Treasurers, Watch Out for This Security

The wizards of Wall Street have cooked up a new structured-finance product that could start showing up in money-market fund portfolios.

Like the diligent shopper who combs the fine print of breakfast cereal ingredients trying to spot synonyms for “sugar,” CFOs and treasurers have to be on the lookout for a new sweetener in their short-term cash portfolios. Called collateralized commercial paper (CCP), the instrument is an asset-backed security targeted to prime money-market funds, a popular short-term investing vehicle for treasurers.

CCP could become “the next major structured funding vehicle for major financial firms,” says Lance Pan, director of investment research for Capital Advisors Group. Barclays Bank was the first to come to market with a CCP issue, creating a $10 billion program last November; other banks may soon follow suit, says Pan. Moody’s rated the notes P-1, its highest short-term rating category. Given the problems with structured-finance creations during the financial crisis, though, it pays for treasurers to learn a little about this new instrument, especially if their brokers try to sell them on it.

CCP is a way to fund long-term assets with short-term obligations, such as when a company sells its receivables to a bank or conduit, which in turn issues them to investors as short-term commercial paper. With CCP, the commercial paper is backed by term repurchase agreements, or repos. In a repo, the seller transfers ownership of some securities to a buyer in exchange for cash, and agrees to buy back the same securities at a later date and at a higher price. If the seller can’t buy back the securities on the set date, the buyer assumes control of the collateral securities.

Why create a new form of commercial paper? “With the casualties of Bear Stearns and Lehman Brothers fresh in everyone’s memories, short-term investors may need more incentive to lend to highly leveraged financial borrowers, broker-dealers in particular,” explains Pan. “Using asset collateral in addition to the issuer’s general balance-sheet strength may prove more palatable [to investors] than plain unsecured [commercial paper] borrowing.”

Money-market funds could also use CCP as “maturity arbitrage,” says Pan. Term repos typically have maturities longer than seven days, and are thus classified as illiquid by the recent amendments to the Rule 2a-7 regulations for money-market funds. Term repos can make up no more than 5% of a money-market fund’s holdings, down from 10%. They are also excluded from the “bucket” of liquid securities that must constitute 30% of a money fund’s holdings. “The CCP structure essentially allows funds to hold the same term repo positions concealed as commercial paper, such that they do not receive the ‘illiquid’ designation,” says Pan.

A major difference between asset-backed commercial paper and CCP is that CCP is a “direct and unconditional” obligation of the issuer’s parent company; unlike asset-backed commercial paper, it is not issued by a special-purpose vehicle through which investors would have no recourse to the parent company. Thus, it works just like unsecured commercial paper issued by a bank or corporation.

But CCP has some of the same risks that lurk in other instruments that exploit funding mismatches, like auction-rate securities. A crisis that causes the market for either CCP or term repos to dry up could stick individual holders and money-market funds with unsellable, hard-to-value investments.

In evaluating CCP, Pan says treasurers must first look to the issuer’s stand-alone credit strength. “Alarms should go off if an issuer lacks a diversified funding lineup and leans heavily on the new CCP structure,” he says. A treasurer may also need to dig deeper into the quality and maturity of the securities in the repo collateral account. It would be critical, then, for investors to have access to that information, says Pan.

In rating Barclays’s offering last November, though, Moody’s said it did not “undertake any assessment of the quality or liquidity of the collateral, nor . . . examine the strength of the repo arrangements or any potential mismatch in terms or rates between the CP issuance and the repo agreements.”

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