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Trading and Capital-Markets Activities Manual

Securitization and Secondary-Market Credit Activities (Continued)
Source: Federal Reserve System 
(The complete Activities Manual (pdf format) can be downloaded from the Federal Reserve's web site)


Asset-Backed Commercial Paper Programs


SR 92-11
April 2, 1992


SUBJECT: Asset-Backed Commercial Paper Programs

A number of commercial banks have become involved in asset-backed commercial paper programs. These securitization programs enable banks to help arrange short-term financing support for their customers without having to extend credit directly. This provides borrowers with an alternative source of funding and allows banks to earn fee income for managing the programs. Banks also earn fees for providing credit and liquidity enhancements to these programs. 

It is important to emphasize that involvement in such programs can have potentially significant implications for the organizations' credit and liquidity risk exposure. Therefore, examiners should be fully informed on the fundamentals of these programs, on the risks associated with these programs, and on the procedures for examining banks and inspecting bank holding companies engaged in this activity.1 

Asset-backed commercial paper programs have been in existence since the early 1980s and have grown substantially over the last few years. These programs use a special purpose entity (SPE) to acquire receivables generally originated either by corporations or sometimes by the advising bank itself.2 The SPEs, which are owned by third 

1SR letter 89-12 (July 6, 1989) originally provided guidance to examiners with respect to asset securitization. Examination guidelines for the review of asset securitization and supplemental background information on securitization was distributed as an attachment to SR letter 90-16 (May 25, 1990). 2To date, the type of receivables that have been included in such programs are trade receivables, installment sales contracts, financing leases, and non-cancelable portions of operating leases and credit card receivables.

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parties,3 fund their acquisitions of receivables by issuing commercial paper that is to be repaid from the cash flow of the receivables. 

Bank involvement in an asset-backed commercial paper program can range from advising the program to advising and providing all of the required credit and liquidity enhancements in support of the SPE's commercial paper. Typically, the advising bank, or an affiliate, performs a review to determine if the receivables of potential program participants (i.e., corporate sellers) are eligible for purchase by the SPE. The scope of the review is similar to that used in strucEagle Tradersg credit card or automobile-loan-backed transactions. 

Once the bank (or its affiliate) determines that a receivables portfolio has an acceptable credit risk profile, it approves the purchase of the portfolio at a discounted price by the SPE. The bank or its affiliate may also act as the operating agent for the SPE. This entails strucEagle Tradersg the sale of receivable pools to the SPE and then overseeing the performance of the pools on an ongoing basis. 

The SPE pays for the receivables by issuing commercial paper in an amount equal to the discounted price paid for the receivables. The difference between the face value of the receivables and the discounted price paid provides, as discussed below, the first level of credit protection for the commercial paper. The individual companies selling their receivables traditionally act as the servicer for receivables sold to an SPE; that is, they are responsible for collecting principal and interest payments from the obligors and passing these funds on to the SPE on a periodic basis. The SPE then distributes the proceeds to the holders of the commercial paper. 

Asset-backed commercial paper programs typically have several levels of credit enhancement cushioning the commercial paper purchaser from potential loss. As noted above, the first level of loss protection is provided by the difference between the face value of the receivables purchased and the discounted price paid for them, known as a "holdback" or "over-collateralization." In some cases, the terms of the sale also give the SPE recourse back to the seller if there are defaults on the receivables. The amount of over-collateralization and recourse varies from pool to pool and depends, in part, upon the quality of the receivables in the pool and the desired credit rating for the paper to be issued. Usually, the level of credit protection provided by over-collateralization is specified in terms of some multiple of historical loss experience for similar assets. 

In addition to over-collateralization and recourse, secondary credit enhancements are also customarily provided. Secondary credit enhancements include letters of credit, surety bonds, or other backup facilities that obligate a third party to purchase pools of receivables from the SPE at a specified price. In addition to credit enhancements, the 

3 Employees of an investment banking firm or some other third party generally own the equity of the SPE. The advising bank specifically avoids owning the stock as it does not want to raise the issue of whether it must consolidate the SPE for accounting purposes.

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programs also generally have liquidity enhancements to ensure that the SPE can meet maEagle Tradersg paper obligations. 

