March 29, 2008 at 6:00 AM EDT
Nearly eight months into the Great Canadian Debt Fiasco, the injuries are only getting worse.
Canaccord Capital, the largest independent broker, has a bruised reputation. National Bank of Canada and the Caisse de dépôt et placement du Québec, pillars of Quebec finance, are wearing twin black eyes. Bank of Nova Scotia is covered in mud. And let's not forget the ones hurting the most: 1,800 individuals, plus some corporations, pension funds and others, whose pain can be measured in one number: $32-billion. That's the amount they put into asset-backed commercial paper that was supposedly ultra-safe. The odds of recovering all of their money seem slim.
They are upset. Who can blame them? Much of the anger is directed at Canaccord, the biggest seller of the stuff. Perhaps more ought to be aimed at credit rater DBRS Ltd., which told everyone ABCP was low risk. But DBRS is a key link in Purdy Crawford's effort to rescue some of that $32-billion. If the rating agency screws up again, there's going to be trouble.
Mr. Crawford will conduct a five-city tour next week to sell his plan. ABCP investors are being asked to trade their locked-up short-term paper for longer-term bonds. To grossly oversimplify: Some of the new bonds are backed by real assets – mortgages and such that are not in default and will be repaid. Others are backed … well, by hope. Or by derivative contracts that might pay off but might also turn out to be worthless.
A perfect solution, it's not. But at least there will be a market for the new bonds and those who need the cash can sell (albeit at a significant loss). That's when the really fun part will begin. How do you value a bond when you can't understand what's behind it?
With corporate bonds, you can look at debt levels, cash flow, interest coverage. With a government bond you can take the measure of inflation, tax revenue and deficits. But many ABCP trusts are highly complicated. Without a mathematics degree, putting a price on them is tough. An average person will have to rely on – gasp – a credit rating. Without one, the market for these notes might not be very liquid. It might be hard for ABCP holders to get a decent price.
So Mr. Crawford asked the credit agencies to step up: Put a letter grade on these new bonds so that those nice folks from Sarnia can sell and put an end to this nightmare. Forget it, said Moody's. No thanks, said Standard & Poor's. Both firms have been battered by their own public relations fiascoes. They don't need another headache.
So the burden falls on DBRS, which helped create the commercial paper mess in the first place, to be part of the solution. The early indications are that at least two of the new sets of bonds will be given a double-A rating – the same as the government of Ontario. (Some of the other restructured ABCP notes – subordinated notes, lower down the food chain – won't be rated at all by DBRS.) This should raise an alarm. A double-A rating, obviously, is meant for blue-chip bonds. Double-A means it's very likely you'll get your money back in the end. It doesn't say anything about volatility or at what price they will trade at between now and maturity. It doesn't guarantee that the credit markets won't go to hell in the meantime.
For a corporate bond, this may not matter. But since a lot of ABCP is based on leveraged bets on credit prices, price volatility does matter. If credit prices fall far enough – that is, if spreads get high enough – it could lead to a margin call and guaranteed losses (this is the scenario Mr. Crawford has been working to avoid). Under the restructuring plan, the odds of triggering a margin call are lower – “significantly more remote,” says Huston Loke of DBRS. But they're not zero.
Given the record, who would trust DBRS to figure out what's a “remote” possibility? This is a time when the impossible seems to be happening twice a week. A month ago, the idea that Bear Stearns could be driven to the brink of insolvency, then sold for $10 (U.S.) a share, would have seemed remote. A decade ago, Long-Term Capital collapsed precisely because its genius managers made highly leveraged bets that could not go wrong, unless the unimaginable happened. And then it did.
The point: In times of financial distress, academic mathematical models don't work so well in the real world. Yet DBRS, having failed in its first attempt to assess the risks in asset-backed paper, is turning to the models again. What if this time, “double-A” turns out to be as much of a mirage as those original ratings were? Then DBRS will have only compounded the hit to its reputation. A credit agency that can't competently rate risk has no reason to exist.