Crawl Across the Ocean

Friday, November 02, 2007

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.


  • Thanks for linking to PrefBlog!

    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.

    I am not aware of regulatory rules anywhere that require liquidity support of any kind from anybody.

    The "Global" liquidity support on most American ABCP stems from two factors: (i) the default of Penn Central in 1972 (?). Following this default, it became virtually impossible to sell commercial paper in America without guaranteed backup liquidity. ABCP may be Canada's Penn Central moment. (ii) The provision of global liquidity support entails some risk for the provider - in the case of Canadian ABCP, that could have meant a demand for bank loans totalling $40-billion over a very short period of time. When this stuff was getting started, Canadian regulations were more strict; the banks were required to make capital provisions for the lines equal to one-tenth of the provision they would have had to make if the line was actually used. In the States, no capital provision was required. This made global liquidity support cheap in the States, expensive in Canada.

    The Fed now requires capital provisions similar - if not identical - to Canadian provisions; a tacit admission that the looser rules endangered the soundness of their banking system.

    Regulators world-wide are now looking at the question more closely; I suspect that the 10% Credit Conversion Factor will be increased somewhat. My preference would be for a tiered system; that is, for instance, a bank could provide a line equal to its capital at a CCF of 10%; the next capital equivalent's worth of guarantees would be charged at 20%; and so on.

    The current SIV crisis - which MLEC is supposed to resolve - is the same story as Canadian ABCP. The conduits can save money by not purchasing back-up lines and can therefore pay a little more for the assets and/or pay a little more for their financing. It's a perfectly straightforward risk/reward business decision.

    Incidentally, can you support your statement that DBRS is changing ratings? As far as I am aware, the credit on these instruments is still perfectly good; it's the liquidity - the confidence, as you say - that's lacking. DBRS has changed their rules to require global liquidity backing, but this has nothing to do with the actual credit.

    There are only three financial institutions of which I am aware that got into significant difficulty with ABCP: National Bank, the Caisse and Dundee Bank. The first two may have had a strategic purpose in their investments; Dundee was such a small player it doesn't matter.

    For companies with 10% or under in ABCP, I have nothing but sympathy, although they don't need it much. It was an investment, it was a good investment, it went wrong. Sad, but it happens. That's why you diversify.

    The private companies that are in trouble are the ones who were speculating wildly with shareholder money. Their boards should, by now, understand that the simple ability to cut a cheque for $10-million does not make anybody a competent portfolio manager.

    By Anonymous James I. Hymas, at 1:34 AM  

  • Thanks James, it's good to get a more informed perspective.

    My comments about regulatory rules were based on media comments such as, "In Canada, liquidity suppliers did not have to provide funding except in catastrophic circumstances." from the FP.

    As for DBRS, their comments about potentially changing ratings were fairly widely reported at various points of the crisis here for example. Or see here for DBRS' comments throughout.

    And as for financial institutions getting into trouble with ABCP, keep in mind there are multiple ways to get into trouble - you might get sued by your clients for instance :)

    By Blogger Declan, at 9:03 AM  

  • "In Canada, liquidity suppliers did not have to provide funding except in catastrophic circumstances."

    This is indeed true, but it is not due to any regulations. It's because investors were willing to buy the paper without a global liquidity guarantee.

    DBRS said on August 24: Since their inception in 1989, Canadian ABCP issuers have used backup liquidity facilities that may or may not be limited by market disruption as a condition to draw. Additional developments in the ABCP market have introduced floating-rate notes and extendible commercial paper, neither of which have backup liquidity facilities (collectively, ABCP). The rating approach DBRS takes for Canadian ABCP is to base ratings on the credit quality of the underlying assets of the ABCP issuer, including structural enhancements as well as the collateral supporting note issuance.

    During the weeks of August 13 and August 20, 2007, DBRS noted that while many ABCP issuers continued market issuance activities in the normal course, a number of ABCP issuers were unable to roll their ABCP maturities. In these instances, backup liquidity facilities were drawn upon and while liquidity was advanced in several cases, in others they were not. In cases where liquidity was not advanced, investors may now be exposed to mark-to-market risk in the underlying assets.

    The breadth of ABCP issuers, asset types, sponsorship, structures, liquidity language and market disruption considerations involved in this situation suggest that any revisions to current criteria will require examination of multiple factors. DBRS will review its criteria for rating Canadian ABCP and publish any revisions to its criteria as they are developed.

    “We periodically update our ratings criteria to reflect observed events as well as future expectations,” says Huston Loke, Group Managing Director and Global Head for Structured Finance. “In light of events in the Canadian financial markets over the last two weeks, we will be reviewing our criteria for rating Canadian ABCP.”

    These changes were made on September 12. It is important to understand that these changes relate to liquidity provisions, not to the actual credit.

    You might, for instance, buy a Royal Bank GIC with a five year term. The credit is perfectly good - it's even got a CDIC guarantee, subject to limits per individual! This does not necessarily mean you will be able to sell it tomorrow at a price that you consider fair - there is not much liquidity in the secondary market for GICs!

    Liquidity and credit quality are not the same thing; a fact that many participants did not fully grasp. DBRS is changing its rating process to include liquidity risk, but they are not, as far as I am aware, hemming and hawing on the credit risk.

    There has been one ABCP lawsuit so far, which the plaintiff's lawyer is taking pains to make clear is based on misrepresentation, not ABCP issues per se. I commented on the lawsuit on October 24th and 25th.

    There may be more lawsuits. There are many, many people out there who think that because a stockbroker has a fiduciary duty to his client, therefore the institutional desk must have one as well.

    By Anonymous James I. Hymas, at 1:09 PM  

  • Thanks Declan and James!

    The post and the discussion has been most helpful.



    By Blogger Gazetteer, at 6:47 PM  

  • DBRS Downgrades Apsley Trust to R-4 from R-1 (high); Under Review with Developing Implications


    There's some hemming and hawing for you!

    By Anonymous James I. Hymas, at 3:24 PM  

  • Where R-1 is the highest rating going, and R-4 is speculative. Nice.

    By Blogger Declan, at 11:23 PM  

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