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ABCP: Top them up

David West

April 3, 2008

In the overall scheme of things, I like to fancy myself as free of a free-marketer there is. But even I have my limits. One of the hottest issues of the day right now is whether retail investors in non-bank asset backed commercial paper should be treated differently from institutional investors in the same bad paper.

In my humble opinion, they should. They should be made whole now, and have the cost of doing so borne by the non-retail community, i.e. institutional investors and the dealers themselves.

To put it in numerical terms, there are approximately 1,800 retail investors owed between $300 million and $400 million in principal amount of the affected paper. Taking the higher of these two numbers, absorbing $400 million into the $32 billion rescue plan rather than jeopardizing it and risking years of lawsuits is peanuts ó especially when only about $100 million of that would represent a top-up, with the balance being backed by realizable security.

Itís also not the point. No matter how much or how little money is involved, either in aggregate or proportionally, it is irrelevant if the retail investor is culpable in their own losses. If retail investors contributed to the problem, they would have nothing to complain about.

And to take it a step further, we must respect one of the most important tenets of the capital markets, which is that your word is your bond. That tenet is how a retail investor can buy or sell tens of thousands of dollars, millions even, in investments with a simple phone call. No lawyers, no paperwork, just a voice on the phone can move money and securities from one place to another. It only works in a world where your word is your bond.

Some would argue that by the retail investor agreeing to buy the commercial paper in the first place, they agreed to accept the risk of the paper. Therefore the retail investor doesnít deserve to be repaid in full now that things have gone sour, any more than the institutional investors deserve 100 cents on the dollar for their damaged paper.

Most times, as a free-marketer, I would agree with that sentiment. ďDonít whine to me now, just because you didnít do your homework beforehand,Ē is one of the best arguments in favor of a wealth transfer from those who did their due diligence to those who didnít. But in this case of faulty ABCP, that argument doesnít hold.

Thatís because, although the tenet of Ďyour word is your bondí is common to both retail and institutional investors, the two camps are different in that thereís a huge informational advantage held by the industry players over their retail charges. Let me put it this way: if an investment advisor told a retail client last winter or spring that investing in commercial paper was a very safe thing to do, how would a retail investor know any different? The investment advisor wouldnít have known any different. And if the retail investor somehow was able to ask a professional institutional money manager how safe ABCP was to invest in, they wouldnít be told anything different, because at the time institutional investors didnít know any better either.

So no matter how much due diligence retail investors might have done, they still would have made the investment. The industry should therefore not hold the retail investor to account for doing something the industry didnít know was wrong to do.

The retail investor has already lost by not having access to their money for the past seven months. Donít make them wait another nine years. Pay them off now.

And if the $100 million stings the industry a little bit, maybe that will spur them into doing a better job of teaching product knowledge to their people before licensing them.

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