Starbucks presented their 2008 Q1 earnings tonight. Revenue was up 17.5% to $2,767.6 million and earnings were up 1.5% to $208.1 million. After share buybacks, EPS was up 7.7% to $0.28.

There are many views on what Starbucks is or isn’t (one contributor to the Seeking Alpha blog thinks it’s a restaurant/real estate play) and what the stock, SBUX, should be worth. The discussion board on Google Finance contains many lively debates about this company and the stock.

You can probably guess my own opinion from the title of this blog but I thought I’d focus today on the words that Chairman and CEO Howard Schultz wrote in a Letter to Partners released today in the “press room” section of the Starbucks website.

This fiscal year, we will also open an additional 75 net new stores in international markets, increasing the international store opening target to approximately 975 stores. In 2009 that will rise to over 1,000 stores internationally, and mark the first time that our International store openings will outpace those in the U.S.

Everyone talks about the international opportunity but they are still a long way from getting there. Non-U.S. store sales are still only about 25% of U.S. sales and their operating margins last quarter were 10% versus 14.6% for the U.S. stores. However, even after dropping 44% over the last year, SBUX still trades at around a 22 P/E ratio. Justified?

In the coming months, you will see a renewed level of commitment to providing superior training for our retail partners. We will invest in tools and provide them with the resources they need to exceed customer expectations.

Just who are these tools that they’re investing in? The they in that sentence seems to refer to their retail partners. A Freudian slip or sentence malfunction perhaps?

We will utilize our 35-plus years of ethically sourcing, buying and roasting the finest coffee in the world to reaffirm our coffee authority.

My impression has been–through reading opinions on the web and interviews in Taylor Clark’s book–that coffee snobs have rejected Starbucks as a destination for quality coffee. There’s nothing surprising here. It’s hard to ensure a fresh and consistent product when you have so many stores to distribute to in so many places.

On another note, we have received a lot of attention in the last week about the $1 brewed coffee 8 ounce short test [...] I’d like to reiterate that Starbucks is built on premium coffee and a premium experience. We intend to maintain our leadership position at the high end, while broadening our appeal. And similar to other leading global consumer brands, we believe there are opportunities to create segmentation, provide an entry point for new customers, and generate trial in a way that will also maintain the value of our core brand proposition.

If I were an an investor in SBUX, this is what would really scare me. When Starbucks had the attention of the world and seemed capable of opening stores forever (and filling them with lineups no less) they were doing it without advertising and without discounting. Now I see print ads fairly regularly and this $1, free refill, coffee is basically a discounting program.

If Starbucks is selling a “premium experience”, I don’t see how they can broaden their appeal “similar to other leading global consumer brands”. You can segment and sell different kinds of shampoo but there’s only one kind of Porsche–the expensive kind. Thus, if the “Starbucks Experience” is just a consumer product, like shampoo, then what’s the upside for the stock at these levels?

“[Gartman] also suggested that even top traders like himself will be wrong 60 to 80% of the time or more. That’s why it’s important to sell quickly when it’s apparent a trade is not working out; and to pyramid profits and buy more when a pick works out and the market validates your idea.”

When I read these comments, I wonder just who the audience is at “Canada’s one-stop resource for investment education and financial guidance.” Are they mostly active traders who are trying to trade their way to riches? I just happened to be looking at Chevreau’s blog today but a quick flip through the newspapers or business TV programs will yield many more market commentators advising some sort of action or reaction.

They all remind me of the Warren Buffett quote: “Wall Street makes its money on activity. You make money on inactivity.”

Trading stocks can be a fun and rewarding hobby. But for most individual investors (who have day jobs, families, and don’t spend all day staring at a Bloomberg screen) I believe that a boring buy-and-hold approach to investing is more appropriate. This idea might seem blatantly obvious but it’s easy to forget with all the voices on internet blogs, newspapers, and TV encouraging us to trade something.

I had a coworker once who said that portfolio management is mostly about managing your emotions; and I think he was right. From my personal experience, I’ve found that it’s easy to get caught up in the excitement and the temptation towards activity. When fear (or euphoria) is high and all the talking heads are saying, DO something, it takes a lot of discipline to go back to a rational place and remember all the planning that went into creating my portfolio: investment objectives, time horizon, asset allocation strategy, and buying quality companies (good earnings, cashflows, identifiable growth plans, etc.) at reasonable valuations.

