Jan 09

Receivables Risk

by David Harper, CFA, FRM, CIPM

FRM |

Asset-backed commercial paper (ABCP) become popular because banks wanted to finance credit-sensitive assets with off-balance sheet methods (some motivation clearly was the Basel Accord but banks have other reasons to get stuff off their accounting, if not economic, balance sheets). As such, they are just another flavor of securitization where a entity (e.g., SPE, SPV, ABCP Conduit) "runs interference" between the risky assets and investors. It is the entity (SPE/SVP) that plays a key role in achieving the off-balance-sheet status; namely, is the risky stuff sold (in a true sale) to the entity?

There are a dizzying array of variations, but an ABCP superficially (from a high level) can be viewed in the same light as asset backed securities and collateralized debt obligations (CDO). The details vary but all of them issue securities to investors, where those securities are collateralized by, and funded with the cash flows (P&I) of, the underlying credit-sensitive assets. Setting aside the recent notion that, effectively, these vehicles may have unwittingly concentrated risk, the basic theory is that credit risk is transferred from an originator to investors and investors are paid for assuming that risk.

In an ABCP, the credit assets may be companies' trade receivables (as on the left, in this simplified diagram).

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The latest GARP Risk Review has a great interview with Igor Zax about receivables and this huge market. Here are some highlights from a guy who knows what he is talking about:

  • There are three main ways to finance receivables: 1. factoring (sell to third party, including servicing), 2. securitization (e.g., via ABCP conduits; as above, issues commercial paper to investors) and 3. invoice discounting
  • Trade receivable include, and mix, credit risk and operational risk (e.g., errors, fraud)
  • Receivables insurance entails "low credit risk but high operational risk." This is instructive! Trade receivable insurance covers undisputed risks; so it would cover a buyer's bankruptcy (the buyer has a receivable but goes bankrupt and cannot pay) but not a contractual disagreement (buyer disputes the receivable). Zax points out that these instruments have no basis risk, "given the instrument covered is the receivable itself." Instead, like any insurance policy, the coverage is not unconditional, so there is operational risk. In short, an insurance policy = no basis risk but high operational risk.
  • The seller's risk (originator) is often greater than buyers' risk! Due to operational risk including so-called "dilution risk" 
  • U.S. firms tend to securitize their receivables but European firms tend to factor (European companies also are more prone to insuring their receivables)
  • From a modeling and/or rating perspective, he says the short timeframe of receivables is a unique feature. Specifically, both rating agencies and the Merton model are better suited to longer timeframes (e.g., Merton understates PD)
  • Trade creditors are often excluded from restructuring negotiations because they need to get paid to keep the enterprise going
  • Regarding subprime problem, the market typically did not differentiate among assets held by the ABCP (typical ABCP held mix of assets). So when CDO tranches (the weaker underlyings) went south, the higher-quality credits (receivables) were guilted (discounted) by association.
  • Related, blames the "mixing of asset classes" (i.e., receivables that are short-term and relatively high quality with CDO tranches, which are different beasts) on confusion and volatility.

Comments

  1. Neha Dim 21 Jan 2008

    I would like to know brief explanation of the digramatic represenation. Also what is the role Bionic turtle is playing as a support group.

    Regards

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