Investors Scrutinizing the Regulators

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Securities Regulation In CanadA

Fox Guarding the Hen House




It's ABCP with an American accent


May 6, 2008 at 4:03 AM EDT

Imagine a market where small investors bought bonds in the belief they were getting short-term securities that were the next best thing to cash, then found themselves stuck with paper they couldn't sell and couldn't value.

It sounds familiar to Canadians after nine months of dealing with exactly that situation in the asset-backed commercial paper market.

But this time the problem is in the U.S., where the market for a similarly obscure product called auction-rate securities has collapsed, stranding investors all across America. And one Canadian bank.

Shareholders of Royal Bank of Canada are likely to pay a price for the bank's involvement as a dealer, a business RBC got into as part of its expansion into U.S. capital markets. Some analysts predict RBC will be forced to take a writedown of $200-million to $300-million on its holdings.

The parallels to ABCP are striking. The $330-billion auction-rate market seized up this winter when buyers disappeared. Nobody knows what the securities are worth now, because there is no coherent market, leaving regulators and issuers scrambling to find a fix so unwitting investors aren't stuck holding the bonds for decades.

"The investor base for this product were folks focused on short-term investments, that needed short-term liquidity, and what they've quickly found out is that in a liquidity crisis this bond is a long-term obligation," said David Hartung, a senior vice-president of U.S. structured finance at DBRS Ltd. in New York.

Auction-rate securities are really long-term bonds with maturities as great as 30 years, but the interest rates were reset every few weeks at auctions where sellers could cash out, so long as new buyers showed up.

As the market exploded in recent years, there were dozens of auctions daily.

Like ABCP, the fault in the auction-rate market was the assumption that a steady stream of new buyers would enable sellers to get out, and that if purchasers weren't available, banks that played in the market would step in as buyers of last resort. In both cases, when the credit crunch hit, some banks balked.

"All it took was one firm, Goldman Sachs in February, to publicly say they are no longer participating in auctions, and the rest of the dominoes fell and the rest of the broker dealers on the Street put up the white flag," Mr. Hartung said.

Prices for the securities now vary wildly, something that drew Warren Buffett to make a $4-billion (U.S.) bet on them. Mr. Buffett said he purchased auction-rate debt with an 11.3-per-cent rate from one broker, while another broker was offering a 6-per-cent rate.

Because the market is so wide, RBC has significant leeway on any writedown. Some banks have said the assets are worth par, while others took writedowns of 20 per cent.

"That's part of the problem: the opacity of the market," said Joe Fichera, chief executive officer of New York-based financial advisory firm Saber Partners.

RBC had about $4.4-billion of auction-rate debt at the end of the first quarter, but with auctions failing since, Genuity Capital Markets analyst Mario Mendonca estimates the bank may now be stuck with $3-billion more.

Mr. Mendonca said in a report that RBC could take a writedown of $300-million (Canadian) related to the debt when it reports earnings May 29, as part of a bigger overall writedown of up to $700-million for troubled assets.

CIBC World Markets analyst Darko Mihelic estimates the writedown for auction-rate debt could be $200-million, as part of capital-markets related losses totalling as much as $800-million.

Those numbers won't break RBC - analysts still expect the bank to post quarterly profit of $1.3-billion - but they sting.

RBC argues, and most analysts agree, that any losses are purely on paper and the assets underlying the debt are solid.

"The credit quality is not in question," RBC's chief risk officer, Morten Friis, said in a question and answer session with analysts last week.

Issuers and banks that sold the debt are now working to refinance the securities in other markets, a slow process.

One reason may be that banks running auctions are paid even if sales fail, reducing the incentive to rush. "They have got to realign the incentives to pay for sales, rather than fails," Mr. Fichera said.


The Citigroup analyst who prompted Royal Bank of Canada to come out fighting after she estimated it could be facing a $5-billion writedown has cut her estimate roughly in half.

Shannon Cowherd sent a new research note to clients yesterday, saying that she revisited RBC's potential exposure to a number of trouble spots "based on further analysis and incremental information," and some of her prior estimates "now appear aggressive in retrospect." She expects the bank to take total writedowns of $2.6-billion, $787-million of which it has already taken.

Her original estimate, issued at the beginning of last week, sent executives at Canada's biggest bank spinning. RBC decided to take the highly unusual step of issuing a press release about the report, saying it contained "significant errors in fact and significantly overstates both the risks and the amount of any potential writedown RBC might incur."

Ms. Cowherd's estimate was much higher than the $400-million to $700-million hit other analysts expect the bank to take this quarter.

Chief executive officer Gordon Nixon told analysts at a conference last week that RBC is not happy about taking any writedowns, but "our exposures and writedowns are well within our risk limits."

Tara Perkins

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