I guess I’m writing this blog today because the recent market volatility is starting to play with my emotions, making the cacophony of opinions resonate all the more, and because I need a reminder that I’m an investor and not a trader.

When reason is not enough to sit and watch dispassionately as my stocks go up and down 5% a day, I’ll use this bit of psychological trickery I found at the Motley Fool: How do you reduce the volatility of a stock? Don’t check the price.

ING DIRECT is once again challenging the high fees Canadians pay for investing and bringing diversification at a low cost to the masses with the launch of a new index-based mutual fund called the Streetwise Fund. The Streetwise Fund is a diversified balanced fund which incorporates several indexes in its investment strategy.

The selling feature is that retail investors can get low cost–the MER is 1%–diversification even if they have relatively small portfolios. This last point is relevant because many online brokerages still charge $29 per trade for small accounts (although the trend seems to be $9.95 pricing).

But is the Streetwise Fund’s 1% MER really low cost? The answer is no. Can you replicate it yourself for less using Index ETFs? The answer is yes.

Here’s an example assuming a portfolio of less than $6,000 (trying to keep equal weighting between the four indices):

This portfolio offers the same exposures as the Streetwise Fund: S&P/TSX 60, DEX Universe Bond Index, S&P 500, and MSCI EAFE.

The weighted average MER of these ETFs is about 0.18%. Even if you were charged $29 per trade, trading fees would be equivalent to about 0.41% over 5 years (4 trades x ($29 / $5711) / 5 yrs)* for a total cost of 0.59% per year–or 0.41% lower than the Streetwise Fund!

Other blogger coverage of the Streetwise Fund:

• ING Index Funds? HUH? [squawkfox]
• ING Direct’s Low-Cost Mutual Funds [Canadian Capitalist]

————–
*Or equivalent to 0.50% if you annuitize it over 5 years assuming a 7% discount rate.

• Audited (Annual) Financial Statements: Annual report.
• Interim Financial Statements: Quarterly report.
• News Release.
• Material Change Report
• (Management) Information Circular: The annual proxy circular. Use this to find out information on officers and directors, their shareholdings, and shareholders that hold more than 10% of the company’s stock. Note that the line here is 10% and not 5% as in the US.
• Insiders and >10% shareholders must file their transactions within 10 days. Note that this is different than the US SEC Form 4 for insiders that has to be electronically filed within 2 business days. The Canadian insider filings can viewed at the SEDI website under “Access public filings”.

• 10-K: Annual report
• 10-Q: Quarterly report
• 8-K: Current report filing. Read these to keep up to date with any material changes in the business.
• DEF 14A: Definitive proxy statement. These are annual reports to shareholders with information that must be distributed prior to the annual general meeting. Interesting sections of this report include names of officers and directors, their shareholdings, and shareholders that control more than 5% of the company’s stock.
• 4: Form 4 Statement of changes in beneficial ownership of securities. Read these to see if insiders are buying/selling stock. These must be filed within 2 business days of the transaction. Some of this information is summarized at http://www.secform4.com/.
• SC 13 D: Schedule 13 D Statement of acquisition of beneficial ownership. Use these forms to see what the >5% shareholders are doing. These must be filed within 10 days of the transaction.

Continued investment uncertainty

A look through Deloitte’s webpage on income trusts highlights that, even more than a year later, trustees still face many uncertainties that make the best strategic next steps not so clear.

Comments from an insider

John Risley, Chairman of Clearwater Seafoods, was on BNN’s SqueezePlay (Dec 5) speaking about–among other things–income trusts. He concedes that the government had a “really difficult problem” given the market’s extraordinary fascination with the asset class. He also raised some strong points for why the income trust industry was so important: trust mania helped small-medium sized companies access public equity markets, and, the structure encouraged good management accountability of excess cash in that management’s responsibility was to “payout all the cash” and say, “look if we want to do something we’ve actually gotta ask you [...] cuz you’ve got to put the cash back in the company”.

