing additional pressure on their balance sheets, notes the article.When some European banks — and a few US institutions as well — quietly started trying to raise new credit lines themselves early this month, it triggered additional alarm, as rumours spread about the potential losses at SIVs — on top of other problems roiling the financial world.

Consequently, by mid-last week, some banks started shutting credit lines to a sweeping list of institutions. “Commercial paper is now being funded on an overnight basis. The banks will not roll paper for three months,” Dominic Konstam, head of interest rate strategy for Credit Suisse, told the FT.

And while it seems that European financial institutions were particular victims of this credit squeeze, the problems were extreme in US markets, as SIVs typically raise a large proportion of their finance in dollars.

Policymakers hope that some of this panic will dissipate this week following the massive emergency injections of liquidity by the ECB and the Fed. And indeed, by the end of last week there were signs vulture funds were circling, ready to pick up ABCP paper at bargain prices.

“What some people are hoping is that the bottom fishers will appear and help the market self-correct,” says one big ABCP issuer. However, nobody close to this sector expects to see a quick solution soon. Commercial paper interest rates have not yet fallen, irrespective  of  central  banks’ actions. In New York on Friday, they closed at their highest level for six years.

There is deep uncertain_ty about what the central banks will do next — making ABCP players even more reluc_tant to start issuing and trading again. “Nobody is going to handle commercial paper if they think the Fed could be about to cut rates or do some_thing else completely unexpected overnight,” explains one.

However, concludes the article, most pernicious problem is that “it is becoming clear central banks cannot resolve the biggest problem — a lack of clarity about valuations in structured credit markets and the almost complete loss of confidence that is infecting even the biggest and most diversified of conduit-type programmes”.

 

Coventree Fails to Sell Asset-Backed Commercial Paper (Update2)

By Sean B. Pasternak and Shannon Harrington

Aug. 13 (Bloomberg) -- Coventree Inc., the Canadian finance company that went public in November, failed to sell asset-backed commercial paper to replace maturing debt because of the credit crunch caused by U.S. subprime mortgage losses.

The shares tumbled 35 percent after the company extended maturities on C$250 million ($238 million) of commercial paper and sought emergency funding for another C$700 million of debt. Toronto-based Coventree's units have about C$16 billion of asset- backed commercial paper outstanding.

``Problems that initially seemed isolated to a few U.S. subprime mortgage lenders have led to broader concerns relating to debt capital markets generally,'' including the Canadian asset-backed commercial paper market, Coventree said in a statement today.

Coventree is among the first companies to delay payments on asset-backed commercial paper in the U.S. and Canada in the 12 years since the debt was created. The company's inability to find buyers for its short-term debt shows the extent to which the slump in subprime mortgages has spread to other assets.

``There's so much CP out there, and if one part of the market locks up, it tends to be contagious,'' said Brian Yelvington, a strategist at CreditSights Inc. in New York.

In the U.S., asset-backed commercial paper, which comprises about $1.15 trillion of the $2.16 trillion in commercial paper outstanding, is bought by investors such as money market funds. The cash allows entities such as those owned by Coventree to buy mortgages, bonds, credit card and trade receivables as well as car loans.

Extendible Notes

In the U.S., extendible notes constitute about $172.5 billion in debt outstanding, according to Moody's. About $60 billion of that is backed by mortgages or securities supported by mortgages, according to a report last week from New York-based Bears Stearns Co. The notes allow the issuer to delay repayment for as long as 397 days, the maximum U.S. money market funds may hold, and may give Coventree more time to find a way to repay its debt.

Shares of Coventree fell C$4.48 to C$8.50 after earlier being halted on the Toronto Stock Exchange. The firm's market capitalization tumbled to C$141.4 million from C$215.9 million yesterday.

Coventree's announcement heightened worries that rising defaults on subprime loans are infecting securities across the credit markets, including asset-backed commercial paper, which has been seen as among the safest of debt.

Contracts on the CDX North America Investment-Grade Index, a benchmark for the cost of protecting investment-grade bonds, rose 6.5 basis points to 76.5 basis points after earlier dropping as low as 64, according to broker Phoenix Partners Group in New York. An increase indicates worsening perceptions of credit quality.

Luminent, Aladdin

Coventree's decline pushed other Canadian finance stocks lower. Bank of Montreal, the fourth-biggest lender, fell C$2.34, or 3.6 percent, to C$62.23, the biggest decline in two years. Royal Bank of Canada, the largest bank, fell C$1, or 1.9 percent, to C$52.75.

Units of American Home Mortgage Investment Corp., the residential-mortgage lender that filed for bankruptcy, Luminent Mortgage Capital Inc. and Aladdin Capital Management LLC, last week exercised options allowing them to delay repaying the debt, according to Moody's Investors Service.

The debt was issued by Coventree-sponsored entities including Apollo, Aurora, Comet, Gemini, Planet, Rocket, Slate, SIT III and SAT, the company said.

Some investors are reducing or eliminating their investments in the Canadian asset-backed commercial paper market, including ABCP issued by conduits, Coventree said in the statement.

`Market Disruption'

Coventree, founded in 1998 by David Ellins, Geoff Cornish and Dean Tai, said it can't predict how long the ``market disruption'' will continue or what effect it will have on earnings. Tai is the firm's chief executive officer.

The company has other commercial paper maturing and may be forced to extend maturities on that debt too and draw more money from other sources, Coventree said.

Coventree had revenue of C$217.1 million in the quarter ended March 31, and a net loss of C$115.1 million, or C$6.92 a share, according to its Web site.

For the fiscal year ended Sept. 30, Coventry had net income of C$57.8 million, or C$3.60 a share, compared with C$24.4 million, or C$1.58, a year earlier.

Craig Armitage, a spokesman for the public relations firm The Equicom Group Inc., declined to comment further.

``If a manager is extending due to the inability to issue new CP, there is little incentive for the traditionally low-risk tolerant CP purchasers to take risk on new paper from that issuer,'' Yelvington said. ``The risk-reward usually is not high enough.''

To contact the reporter on this story: Sean B. Pasternak in Toronto at spasternak@bloomberg.net ; Shannon Harrington in New York at sharrington@bloomberg.net

Last Updated: August 13, 2007 16:38 EDT