Invest Skeptically

Over the last few weeks there has been intense media coverage of U.S. subprime mortgages (still), the securitization of such (still), Canadian ABCP programs (that’s new), and demands for new regulation (gasp). After much Googling and newspaper-flipping here are some of my comments.

U.S. Subprime Mortgages

I specify U.S. subprime mortgages because the Canadian version of the product is supposed to be relatively safe–isn’t it? (See chart of XMC). The media has been attributing the disaster in this industry to the ability to securitize the product. Underwriters were motivated to get more business by weakening underwriting standards and thereby making them more money when they eventually sold the mortgages to securitization programs.

• This shows a complete lack of ethical backbone. A large factor in the subprime blowup were these ticking time bomb products where the borrowers were enticed by low teaser rates for two years and then some GINORMOUS rate thereafter. How can you advise consumers to take such a product? I think history should remember this as the true scandal of the industry.
• This shows a complete lack of professionalism by the underwriters. You cannot just start underwriting junk for the sake of reselling it to the capital markets–albeit with a shiny new sticker on it. This is the financial equivalent to contaminating wheat gluten with melamine and selling it to pet food manufacturers as a high protein ingredient.
• Where was the due diligence from the investors in securization paper? Even without specialized knowledge there should have been enough scary signs in the prospectuses to set off alarm bells for credit managers and cause them to demand higher yields and more information on the underlying mortgages.

Canadian ABCP Programs (a.k.a. The Canadian Conduits)

The story here is that the independent Canadian conduits (to distinguish them from the Bank sponsored kind) have been unable to roll their commercial paper. This is an asset-liability matching problem where you have long dated assets (say 5-10 years) and short (say, 30-day) liabilities. The conduits managed this by essentially making the interest rate risk of the assets much shorter–that’s how the rating agency can believe that CP investors will be paid their interest and principal. But the value of the assets are not so much interest rate sensitive as they are credit market sensitive. And credit markets have not been a happy place (read: value goes down). So how do you pay back investors every 30-days? Just find new investors. There are no new investors? Uh oh…

What normally happens, were this corporate CP or U.S. style ABCP, is that a liquidity provider steps in and pays back CP investors. The reason this has not happened across the board is because under Canada’s DBRS regime ABCP was (but no longer) covered only under General Market Disruption (GMD) liquidity. The basic idea of GMD is that your liquidity providers must step in when Canada’s ABCP market becomes totally broken. A highly unlikely event given that, even now, bank sponsored conduits are still able to roll their CP.

• The most important point to make is that there have been no reports (that I could find on Google) of any credit related problems in these conduits. So while news reports talk about U.S. subprime mortgages and the Canadian conduits in the same breath, you can not assume that these conduit assets have had any problems. On their website, Global Securities Corporation reports that Coventree sponsored conduits have less than 4% exposure to U.S. subprime and all in pre-2006 vintage (read: before the poor underwriting mentioned above). So what’s the problem? These conduits are suffering through a period of poor liquidity in the CP markets–not necessarily poor credit quality in their portfolios. This is not entirely clear when you see Barry Critchley’s column (August 23, 2007) where he begins by quoting a voicemail message saying, “What happened here is that a bunch of people who were supposed to be watching credit quality took their eye of the ball and let a lot of stupid stuff get done in the market.”
• In the same article Critchley points out that CP investors (usually large institutional buyers or corporate treasuries) have been paid 12-14 bps more than their U.S. counterparts because of the GMD language. In other words, they knew, or should reasonably have been expected to know, what they were getting themselves into and accepted compensation for the extra risk. I tend to agree.
• While both the conduits (particularly Coventree because it’s the only public company) and DBRS have taken a lot of heat in the media, the money market managers buying the paper had a responsibility to know what they were buying. Much ink and server space has been used to ponder, “Are Money Market Funds Really Safe?” In his most recent column (August 24, 2007) Critchley quotes a money manager as saying, “[my clients] are having ulcers about their hard-earned savings, which were supposedly invested in low-risk commercial paper.” Where are the articles asking, “how much does my money market fund manager make and why does he/she deserve it?”
• As for the corporate treasuries that bought R-1 (high) ABCP and got unwittingly burned (or maybe just warmed so far), some blame must be laid upon the financial advisors that put them in this product without understanding what it was all about and clearly communicating the risks to their clients.
• Worst case scenario: the independent conduits can’t refinance the CP and have to wind down the trusts. Existing CP investors get paid back whatever the market value of the assets is. Which is…??? I think history should remember this as a serious failure in the investment process. While money market managers were buying this paper (on behalf of ordinary consumers), and financial advisors were telling corporate treasuries to buy it, did anyone actually know what was in these things? And what the NAV was? Do they know that now? Has anyone even bothered to ask the sponsors? Did they ever ask? My Google search is silent on this question.

Regulation

Of course, all this market commotion causes people to start thinking about regulation, or an increase thereof. At first I was a bit shocked and offended when I saw the title, “Thinking the Unthinkable: Regulating the Brave New World of Finance,” on the naked capitalism blog. In this post, the author quotes Clive Crook of the Financial Times as writing, “financial innovation itself is the problem.” Well that doesn’t sound too good.

In another post, naked capitalism quotes Henry Kaufman (a.k.a. Dr. Doom) as writing,

“At the heart of the long-term underlying challenges that face the U.S. financial system is the question of how to enforce discipline. One way is to let competitive forces discipline market participants: The manager who performs well prospers, while those who do not fail. This is the central precept of free market economies. But this approach is compromised by the fact that advanced societies typically do not allow the process to follow through when it comes to very large financial institutions. The fear is that the failure of behemoth financial institutions will pose systemic risks both here and abroad.”

I think lack of discipline stems from a lack of professional and ethical standards. A colleague of mine once said that, “people are either ethical or they’re not;” meaning ethical “standards” won’t do much to reform them. After factoring in the not-so-healthy dose of greed of most capital markets participants, I’m starting to come around to the idea of increased regulation. Or different regulation. Or maybe just some subtle but targeted measures as required.

But how can you enforce market discipline without tying the hands that make the markets efficient? Even in hindsight, cause and effect relationships are difficult to work through. For example, what if banking regulators had required the same amount of capital reserves for GMD style liquidity as U.S./International style liquidity? That’s a subtle and targeted measure. But would we have got to where we are now anyway?

The Conclusion

As usual, the lesson from subprime and ABCP is to know what you’re buying and invest skeptically. I’ve said it before and I’ll continue saying it, until, one day, investors change their ways and I’ll have nothing to write about.