Finadium report: Guarantees vs. Collateral: Risk in ABCP, Collateralized Commercial Paper and New Structured Products

A new report from Finadium looks at the risk profiles of Asset-backed Commercial Paper (ABCP), Collateralized Commercial Paper and short-term products with new names but similar economic outcomes. Investors must consider two at least levels of risk when considering collateralized products: these are collateral quality and bank guarantees.

ABCP and similar structured products are meant to be backed by collateral that is appropriate for the risk taken by an investor. In the event of a missed payment or other default circumstance, the investor is supposed to be able to claim the underlying collateral to make good on the investment. As the circumstances of 2008 unfolded, it became clear that the collateral underlying some ABCP and structured investment products was itself in default. This left investors with neither their payment stream nor sufficient collateral to reclaim the value owed. Regulators have meant to address this issue but product structures may or may not support an adequate resolution.

The second is counterparty risk. According to Finadium research, roughly 75% of collateralized short-term investment products are supported by a bank guarantee. As a result, investors are not betting first and foremost on collateral to be there in a crisis. Rather, they are betting that the financial sponsor of their product will show up in case of a payment stream default to make the investor whole.

An assessment of collateral and guarantees is critical to understanding where risk lies in collateralized products. With ABCP the answers are fairly straight-forward and are getting clearer, thanks to government regulation in the US and Europe. For Collateralized CP, Funding Notes, Special Purpose Vehicles, Total Return Swaps and other bespoke transactions that rely on collateral as the basis for investor comfort in the trade, quality collateral can be all over the map and sponsor guarantees may or may not be meaningful. As we enter an era of greater Shadow Banking and non-bank transactions, these issues will take greater prominence for investors in collateralized products.

This report presents the findings of our investigation into collateral and guarantee risk across a range of collateralized products. We have been concerned for some time about the risk in these products, as we observe our consulting clients investing with limited information on why and how these instruments are secured. While there will always be questions on specific instances, we provide a general view on what investors can expect across these products, how important a robust understanding of collateral may be, and what follow up steps should be taken. Our analysis also suggests that pricing for various products may be uneven relative to the risks involved.

This report is part of the Finadium Executive Briefing series, providing briefings and analysis to the financial markets industry.

Finadium subscribers with logins can log in to access this report.

For non-subscribers, more information on this report and subscription information is available on the Finadium reports home page.

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