Sunday, September 16, 2007

What is a Conduit and What Does It Have to do With Commercial Paper and Banks?

Excerpts below from an article in the WSJ summarizes the basics of conduits, that is, how banks assemble securities (assets) from companies to use as collateral for commercial paper issued in the name of the company. The important part that banks play in the process is that they agree to cover the commercial paper if it cannot be sold when it matures, thereby creating a contingent liability for the bank. The excerpts below also go into how the bank is able to make this an off balance sheet transaction.

Subsequent articles in the WSJ concerning conduits and their potential effects on banks are covered in the following articles: #1, #2, #3, and #4. These are all worth a read because it gives a feel for how large the market is, the potential problems in the market, and what some banks are doing.

The subprime-mortgage downturn keeps showing up in unexpected places in unusual ways. . . .

. . . . Conduits are a twist on the age-old banking practice of taking a client's assets such as receivables or securities and turning them into cash.

Banks create conduits that are then filled with an array of assets that could include credit-card receivables, auto loans or mortgages. Using these assets as collateral, the conduit sells commercial paper to big investors, who are seeking generally safe, short-term investments while getting a slightly higher yield than that offered by ultra-safe instruments such as certificates of deposit or Treasury bills.

The cash from the sale of the commercial paper goes back to the companies that put their assets into the conduit.

In the past, the assets in a conduit generally came from one bank or company. But in recent years asset-backed commercial-paper conduits that combine debts from different companies, banks and financial firms have become more popular, accounting for about half the commercial-paper market. These notes can include some subprime mortgage securities, which are terrifying investors around the world.

Notes issued by these conduits account for just less than half of the nearly $3 trillion global commercial-paper market.

Banks earn fees to set up and run the conduits. They also often agree to provide funding if a conduit can't resell its commercial paper when it matures, which is generally every 90 days. That is where today's problems lie.
(This guarantee of funding by the bank for the commercial paper if it cannot be re-sold at maturity creates a contingent liability for the bank.) Conduits are essentially using the sale of short-term debt, commercial paper, to fund the purchase of long-term assets. That creates a mismatch if demand for the short-term paper disappears.

These days, skittish investors are shunning even typically safe commercial paper that doesn't necessarily have mortgage exposure. As a result, some banks can't resell the commercial paper when it matures and in some cases are being forced to step in and provide the funding instead. That is why investors are nervous about the banks' exposure to these conduits.

The problem is these conduits are created as independent entities, so they don't sit on the banks' balance sheet, at least until the things go bad. "The extra step we're missing is the added bit of disclosure saying what you are on the hook for," said David Zion, an accounting analyst at Credit Suisse.

"I don't think putting these on the balance sheet is necessarily the perfect answer," he says, "It's maybe just giving investors enough information."

The worry is that banks could have to divert resources if they have to take conduit assets onto their own books because of commitments to provide funding for the conduits.

"The more that comes on balance sheet and the fewer the funding options, the less liquid the banks and the banking system," said Chip MacDonald, a securities lawyer at Jones Day's Atlanta office.

Globally, the amount of asset-backed commercial paper is about $1.3 trillion. Of this asset-backed paper, $1.1 trillion is backed by funding lines from banks, according to the Merrill report, which focused on European banks. "Theoretically, all of the $1.1 trillion bank back-up funding lines could be drawn down," the report said. "However, in reality, we think the probability of that is low."

The same issue that has hit the banks also slammed investment firms such as Carlyle Group, Cheyne Capital Management and Kolhberg Kravis Roberts & Co. These firms and others operated funds, sometimes known as structured investment vehicles, or SIVs, that tried to profit by selling commercial paper that paid a certain interest rate and used the money to buy higher yielding mortgage securities, pocketing the difference.

When their commercial paper matured and there were no buyers, the firms either said they would put up cash or sold securities. SIVs differ from conduits because conduits have bank-supported credit lines to carry them through if they can't roll over their commercial paper, while SIVs receive only limited support.

The banks aren't violating accounting rules by keeping these conduits off their balance sheets. Indeed, the accounting gurus tightened these off-balance-sheet rules dramatically after Enron Corp. collapsed under debt issued by its off-balance-sheet entities. But conduits were structured in such a way that they didn't have to come onto the books. That is because conduits are strange beasts and, essentially no one lays claim to them. While banks and other financial companies set them up, they don't own the conduits.

Banks also say they don't control the entities, which are typically incorporated in tax havens such as the Isle of Man. For accounting purposes, potential losses are sold for a nominal amount to an outside investor. This lets banks say they don't bear any of the risks associated with the conduits.

All of this allows banks to keep a conduit off the books, preventing what many banks believe would lead to a ballooning of their balance sheets. That could require them to set aside more capital for regulatory purposes. Despite this off-balance-sheet treatment, banks reap generous fees from the services they provide to conduits.

"They helped banks generate revenue by creating a tool to finance investments that was highly rated, did not contribute to accounting volatility and did not need much regulatory capital," said Adrian Docherty, head of BNP Paribas SA's financial institutions advisory practice. "For some banks, conduits became a major component of their business strategy and revenues."

What is especially troubling for investors is they have little information to help gauge the depth of the problem. Citigroup Inc., for example, disclosed in its second-quarter results that its off-balance-sheet conduits had about $77 billion in assets and liabilities but gave little other information about them. Citigroup declined to comment.

In its most recent quarterly filing, J.P. Morgan Chase said off-balance-sheet conduits that it administered had issued about $54 billion in commercial paper.

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