John Chant
Friday, January 23, 2009


The head security regulator of Quebec has asked whether the asset-based commercial paper collapse could have been avoided. My answer is yes, the crisis was avoidable.

It was not a rare unpredictable Black Swan event. Nor was it a perfect storm where many unfavourable forces come into an improbable alignment. ABCP was an unstable financial instrument that should not have had a market, especially from safety-minded investors. Without a market, the crisis would not have occurred. How then did a broad market develop for such a flawed investment?

First we need to consider what was ABCP and what were its flaws: ABCP consisted of short-term notes issued to the public by a trust that held a portfolio of longer-term assets collected by the trust's sponsor. The character of both ABCP trusts' assets and its financing contributed to ABCP's inherent fragility and instability.

The 30-to 90-day maturity of the notes issued by the trusts and the longer-term nature of assets forced the trusts to continually seek refinancing for maturing notes, leaving them highly vulnerable to the vagaries of market conditions.

The assets acquired for the trusts by their sponsors included packages of securitized mortgages, many of which contained U. S. subprime mortgages. These packages were not acquired from the parties that originally made the mortgage loans. Rather the trusts were often several steps removed, as the original lenders had sold the mortgages to others who, in turn, may have repackaged them and sold them on again. Outside observers were unable to determine the quality of the trusts' portfolios because of the many layers separating the trusts from the original mortgage lenders.

The ABCP trusts also held synthetic assets in the form of credit derivatives. Surprisingly, they did not buy derivatives to protect themselves against credit risk but instead wrote them to take on the risks of others. Even more surprising, they did this on a levered basis that magnified their exposure to risk. These transactions also required the trusts to put up additional collateral to back their commitments according to market conditions.

In light of the trusts' asset-liability mismatch, their exposure to subprime mortgages and their credit derivative position, ABCP trusts were essentially hedge funds, albeit with capped returns. They offered investors high risk together with low returns. All in all, they were totally unsuitable for investors seeking a safe haven and would have had few takers had their true nature been known. A broad market developed through a combination of limited information, forbearance from securities administrators and positive credit ratings.

The sponsors of ABCP released only sparse information, and that information tended to reassure investors. Investors in Comet Trust, for example, were told that the trust's sponsors would exercise the same care as they would if acting on their own account, that assets would be acquired only from sources approved by the rating agency and that a liquidity agreement would be in place for repaying notes in case of a market disruption. Only passing reference was made to the possibility of involvement in credit derivatives, with no mention of exposure to leverage or the fact that they would be using these instruments to undertake additional risk.

It was an exemption from prospectus requirements that allowed sponsors to offer such limited information. This exemption, intended for issuers of traditional commercial paper, was unsuitable for an instrument as risky and complex as ABCP. Normally, this meagre information would have rung alarm bells and have driven investors away. But this did not happen. The very fact of the exemption appeared to give investors confidence that ABCP was comparable to investments exempted in the past.

The ABCP market was also broadened by the favourable credit ratings given to the notes by a credit rating agency. These ratings made ABCP eligible for investment from many institutional investors including pension funds, mutual funds, life insurers and government agencies. The ratings also had an important psychological effect: Investors were assured that transactions would be reviewed by the credit rating agency and that only securitized ones rated R-1 (high) would be held by the trusts. With these assurances, investors could be excused if they attached credence to the ratings and treated ABCP issues as safe investments.

The end came for ABCP in August, 2007, when concerns about the U. S. subprime crisis left the trusts unable to roll over their maturing notes, causing the $29-billion market to freeze. The resulting muddle was finally sorted out only in early 2009.

What can be done to prevent a replay of the crisis? First, there are some actions that should be avoided: It is neither feasible nor desirable to police all security issues in the hope of protecting investors. It would be a mistake to always treat the elements of ABCP as dangers to investors. Each on its own makes a valuable contribution when used properly. Maturity mismatches between lending and borrowing are at the heart of the business of banking but take place in a controlled framework that offers protection to depositors. Securitization enhances the funding and investing opportunities available to businesses and households. CMHC has used securitization to foster housing finance since the early 1980s. And the use of derivatives has a long history of protecting farmers, materials producers and investors from market fluctuations.

Steps can be taken to make investors better informed by having securities administrators tailor their disclosure requirements to the characteristics of investments rather than the labels they go under. The present privileged access to information granted to credit rating agencies should be removed, allowing other financial observers, such as journalists, analysts, investment managers and even the investors themselves, to have access to information on the same basis. With these changes, investors would be better able to recognize flawed investments such as ABCP as dangerous to their financial health. - John Chant is an Emeritus Professor at Simon Fraser University. A fuller treatment of the issues can be found in his ABCP Crisis in Canada: Its Implications for Financial Regulation which was prepared for the Expert Panel on Securities Regulation and is posted at www.expertpanel.ca.

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