While it makes sense from a psychological point of view to buy over time and–hopefully–take advantage of market volatility (i.e. buy more shares lower prices and less shares at higher prices), my personal take is that dollar cost averaging is a good tool for saving & investing over time rather than a prudent investment strategy. To me, it doesn’t make any sense to allocate money to risky investments and then let it sit idle because you want to dollar cost average your way in.

Some links:

• Two instances of academic arguments against the strategy, versus lump sum investments, are Knight and Mandell (1993), and, Greenhut (2006).

• The folks over at MoneyChimp have created this calculator to back-test the two strategies (dollar cost averaging versus lump sum) and concluded that the dollar cost averaging “advantage looks like a myth”.

Despite the recent turbulence in the credit markets they have maintained their AAA rating (in Primus Financial Products LLC) and grown the portfolio. The notional size (amount of credit protection they’ve sold) of their portfolio at September 30, 2007 was $20.4 billion.

Economics–
One way of measuring the value of the business is to estimate the value of their backlog. Essentially the business model is a net interest margin (NIM) or net spread business. To illustrate, the $20.4 billion portfolio pays a CDS premium (like an insurance premium) of 46 bps annually. This portfolio is financed using debt and preferred shares that cost 14.5 bps to service. This makes the NIM 31.5 bps or $64.3 million annually. The value of the portfolio is the present value (PV) of this stream of cashflows: $226 million, or about $5 per share. As a comparison, the stock closed on Thursday at $6.53.

These figures were calculated using a discount rate of 5.35%, the yield on GE Capital bonds (let’s say this is the minimum cost of capital to Primus), and a tenor (or term) equal to 4 years.

The portfolio’s value represents the amount that a similar credit derivatives product company with the same skills, technology, and back office support (to avoid incurring additional operating costs) would pay to buy the portfolio. In other words, this is an absolute maximum value for the business at a given point in time. If operating costs were included in this analysis, the net spread would go from 31.5 bps to 8.2 bps, or 74% lower.

Growth is a risk–
The above analysis indicates that the stock is at least 23% overvalued. But this analysis looks at the portfolio at a point in time. What if it changes? Management can grow the notional size, extend the tenor, and increase the spread (spread ~ riskiness). Over the last four quarters, the portfolio has been growing at an average rate of 7% per quarter, or 31% annually. Can this continue? I think not:

• The portfolio is already quite large at $20.4 billion
• Continued fears in the credit markets may make it difficult to raise new capital at favourable rates
• The ratio of shareholders equity to portfolio notional has been declining over the last four quarters and now stands at 1.5%. This may make it difficult to grow without raising new equity capital which will be costly and dilutive to existing shareholders. Equity capital is undoubtedly required to maintain their AAA rating.
• While CDS spreads have risen dramatically in the last six months, the ability to trade into new, higher spread, contracts will be limited as the rise in spreads has resulted in negative mark-to-markets on existing positions.
• Defaults will change the capital requirements of the business and hinder growth. The historically low default rates enjoyed in recent years can not continue forever… can it?

I’m including a link to a summary of my PRS backlog analysis. The four scenarios at the top try to incorporate a suddenly larger portfolio size and longer tenor on day 1. The average stock price of the four scenarios is $6.42. Again, this backlog figure is the theoretical value of buying the portfolio and collecting the net spread without incurring any operating costs to manage it.

Here’s a brief–and greatly simplified–summary of some popular indices:

• The CDX.NA family of indices represent North American (mainly U.S.) corporate credits. The “.HY” stands for High Yield, “.IG” stands for Investment Grade, “.HVOL” stands for High Volatility, and “.XO” stands for Crossover (credits between high yield and investment grade). They are quoted in spread, which represents the premium in bps you would have to pay to buy protection on the index. For example, a spread of 76 on the CDX.NA.IG means you pay 0.0076% annually to buy default protection on the 125 names in the index. The index is “rolled” every six months which creates a new series.
• The iTraxx Europe indices are similar to the CDX.NA but for European credits.
• The ABX-HE (CDS on Home Equity ABS) indices are for CDS protection on tranches of subprime mortgage securities. As with the corporate credit indices, these are rolled every six months. Because of the nature of the underlying product, the labelling and quoting is a little bit different. The caption, “ABX-HE-BBB 07-2,” means its the ABX-HE index of BBB subprime RMBS tranches created in the second half (July) of 2007. It is important to remember that this is an index of BBB tranches from different subprime securitizations. So the exposure is to, say, 20 individual tranches but possibly thousands of underlying mortgages. Because of the timing of the roll this index would be mainly comprised of RMBS issued in the first half of 2007. If ABX-HE-BBB 07-2 quotes at a price of 22, this means you would pay 78% (=100%-22%) upfront (i.e. on day 1) and then 500 bps (or 5%) annually to buy CDS protection on this index. Sound expensive?
• The CMBX is similar to the ABX but for CMBS securities. It is quoted in spread.

