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originally made the mortgage loans.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
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
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
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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