Invest Skeptically

Last weekend (Nov. 17, 2007) the Globe and Mail published a good summary of the Canadian ABCP story called, The ABCP black box explodes, by Boyd Erman, Jacquie McNish, Tara Perkins and Heather Scoffield.

The reporters correctly point out that the main “trigger” behind the Canadian ABCP conduit crisis was that “investors were beginning to panic that an unknown quantity of toxic subprime mortgages had infected the assets that backed Canadian ABCP”. In fact, “had investors been able to clearly comprehend the workings of Canada’s ABCP, they might have known that subprime holdings were minimal. The boycott of buyers, and the frozen market that resulted, could potentially have been avoided.”

They quote Huston Loke, of DBRS, saying, “everyone was very conservative, from a credit perspective.” And, in general, I believe that.

There are many stories out on this subject with the majority of them leaning towards outrage and astonishment that such “toxic” products were rated AAA (or R-1 high in this case). Barry Critchley quotes Diane Urquhart as saying, “distributors [of ABCP] should also expect to contribute to accommodating settlements [...] since they too were part of the negligence or deceit in the provision of this defective product to Canadian pension funds, governments, corporations and thousands of retail customers.” (Emphasis added).

This tone from the press has permeated into the general public. On the Globe’s website for their ABCP piece a reader calling himself Henry Egan, from Cyberland, Canada, writes: “when no one knows or cares what the nature or quality of the underlying assets are, what was to prevent the lenders from deliberately creating, securitising and ejecting all of their junk onto the marketplace as high yielding ABCP’s?”

I think that the reporting to date has been very muddled in terms of the source of risk for investors. The ABCP issue can be broken down into three sub-risks: (1) credit; (2) liquidity; and (3) market risks.

1. Credit Risk - Continues to be relatively low

I believe the statements out of DBRS that the credit quality of the underlying assets is generally good. To reach a AAA rating, these transactions were structured with relatively high attachment points, or, levels of subordination. Subprime exposure was low and much of the exposure in single tranche synthetic CDO transactions (or CDS on a CDO tranche) involved corporate credit as the underlying.

And how is corporate credit doing these days? I saw this headline on the Default Research section of the Moody’s website:

Global corporate default rate hits lowest level since 1995; 1.1% in October
Despite diminished liquidity and volatility in the credit markets, the global speculative-grade default rate continued to fall in October, reaching 1.1%, its lowest level since March 1995, our latest default report reveals. The rate has now declined approximately 33% from the beginning of 2007.

2. Liquidity Risk - Usually very low… until it’s not

While it is a fact that Canadian ABCP operated under “general market disruption” language for its liquidity backstops rather than the more robust “global-style” arrangements, the risk of funding problems (i.e. rolling the paper) is low as long as the market continues to function normally. So while the Globe characterizes the conduit business as being great until “someone stops paying their mortgage,” the greater risk to the business model is that commercial paper investors will stop buying commercial paper. And that’s where we are today.

3. Market Risk

I once heard a speech in Toronto by a rating agency spokesperson who said that investors want “risk-free spread.” (This same speaker also said that the leveraged super senior transactions inside the conduits were, “very AAA”.) Canadian ABCP investors were being paid relatively high interest rates for top quality, short maturity, debt. So what type of risk were investors being paid for?

Market risk.

In the absence of robust liquidity backstops, CP investors were still protected in that the trusts could sell their underlying assets to repay the commercial paper. However, as the Globe article points out, under current conditions “there would be a fire sale of assets in tumbling markets, and ABCP investors would have no chance of getting all their money back.”

Conclusion

ABCP investors now find themselves stuck in the unenviable position of holding high credit quality paper with underlying assets that can’t be sold into falling credit markets, and, with a current illiquidity in the CP market that makes it undesirable to other would-be purchasers.

While much blame has been apportioned to the investment banks behind the CDOs, issuers and dealers of commercial paper, and DBRS, at the end of the day there is no such thing as “risk-free spread”.  All money managers, advisors, and consultants had an ethical duty to their investors/clients to exercise care, diligence, and skill when making investment recommendations and taking investment actions. And presumably this included understanding the risks they were taking.

I’ll close with this David Dodge quote from the Globe article:

“The responsibility lies on the investor and if he or she takes risks, they should expect to benefit if things turn out very well, and should be expected to pay the costs when things turn out not so well.”