Small investors should not have to take
the fall for the greed of others in risky scheme
Apr 06, 2008 04:30 AM
An important restructuring plan has been worked out by the large
investors and sponsoring institutions for the $32 billion asset-backed
commercial paper market (ABCP) that seized up last August. The current
version of the restructuring plan places the investments in the 20 ABCP
financial conduits under court protection.
It is now clear that the asset-backed commercial paper business was a
scheme to fund highly risky loans with short-term borrowings without the
full disclosure of the nature of the investment risk. Investors were led
to believe that the ABCP instruments had a high probability of modest
gains compared to government treasury bills and a low probability of
loss. Unfortunately, the low probability failure option was grossly
underplayed by those with an interest in earning huge fees.
Some banks and credit unions have already fully compensated clients for
their ABCP investments, others have not. Two thousand small investors in
the $32 billion ABCP market were not included in the original
restructuring negotiations. These retail investors, who make up roughly
1 per cent of the face value of the conduits, or about $330 million, are
needed to go along with the restructuring plan, which will convert the
original short-term commercial paper into longer-term securities. Under
the restructuring plan, small investors would have to agree with the
large investors not to sue the institutions that sold them the
Before the ABCP market seized up, investors thought that they had
purchased liquid, secure commercial paper offering slightly better
returns compared with government bonds or treasury bills. And despite a
mishmash of underlying assets, the commercial paper also was typically
rated AAA by a recognized bond rating firm.
Selling the commercial paper product also paid off well for the
companies and banks that originally issued them, since they received
handsome fees. The issuing companies also paid a fee to the rating
agency to have their notes certified. And, of course, the instruments
were popular with the brokerage houses and investment advisers that sold
them to retail, institutional and commercial investors.
These dodgy products were packaged with a AAA rating and were sold to
individual investors with the expectation that they would be as liquid
as treasury bills or bank CDs, but ended up being frozen and illiquid.
However, the effective result has been a financial fiasco for the
unlucky investors who were not bailed out by the sponsoring
Individual investors have every right to be outraged at those who
created these securities, at the firm which rated them as "riskless" and
at the investment professionals who sold the notes to unsophisticated
Indeed, what began as an attempt to avoid a fire sale of these
securities for the large investors has turned out to be a potential
disaster for some retail investors.
The restructuring plan that was worked out by the large holders of the
investment securities is now being presented to the 2,000 small
individual investors for their approval. The Crawford Committee's
restructuring proposal would replace the ABCP short-term notes with
long-term bonds backed by the same questionable securities that backed
the original paper.
The question is whether small investors should be treated the same as
the large investors, who have negotiated the restructuring scheme. The
individual investors hold a relatively small proportion of the total $32
billion pie and treating this group separately should not greatly affect
the whole plan as negotiated by Purdy Crawford and the large investors.
There are other ample reasons for the individual investor to be treated
differently. Retail investors were sold the ABCP notes as being as good
as cash, or nearly so. Small investors lacked the sophisticated analysis
that the large investors should have had, which would have allowed them
to avoid these risky investments.
Some have suggested that the large investors, in some cases pension
funds, are really just representing individuals and that they should be
treated equally. But the pension funds are advised by skilled investment
professionals and if they make mistakes, then the pensioners and
prospective pensioners should hold their advisers responsible. For all
these reasons it would make sense for the individual investors to be
treated in a much different manner than the large sophisticated
The individual investors are being told that the frozen securities they
currently hold are worth only 20 to 30 cents on the dollar. But if they
hold the bonds to maturity, five or more years, the investors will get
all or almost all of their original investment back. What nonsense!
If an investment is worth 20 cents now, what annual rate of return would
be required to make it worth one dollar in five years? A 10 per cent
annual return would make a 20 cent investment worth about 33 cents in
What is needed is for those responsible, those who packaged the ABCP
notes, those who rated the paper as AAA, and those who sold the paper to
individual investors, all to take responsibility for their greed, their
lack of transparency and their mistakes. And along with these one should
also include the regulators who allowed these questionable securities to
be sold to individual investors.
Let all of them step up to the plate and take the individual investors
out of the debacle that seems to be looming.
Finally, what new regulations are needed to prevent this kind of
disaster from happening again? In the United States, the Secretary of
the Treasury has proposed a host of new regulations and new set of
regulators. In Canada, we do not even know who is the responsible party
for regulation – the federal government or the individual province.
What is clear is that a consistent national set of regulations is
required for Canada's so-called "shadow banking sector." The federal
Finance Minister has stated that he is in favour of creating a national
securities regulator. Thus he should take this opportunity to set forth
rules and create a regulator for the portion of the financial sector
that does not at present fall under federal jurisdiction. The federal
government can do this by imposing rules on all securities that trade
across provincial borders. Considering the present mess, it should also
have the support of the provinces, none of whom seem eager to enter into
the regulation of these complex instruments.
In closing, what is really required is a careful study of the present
complex set of financial circumstances surrounding the ABCP market and
the current regulatory deficit. Some of the components that will need to
be examined for more complete regulation include the appropriate level
of transparency for such financial instruments, the appropriate capital
requirements for the shadow banking sector, the supervision and auditing
requirements for this sector, as well as a careful look at conflicts of
interest between rating agencies and their customers.
Doug Peters is the former chief economist of the Toronto-Dominion
Bank and was secretary of state (finance) from 1993 to 1997. Arthur
Donner, a Toronto economic consultant, began his career as an economist
at the Federal Reserve Bank of New York.