A, B, C, P??

Ross asked about Asset Backed Commercial Paper (ABCP) in the comments to a previous post, a topic I am reluctant to discuss for two somewhat contradictory reasons:
1) It cuts a little close to my day job and I try to keep that separate from the blog
2) I know very little about it and will probably end up saying something stupid.

First of all, keep in mind that markets generally face at least two types of risk.
The first risk is simply that the goods/services provided to a market turn out to be poor quality or get destroyed or lose value for some reason. In a toy market, you may find that many of the products are tainted with lead. In a mortgage market you may find that people can't afford to actually pay back their mortgages. Faced with a problem like this, there isn't much you can do as you are up against a cold unpleasant reality that won't budge.

A second risk is that there is a loss of confidence in the market. This is a well-known problem with the used car market. It is hard for sellers to get a truly fair price for selling used cars as buyers lack an effective means to assure themselves that they aren't buying a lemon. In an extreme case, confidence in a particular market will drop so low that nobody is willing to buy or sell anything and the market is effectively frozen - even though the products which are on the market may well still have value.

We can see how these two problems interact with each other. Say, hypothetically speaking of course, that house prices rise way out of line with both rents and incomes. At first the rising prices instill confidence in everyone. Buyers are confident that the value of their home will go up so they will buy at almost any price. Sellers are happy to be receiving more than they paid themselves. Borrowers are confident that they can make the payments and if they can't they can just refinance since the house will be worth more than they paid and be OK. Lenders are confident for the same reason.

At some point, people start to look down and get nervous. People are no longer willing to pay more for a house either because prices seem out of line (Problem 2: lack of confidence) or they won't pay more because they simply can't (Problem 1: the goods being brought to market aren't worth as much as the market thinks).

So prices stop rising and start to fall. Suddenly those borrowers who were just going to refinance when they got into trouble can't. Suddenly the lenders start to think about just who they've been lending to (if they even know!). There is a serious type 1 problem - people have mortgages on houses and they can't afford them. You can provide bailouts, or try to refinance the deals, or just let house prices fall and people suffer but one way or another, someone, somewhere makes up the gap in what prices were and what the value of the goods (mortgages) on the market really were. And of course having a real type 1 problem tends to cause a type 2 problem as well -> lack of confidence. And what was a virtuous cycle on the way up, becomes a vicious cycle on the way down


So, asset backed commercial paper. By 'paper' we mean short term. Less than half a year until it matures, normally. By 'commercial' we mean that this is a product generally issued and bought by companies (because it provides a good interest rate for a short term investment). By 'asset-backed' we mean that the money to provide the interest on this paper comes from interest payments that people (generally customers of financial institutions) are making on various loans: car loans, trade finance loans, mortgages - oh, you begin to see the problem.

So, all of a sudden, some of those assets that are supposed to be doing the backing - U.S. mortgages in particular - aren't looking as rock solid as they once did, which makes people nervous. Nervous = loss of confidence in the market. Aggravating the situation is the complex nature of the product. Most buyers of asset backed commercial paper have little idea what exactly the assets are that are backing it and how certain they can be that those assets are still good (or ever were in the first place!). Aggravating the situation further is the short term nature of the product. These things are maturing in large volumes all the time, meaning that they constantly need to be replaced either by new asset backed commercial paper or by some other kind of lending.

So, take a Canadian company, let's call them Coventree, which is heavily involved in buying asset backed commercial paper and selling it to companies. One month end, a pile of their short term ABCP is maturing so, as usual, they need to sell more to replace it - otherwise they won't have the money to pay the interest on all the outstanding ABCP they have already sold. But what happens? Nobody has enough confidence in what the ABCP is currently worth to actually buy any. Making things worse, the rating agency (DBRS) which used to gives its professional opinion that this paper was rock solid (AAA rated) is suddenly hemming and hawing and talking about re-rating things and changing its mind.

And here comes the final straw for the Canadian ABCP market. While in other countries, regulatory rules generally required the original issuers of ABCP to step in and provide liquidity support if necessary (i.e. to buy if nobody else will), the Canadian rules allow many ABCP issuers (many of whom are not banks and hence are not regulated the way banks are) to wiggle out of this responsibility and some of the people that issued the ABCP that Coventree was trying to sell decide to do just that, leaving Coventree holding the (now effectively worthless until a buyer can be found) bag.

So, Coventree announces that they are in big trouble and need some financial help in a hurry or they are going down (e.g. bankrupt). For now, they do the only thing they can do, they tell the people that they were supposed to give money to that they will get it later (extend the maturity on the ABCP). Coventree's stock plunges, there are big headlines in the business section, and if you thought that confidence was getting low in the ABCP market before, well, it's pretty much all gone now.

So, we're facing a classic second type of market risk - no confidence = nobody willing to buy or sell = no liquidity = a lot of companies stuck holding assets they had no plans to hold and a lot of sleepless nights for CFO's and the federal regulators.

Facing a crisis, everyone involved (banks, companies, pension funds, pretty much anyone who handles a lot of money) got together (in Montreal) to try and make a collective deal (Montreal accord) to restore confidence. In the end, they'll probably succeed. It's in nobody's interest to have the market remain frozen and, after all, while mortgages in the U.S. are certainly a mess, in truth most of the assets that are backing the ABCP are probably fine. So mostly it is just a matter of restoring confidence and getting the market back on it's feet, likely with some tougher regulatory rules to help provide that confidence and ensure that financial institutions which are charging fees for their support of ABCP in times of trouble - actually have to provide that support when called upon. For the moment, it's likely a game of chicken with buyers and sellers of ABCP trying to force the other side to take the losses involved in recognizing lower values for ABCP which will get the market moving again.

So that's the story, as best as I can understand it. Basically your standard issue short term liquidity crisis, triggered by bad mortgage lending, the creation of some not very transparent products, overly aggressive risk-taking and some regulatory oversight (or lack of oversight, depending in which definition of oversight you want to work with).

As for the moral of the story, hard to say - here's one interpretation. Free market fundamentalists will tell you that more competition is always good. But one of the things that more competition in the financial industry means is people/companies that are always inventing new financial products / rules to try and push the envelope and more often than not it just leads to a lot of unnecessary trouble and a belated realization that that envelope was where it was for a good reason. Sometimes more competition / deregulation just means more problems.

Final note: neither regulators or rating agencies are anywhere near infallible, so you always need to do your own due diligence. Or, as Kenny Rogers put it, know when to walk away, know when to run - and don't join in any poker games when you don't know how much the chips are actually worth.

Some more reading: A good article in the Financial Post which explains why the ABCP problems are potentially more severe in Canada than elsewhere.

A decent summary from the Economist.

The Economist again, on how ABCP is just the start of potential problems in short term commercial lending.

A summary from the Progressive Economics Forum.

Finally, everything I said only clearer and more accurate, a summary from OSFI (Office of the Superintendent of Financial Institutions) the Canadian financial regulator (an interested party with its reputation on the line, so keep that in mind as you read pp2-4) Note that even OSFI calls ABCP esoteric so I don't feel so bad for not understanding it particularly well... link to OSFI speech via Prefblog.