The Hidden Hand: How Banks Pioneered the ABF Revolution

In my prior article, “From Nerd to Star: The Rise of Asset-Based Finance”, bank disintermediation was highlighted as a key catalyst driving today’s interest in structured finance.  However, bank disintermediation is not a new concept. According to a report by the consulting firm Oliver Wyman[1], bank lending as a share of total borrowing began to decrease in the 1970s with inflation and interest rate shocks forcing investment grade companies to borrow from the commercial paper market and bond market.

 It is no coincidence that securitization was introduced around the same time[2]. The first modern day asset-backed security was developed in the 1970s with the US Dept of Housing and Urban Development repackaging mortgages purchased by Ginnie Mae into securities. This financing technique quickly took off and expanded into the auto loan and credit card markets in the 1980s.

It appears that bank retrenchment was the catalyst for every wave of innovation in the structured finance sector since the 1970s. This is partially true. Over time, securitization – as well as high yield bonds – allowed borrowers to bypass banks who were less likely to lend to them anyway. However, at each stage of development, new securitization ideas were fueled by low-cost financing solutions that were developed and provided by…..banks. There are many examples of banks’ veiled efforts to advance the structured credit sector without heavily utilizing their balance sheets. Let’s take a look at one of them: the 1990s when securitization rapidly expanded beyond its core asset classes.            

1990s & Early 2000s: The Bank-Administered Conduits

The 1990s was a period of innovation and experimentation with securitization technology applied to many different types of contractual cashflows such as commercial real estate, aircraft leasing, equipment leases, among others. Banks fueled this revolution, not directly with their balance sheets, but with fee-generating off-balance sheet vehicles that transferred credit risk to short-term investors: asset-backed commercial paper conduits.

Asset-backed commercial paper conduits (ABCP vehicles) were (“are” since some still exist) entities administered[3] by highly-rated financial institutions (A-1/P-1). They purchased financial assets and ABS securities from originators and funded those purchases by issuing short-term commercial paper debt (usually less than 270 days). Initially the assets purchased were also short-term (trade receivables, inventory financing) but as the market developed, these vehicles purchased longer-dated assets such as auto loans, equipment leases, student loans and more esoteric assets such as insurance cashflows, film finance, and mutual fund financing. These vehicles offered lower financing costs than the Libor-based bank lending market and allowed banks to retain their client relationships by providing them with critical financing.

The primary source of repaying the CP was to roll over or issue new CP when the original paper matured. To mitigate this roll-over risk, the bank administrator provided both transaction-specific and program-level committed liquidity facilities upon which investors could draw whenever the CP could not be repaid. The banks provided these undrawn commitments under the auspices that the CP would always roll and CP investors would rarely – if ever – draw on these facilities. Given the (theoretical) zero probability that these facilities would not be drawn, banks were not required to report on their financial statements both these commitments as well as the assets that the conduit purchased from the originator. Hence the conduits and the liquidity facilities were deemed to be “off-balance sheet[4]”.   

By the late 1990s, ABCP conduits – administered and back-stopped by banks - were the leading provider of private ABF capital with over $500bn outstanding by the end of the decade[5]. Given that these vehicles funded originators either before or in lieu of public ABS financing, they were the first step in launching a new asset class, originator or financial structure. Asset classes that are “mainstream” today, such as royalty financing, structured settlements, whole business securitizations, were first financed by ABCP conduits with banks performing the underwriting and developing the financing structures still used today.  Banks can take credit for developing the current day securitization market even though, based on the macro data, they were pulling back from directly lending to these asset originators.

In 2001, Enron’s bankruptcy exposed complex off-balance sheet financing transactions that had employed structured finance’s technology. Not surprisingly, several transactions were funded by bank-managed ABCP conduits. The wave of accounting rule changes post-Enron ended the era of off-balance sheet treatment and many banks struggled with bringing these multi-billion-dollar funding vehicles onto their financial statements. Some banks found a solution involving third parties and others justified the balance sheet consolidation with the profitable fee stream from these transactions.

Despite the demise of the bank-administered ABCP conduit, banks created an important foundation for the structured credit market by developing alternative asset classes and structures that many credit funds are embracing today.  Banks have always been creative participants in the asset-based finance ecosystem without heavy usage of their balance sheets, thus giving the appearance of “disintermediation”. Recently several bank-credit fund partnerships have been announced reinforcing the concept that banks have been and will always be key players in the advancement of the structured credit industry.

For more details on the rise (and fall) of ABCP conduits, there are several well-detailed reports available to the public. Capital Advisors Group (“Demystifying Asset-Backed Commercial Paper”) and the Federal Reserve Board (“The Evolution of a Financial Crisis: Panic in the Asset-Backed Commercial Paper Market”) produced papers that are particularly informative.

[1]   “Private Credit’s Next Act”, Oliver Wyman, 2024.

[2]   Actually, the concept of “securitization”, or monetizing a stream of cashflows, first appeared in the mid-1800s with the creation of the farm railroad mortgage bonds. Their issuance contributed to the onset of the Panic of 1857, so not a great start to the product

[3]   “Administration” duties included entity management, asset underwriting, rating agency coordination and commercial paper issuance

[4]   This concept of “off-balance sheet” also existed on the asset originator side. The asset sales to the ABCP vehicle (and an ABS transaction) were treated as 100% risk transfer to the buyer (eg, conduit) and thus the originator did not report the assets (and the related liabilities) on its balance sheet.

[5]   Source: Federal Reserve, retrieved from FRED, Federal Reserve Bank of St Louis