Investors Scrutinizing the Regulators

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Fox Guarding the Hen House




March 2008
Public firms struggle to estimate value of ABCP holdings
Regulators require companies to provide a fair valuation of the distressed paper in their yearend financial statements

By Laura Bobak

Dozens of public companies working on their yearend reports are struggling to estimate the value of the distressed asset-backed commercial paper they hold — the fate of which will remain unknown until a plan to rescue about $33 billion worth of the troubled notes is finalized.

With the market for the ABCP frozen since this past August, corporations attempting to do a fair valuation for their balance sheets have had to resort to accounting methods such as discounted cash flow analysis to produce a number that will satisfy regulators. The companies are, however, working with incomplete information concerning the assets underlying the notes.

And there are other unknown variables, such as the success of the restructuring plan being overseen by the Pan-Canadian Committee chaired by Osler Hoskin & Harcourt LLP lawyer Purdy Crawford.

But, according to the Canadian Securities Administrators, fewer than 100 publicly traded corporations hold “significant amounts” of ABCP. Financial statements for companies that trade on the Toronto Stock Exchange must be released 90 days after their fiscal yearend, or 120 days after the fiscal yearend for companies that trade on the TSX Venture Exchange. This means most companies will have to do number crunching well before the March 31 deadline for the Pan-Canadian Committee.

Officials with the Canadian Accounting Standards Board are reminding companies to explain in as much detail as possible how they arrived at their valuations by indicating what assumptions were used in their calculations.

The process is further complicated by the fact that there are at least 20 ABCP issuers with about 40 series of note among them, each series with different terms and conditions, says Peter Martin, the CASB’s director of accounting standards in Toronto.

An alternative to the discounted cash flow method for calculating values is to look at U.S. transactions in non-bank ABCP, which have been tracked by indices, he says: “We’ve seen such a range of reported values. The key is to disclose what your key assumptions are.”

The ABCP valuation problem is similar to the challenge of valuing other financial instruments, such as over-the-counter derivatives, portfolios of mortgage loans or a company’s property, manufacturing plant and equipment. “It’s more than looking up a quote in a newspaper,” Martin says.

Chris Hicks, principal of knowledge development for the Canadian Institute of Chartered Accountants in Toronto, says explaining the rationale is critical for investors: “Investors need to be able to see the process that management has followed.”

Companies also need to explain the impact of the change in category from a current (or near-liquid) asset to a long-term asset, Hicks says. “Does it affect financial covenants?” he asks. “If so, how? Does that affect the company’s strategy?”

Hicks notes a company may have had to seek alternative financing while the ABCP is being restructured.

Forensic accounting expert Al Rosen of Rosen & Associates Ltd. in Toronto feels accounting authorities should offer a range of writedowns to contemplate, especially as Canada will soon be adopting international financial reporting standards, which emphasize fair-value accounting.

“We should damn well come up with some standards of what fair value is,” Rosen says. “You can’t remain silent.”

Rosen’s firm conducted a research study of third-quarter results this past fall and found that one in five companies in Canada holding non-bank sponsored ABCP had taken no losses on their third-quarter earnings. He says hundreds of million of dollars more should have been written down.

Such companies also have drawn the attention of securities regulators, which have since reminded companies that regulators expect more realistic valuations. The CSA has warned corporations that they will be asked to refile financial statements if they are found to be “materially deficient or fail to meet relevant accounting and disclosure requirements.”

Said Jean St-Gelais, chairman of the CSA and the Autorité des marchés financiers in Montreal, in a statement: “Compliance with accounting and disclosure requirements is critical in a situation such as this, and we, as regulators, are carefully reviewing issuers’ disclosures.”

The CSA adds that companies must outline the impact of the holdings on their short-term cash needs, as well as the broader impact of the current credit market on their companies.

For its part, the Ontario Securities Commission is examining both financial statements and management discussion and analyses for disclosure.