One important caveat about these “indices” is that they are created based on the relatively high liquidity of the underlying names. They do not necessarily serve as a broad credit market proxy. For example, the CDX.NA.IG only has 125 names in it.

• FocusShares ISE-CCM Homeland Security Index Fund (MYP)
• FocusShares ISE SINdex Fund (PUF)
• FocusShares ISE-Revere Wal-Mart Supplier Index Fund (WSI)
• FocusShares ISE Homebuilders Index Fund (SAW)

24/7 Wall St thinks they’ve gone too far in becoming so specific and offers some new ETF suggestions, including a porn ETF.

• Why the OSC so rarely gets its man
  “More than 450 employees work at the Ontario Securities Commission. About 40% are paid more than $100,000 a year. Their dismal track record begs the question: What on earth are they doing?”
• Who’s in charge?
  Graphic of the “Canadian enforcement mosaic” (David Wilson).
• Why white-collar crime team fizzled
  “Launched four years ago to clean up markets, police squad is now best known for its failures.”
• OSC chief takes it all in stride
  “Under fire for perceived regulatory failings, David Wilson says he ’sleeps pretty well’.”
• Fraud squad lacking credibility
  “The elite teams became bogged down by bureaucracy, staff turnover, lack of leadership and low morale.”
• Richer rogues not on radar
  “New study on corporate crime suggests system is stacked in favour of influential industry insiders.”

For further depressing reading the ROB Magazine did a lengthy article on the Ian Thow (formerly of Berkshire Investment Group, which is now owned by Manulife Financial) case.

And also: Diane Francis’ take on the RCMP’s poor record on white-collar crime.

This type of behaviour is bound to attract criticism from other shareholders and market watchers. It can’t be anything but bad PR. So what would motivate an issuer to perform such a transaction? Are they getting good fees to do this? Is this is a favour to a long-standing and profitable client? It’ll be interesting to see if any further disclosure from the company is offered on this topic.

Here’s the Sun Life press release:

Sun Life Financial to purchase up to 2.55 million Common Shares for cancellation in Private Purchases

TORONTO, Dec. 7 /CNW/ - Sun Life Financial Inc. (TSX/NYSE: SLF) announced today that it intends to purchase for cancellation up to 2.55 million (0.46 per cent) of its common shares currently outstanding pursuant to private agreements between Sun Life Financial Inc. and an arm’s-length third-party seller (the “Private Purchases”) between December 12, 2007 and December 31, 2007. The shares purchased for cancellation pursuant to the Private Purchases will be included in calculating the maximum number of common shares that the Company may purchase through its normal course issuer bid share repurchase program that was announced on January 11, 2007.

The Private Purchases will be made pursuant to an issuer bid exemption order issued by the Ontario Securities Commission and a Notice of Intention to make an exempt issuer bid filed with the Autorité des marchés financiers in the Province of Quebec. The price that the Company will pay for the shares purchased under the Private Purchases will be negotiated by the Company and the seller, provided that in no circumstances will the price paid for the shares be greater than the closing market price of those shares on the Toronto Stock Exchange on the dates of the purchases. The Company believes that purchasing its shares under the Private Purchases at a price below the market price of its shares is an appropriate use of corporate funds.

None of the directors or senior officers of the Company, nor any associates or affiliates thereof or of the Company, nor any person holding 10% or more of any class of equity securities of the Company, nor any associates thereof are eligible to sell shares pursuant to the Private Purchases since the Company intends to purchase shares only from the arms-length third-party seller.

The same reminder message also told me to watch out for the superficial loss rules in the Canadian Income Tax Act. After some quick googling, here are two links on the subject by the Canadian Tax Foundation and by Wood Gundy. My understanding (although I’m no tax lawyer) is that the laws are in place to prevent investors from crystallizing a tax loss while maintaining an economic interest in the asset.