The rating agencies typically require an SPE's commercial paper to have secondary enhancements aggregating 100 percent of the amount outstanding in order to receive the highest credit rating. These enhancements are generally structured in one of two ways. In the first, a commercial bank enters into a single agreement under which it is unconditionally obligated to provide funding for all or any portion of maEagle Tradersg commercial paper that an SPE cannot pay from other sources. The obligation to fund may be triggered by credit losses, a liquidity shortfall, or both. In the second, two separate agreements that jointly cover 100 percent of an SPE's outstanding commercial paper are established. The first, typically an irrevocable letter of credit, is primarily intended to absorb credit losses that exceed the first tier of credit enhancement for the commercial paper. The second arrangement is a "liquidity" facility that may or may not provide credit support. This second structure will often have a letter of credit equalling 10 to 15 percent of outstandings, with the liquidity facility covering the remaining 85 to 90 percent. 

Risk-Based Capital Treatment 

Generally, a single funding agreement that has no escape clause, such as a material adverse change clause, which requires a bank to unconditionally provide funding to repay maEagle Tradersg commercial paper when the need arises because of either credit or liquidity problems should be treated as a direct credit substitute, or guarantee. The risk-based capital guidelines specify that the full amount of such obligations are to be converted to an on-balance sheet credit equivalent amount using a 100 percent conversion factor. No part of these arrangements should be considered commitments (either short-term or long-term) for risk-based capital purposes and assigned the conversion factor of a commitment. In the case of enhancements provided by separate facilities, a 100 percent conversion factor should be assigned to a letter of credit or any other form of credit guarantee provided by the bank. The accompanying liquidity facility, on the other hand, should be treated as a commitment and assigned a 50 percent conversion factor if over one year in maturity and a zero percent conversion factor if one year or less in maturity. One of the characteristics of liquidity facilities is that such arrangements generally have some reasonable asset quality test that must be met before extending funds to the SPE to ensure that the bank is not providing credit protection. 


A banking organization (i.e., a bank or bank holding company) participating in an asset-backed commercial paper program should ensure that such participation is clearly and logically integrated into its overall strategic objectives. Furthermore, the management should assure that the risks associated with the various roles that the institution may play in such programs are fully understood and that safeguards are in place to properly manage these risks.

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Appropriate policies, procedures, and controls should be established by a banking organization prior to participating in asset-backed commercial paper programs. Significant policies and procedures should be approved and reviewed periodically by the organization's board of directors. These policies and procedures should ensure that the organization follows prudent standards of credit assessment and approval regardless of the role an institution plays in an asset-backed commercial paper program. Such policies and procedures would be applicable to all pools of receivables to be purchased by the SPE as well as the extension of any credit enhancements and liquidity facilities. Procedures should include an initial, thorough credit assessment of each pool for which it had assumed credit risk, followed by periodic credit reviews to monitor performance throughout the life of the exposure. Furthermore, the policies and procedures should outline the credit approval process and establish "in-house" exposure limits, on a consolidated basis, with respect to particular industries or organizations, i.e., companies from which the SPE purchased the receivables as well as the receivable obligors themselves. Controls should include well-developed management information systems and monitoring procedures. 

Institutions should analyze the receivables pools underlying the commercial paper as well as the structure of the arrangement. This analysis should include a review of: 

(i) the characteristics, credit quality, and expected performance of the underlying receivables; 

(ii) the banking organization's ability to meet its obligations under the securitization arrangement; and 

(iii) the ability of the other participants in the arrangement to meet their obligations. 

Banking organizations providing credit enhancements and liquidity facilities should conduct a careful analysis of their funding capabilities to ensure that they will be able to meet their obligations under all foreseeable circumstances. The analysis should include a determination of the impact that fulfillment of these obligations would have on their interest rate risk exposure, asset quality, liquidity position, and capital adequacy. 

Reserve Banks are requested to review carefully the asset-backed commercial paper facilities provided by banks in their Districts to ensure that banks are applying, for risk-based capital purposes, the proper conversion factors to their obligations supporting asset-backed. commercial paper programs. In addition, examiners should review that the policies discussed above are operative and that institutions are adequately managing their risk exposure. A discussion of the size, effectiveness and risks associated with these programs should be included in the confidential section of the examination report if not appropriate for the open section.

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Should you have any questions, contact Roger T. Cole (202-452-2618), Rhoger H. Pugh (202-728-5883) or Thomas R. Boemio (202-452-2982). 


Stephen C. Schemering 
Deputy Director


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