“Ensuring that our accounting and disclosure requirements are complied with is always an important priority,” says Carolyn Shaw-Rimmington, assistant manager of public affairs for the OSC in Toronto. “Issuers who do not comply with our accounting and disclosure requirements can expect to hear from us.”

Companies that need guidance can seek advice from securitization experts such as Lorraine McIntosh, a partner in Deloitte & Touche LLP’s complex accounting and transaction expertise group. She says the most common methodology for situations in which quoted prices are not available is to do a discounted cash-flow analysis.

“You come up with a number of different scenarios of how you think the cash flows might play out over the life of the instrument you hold,” McIntosh says, “and apply an appropriate discount rate that takes into consideration the risk and the uncertainty associated with those particular assets.”

The key factor to consider in a valuation is the category of assets backing the notes, McIntosh says. This information is available at a high level in a Nov. 6, 2007, report issued by DBRS Ltd. that provides a breakdown of each of the deals in each series within each of the conduits — including the dollar size of the deal, the currency, the asset class, the rating and the presence of leverage.

“There’s the good, the bad and the ugly,” McIntosh says, “if you want to call it that.”

The top category includes traditional securitization transactions, such as mortgages, loans and automobile leases. “There will be some kind of a haircut,” McIntosh says of those notes. “But I would say most people aren’t expecting it to be very high.”

The “ugly” category includes subprime or almost subprime residential mortgages. For these notes, McIntosh says, losses could be up to 50% or more.

The middle ground is hardest to value, as it includes combinations of credit-default swaps or synthetic transactions with a few traditional securitization deals blended in.

“The more important message coming out of yearend is quality of disclosure,” McIntosh says. “Take your best shot at it, disclose the methodologies you followed and disclose the key assumptions that went into your estimation process.”

Companies should also outline a reasonable range of outcomes that would come if they changed some of the assumptions.

“Just try to get an idea of a range of values rather than a point estimate,” she says. “Because we all know that whatever point estimate you pick, it is probably going to be wrong, given the information.”

Although there are still many unknowns, it’s anticipated that the troubled part of the ABCP market will be stabilized with the help of a margin facility financed by the banks. Four banks have signed on to a deal that would back the proposed restructuring plan, which involves the creation of a new bond issue. TD Bank Financial Group has decided not to participate because it was not involved in the ABCP debacle.

The new bonds, which would replace the frozen ABCP, would have an average maturity of about seven years. However, that would be too long for some noteholders, says Daryl Ching, a structured finance expert and former employee of beleaguered ABCP issuer Conventree Capital Group Inc. of Toronto, which triggered the crisis this past July when it failed to roll over millions of dollars worth of paper.

As a result, desperate ABCP noteholders will be forced to sell at a discount in the secondary market when it opens up, says Ching, who now runs Clarity Financial Strategy Inc. , a Toronto-based consulting firm that offers advice to smaller, independent noteholders.

It’s not known how many individual investors hold ABCP, but Ching estimates that there are hundreds. At least two dozen Canaccord Capital Inc. clients have complained about their ABCP holdings, and a lawsuit has been filed against the Vancouver-based brokerage firm. Canaccord, which has written down its own ABCP holdings by 20%, has said its clients hold about $269 million in third-party ABCP.

Ching, who is observing the ABCP market to determine resale value on behalf of clients, says the only publicly disclosed sale of non-bank ABCP since the fall was by Calgary-based technology firm Westaim Corp., which sold half its paper in December for 70¢ on the dollar to a hedge fund. The company did not disclose which issuer’s paper it held, he says.

Ching says that even notes backed by solid assets would be subject to a writedown, if traded on the secondary market, because they are perceived as being distressed. That’s why there are buyers ready to pounce on the notes.

There are interested prospectors, including investment advisors, waiting to scoop up the ABCP at heavy discounts on the secondary market, Ching notes. The appeal is the prospect of an 8%-9% yield on AAA-rated assets.

“Buyers are sitting on the sidelines,” Ching says. “A lot of brokers and investment advisors are salivating at this opportunity.” IE