• China Resisting Pressure on Product Safety
  “The ’strategic economic dialogue’ begun by Mr. Paulson was meant to obtain greater access to the Chinese market for American goods, services and investments, as well as steps by China to allow its currency to appreciate in value against the dollar, making American goods cheaper there and Chinese exports more expensive for Americans. In return, China got a forum to air grievances with Washington.”
• China Cracks Down on Food Safety Violators
  “Beijing has been moving aggressively in recent months to complete a six-month long campaign to root out fake and substandard food, drugs, toys and other consumer goods, after a year of scandals involving product safety.”

It seems the plan is to charge $59.99 for the Platinum version of the software (the most flexible package) which allows for preparation of two (2) returns. This is as compared to the 2006 Standard version which covered “virtually all tax situations”, allowed five (5) returns, and sold for $39.99.

I for one will be switching to a cheaper CRA Certified alternative.

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.”

• The economy at large
  In his Blue Magic video Jay-Z flashes 500 Euro bills instead of the more traditional Dollar. Truly there is no single economic indicator more weighty than this.
• U.S. residential real estate
  While browsing the web today I came across this blog entry about rising “real estate owned” in Orange County. They’re foreclosing on mortgages in the O.C.?!
  
• The financial system
  There has been much, duly deserved, positive commentary of the bail-out plan for U.S. structured credit vehicles. However, I think it’s noteworthy that the final list of institutions who were able to step-up to the plate (Citi, BofA, JPM) all have very large commercial banking operations. Where were the money-centre banks? Perhaps they’re in so deep that they aren’t in a position to offer market stability. Contrast this trio to the broad consortium of counterparties that bailed-out LTCM.
• The future
  There was a PBS documentary on the other night about the “space race” and I was reminded of how fast the U.S. can move when they really put their minds to it. They have contributed as much as, if not significantly more than, any other modern nation in the development of science and math into techniques that alter the course of civilization and increase standards of living. But where does the education system focus its energies nowadays (remember that I’m an outsider and that I only see the country through the eyes of the American media headlines)?: abstinence-only sex-ed programs, breathtakingly inane battles over intelligent design, and charter schools that try to fill the void left by a public education system that is viewed as failing.

Why it’s a valuable management tool

Measuring risk quantitatively is a very important exercise for the purpose of financial risk management. You need to be able to quantify your exposures for the purpose of (among other things): setting capital reserves, reporting risk to regulators and investors, understanding how you’re doing in terms of managing your risk, creating scenarios for contingency planning, and, rating structured financial assets as ‘AAA’.

My naive generalization of the approach

Using a plethora of assumptions about probability distributions, relationships between asset classes, and all the required input parameters for such, you create a correlated loss distribution. In practice this is generated through simulation but in theory it is a nice continuous function. This distribution can tell you things like: how much will be lost with X probability? (you do this to calculate things like VaR or finding the rated attachment points in a CDO).

The real dangers

The problem with any purely quantitative approach, at least my version as outlined above, is that the “real” dangers to any financial operation are typically very lumpy/chunky/discrete. Examples:

1. When liquidity runs out (as with the Canadian conduit market right now, or with LTCM’s collapse), no matter how well positioned you believe you are, the game is over.
2. When a company defaults or goes bankrupt, and you’re holding the credit risk, you’re in big trouble fast. A colleague of mine once taught me that diversification works differently with credit. In your stock portfolio, your winners can make up for your losers, but the best a bond can ever do is pay you back.
3. Changes in the rules (whether from regulators, legislators, or even your suppliers) can completely ruin the economics of a business model. Check the monthly growth of the ABCP market across 2006 versus YTD 2007. This is after the press release from DBRS, DBRS Revises CDO Criteria for Canadian ABCP Issuers (January 19, 2007 ), saying CDO transactions must be, “supported by liquidity facilities from DBRS-approved liquidity providers that contain conditions to draw that are not limited to market disruption and are not dependent on a confirmation of the then-current ratings” (emphasis added).

The conclusion

While modern risk management is a mathemagician’s game, there’s always going to be an important role for people that can understand and make prudent judgements about fundamental risks that can’t be accurately modeled.

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.