When the tide goes out, as Warren Buffett is wont to say, you get to see who's been swimming naked, and it looks like darn near everybody has been caught skinny-dipping down at Liquidity Beach.
I'm talking, of course, about the liquidity crunch in asset-backed commercial paper (ABCP), the big market story lately. Every day there's another report about someone else's exposure to suddenly toxic ABCP.
Bloomberg this week had a list of 23 Canadian corporations with cash parked in non-bank ABCP, with a total of $330.8-million in missed payments so far, and possible redemption delays on another $1.18-billion worth. Ontario Power Generation announced Tuesday that it holds just over $100-million worth of non-bank-sponsored ABCP, though DBRS says that shouldn't pose any significant risks to OPG's credit quality. Global DIGIT announced that, since it couldn't roll over its maturing MMAI commercial paper, it was halting redemption of its units. State Street Corp. admitted it has off-balance-sheet exposure to $28.8-billion (U.S.) worth of ABCP conduits. The hits keep on coming, and every day there's another hedge fund, collateralized debt obligation (CDO) or ABCP conduit carried off the market field on a stretcher.
Briefly, an ABCP conduit goes out and buys a pool of income-producing assets - like car loans, equipment leases, credit card receivables or mortgages - and pays for it by borrowing money through the issuance of short-dated paper secured by that pool of assets, or ABCP. Generally, the credit quality of the ABCP is enhanced with a liquidity guarantee from a foreign or domestic bank.
U.S. ABCP has a different liquidity guarantee from Canadian issues, the main difference being that, had Coventree, for example, been a U.S. issuer, its guarantors would have had to finance the rollover of its maturing ABCP. The Canadian-style liquidity guaranty, much to the chagrin of the skinny-dippers, apparently only kicks in if the whole world goes to hell on a sled, not merely because of problems in the ABCP market.
Still, the assets underlying most of this stuff are pretty good. There's some hysteria about the possibility that some domestic ABCP pools may contain (gasp!) U.S. subprime mortgages, but of more real concern is that some of these pools are rather heavily weighted with something called leveraged super-senior (LSS) tranches. In fact, structured financial products, mostly LSS, are the biggest single class of assets underlying domestic ABCP, comprising about 29 per cent of the total, or about $33-billion (Canadian).
These structured instruments are usually linked to an index of investment grade debt like iTraxx or CDX IG. Because the stuff is overcollateralized way more than is needed for a triple-A rating, it is called super-senior. The problem is, being such a high-grade piece of paper (roughly half of the entire investment grade credit universe would have to default before the super-senior tranche was impaired) it is issued at very tight spreads, so there isn't much juice in it for investors. Not to worry, though, since conduits can goose the spread nicely by leveraging the stuff 10 or 20 to one, and still keep that coveted triple-A rating.
But because of the current credit jitters, spreads of these super-senior tranches, along with most other credit spreads, have widened (U.S. commercial paper has widened by 71 basis points this month alone). This causes major problems when you try to mark the stuff to market, because the leverage amplifies the spread effect big-time.
Bear in mind that there has been no real change in the value of the underlying assets, just in the mark-to-market price. But when you're financing a five- or 10-year asset with 30- or 60-day ABCP, it makes it darned hard to refinance when the asset is nominally not worth nearly as much as it is supposed to be.
But hey, LSS paper is just the tip of the iceberg. Down in the United States, they've had an even better idea, the structured investment vehicle, or SIV. Like an ABCP conduit, a SIV buys income-producing financial assets (mortgages, etc.) and pays for it by issuing short- and medium-term debt. Unlike ABCP, however, SIVs seldom have any kind of bank liquidity guarantee.
And, not surprisingly, SIVs have suddenly started leaking like, er, sieves. This week, Standard & Poor's announced that an SIV run by Cheyne Capital Management Ltd., which has $20-billion (U.S.) in assets, has breached debt covenants because of losses and may have to be liquidated. S&P then promptly slashed the senior debt ratings on the program - Cheyne Finance LLC, with $3-billion of commercial paper and $6.4-billion (in medium-term notes) - by a stunning six notches, from triple-A to A-, cut the commercial paper by two notches, from A-1-plus to A-2, and placed both on negative watch for more downgrades. As recently as Aug. 15, S&P had said: "SIV ratings are weathering the current market disruptions." Yeah, right. Around 23 per cent of all SIV assets are mortgages or CDOs containing mortgages, some of it of the noxious subprime variety.
Anyway, there's much more of this kind of thing yet to come. Indeed, as Aretha Franklin might put it: Cheyne of Fools.