The Big Freeze
IN PRINT ARCHIVE CIR Winter 2007
By Marlene K. Puffer, managing director, Twist Financial Corp.
Fixed income markets have been in the headlines since mid-summer 2007, with the spotlight on mortgage-backed securities, structured products, corporate credit, and liquidity. The impact on Canadian institutional investors who steered clear of U.S. Credit Default Obligations (CDOs) or Structured Investment Vehicles (SIVs) has been mainly indirect through the repricing of risk and mark to market valuation impacts on other credit investments like corporate bonds. However, there are many investors who have taken a direct hit and remain mired in negotiations to sort through the mess in Canadian Asset-Backed Commercial Paper (ABCP).
ABCP provides short-term funding to conduits (typically trusts) that hold portfolios of longer-term (typically five to 10 years) financial assets such as credit card receivables, prime and subprime mortgages, and other types of loans, as well as CDOs, which themselves contain financial assets and derivatives, often on a highly levered basis. In this article, I explore the dynamics behind the ABCP market and the role of the U.S. subprime market in creating the liquidity problem currently facing Canadian investors.
The trigger for the global liquidity mess was rising defaults in the U.S. subprime mortgage market. This was coupled with a lack of transparency in CDOs and ABCP conduits. This lethal mix exploded in fear and panic as investors worried that there could be more subprime mortgages buried within structured investment products that could lead to more defaults than they had previously anticipated. Concerns arose that the structural enhancement within the conduits and CDOs would provide less protection against default than previously believed, and there was insufficient information to assuage these fears where warranted. Liquidity evaporated rapidly as investors feared the worst. In Canada, the tinder was particularly dry as the liquidity backstop protection provided by banks to many ABCP conduits differed from the global standard and was not triggered for conduits that were not sponsored by the big Canadian banks. ABCP investors in these third-party conduits were left holding portfolios of long-term assets when what they thought they bought was a high-quality short-term liquid investment.
Conundrum – overview
The simplest form of credit enhancement is overcollateralization, which means there are more assets in the pool than are required to pay off the investors in full, with the cushion determined by the default assumptions. Other forms include reserve accounts to cover excess losses. Fears were sufficiently intense this summer as investors perceived that the credit enhancement would offer insufficient protection, and that even highly rated securities could suffer losses. This fear contributed to refusal to roll over their investments in ABCP or other short-term funding for structured vehicles.
Structures are also designed with liquidity enhancement to provide protection when buyers do not materialize. Liquidity enhancement takes various forms, including extendible notes, and liquidity facilities such as liquidity loan facilities, where a loan can be drawn to finance the assets, or liquidity asset purchase agreements, where the assets are purchased out of the conduit. This type of liquidity is available on a same-day basis. Liquidity enhancement does not cover defaulted assets in most cases—this is usually covered through credit enhancement. Clearly the rating of the liquidity provider is an important determinant of the rating of the ABCP.
Global style liquidity can be triggered in two general circumstances: if the specific conduit is unable to obtain funding within a certain time period and at a specified spread level, or a general market disruption that affects all ABCP. For most Canadian ABCP, the triggers were weaker than in other markets and only included general market disruption clauses. Only a handful of conduits had global style liquidity. Strong liquidity enhancement can mean that there is less need for extensive credit enhancement.
The added complication is that many structured products have poor transparency. The information flow is particularly limited and complex for structures that contain CDOs that may themselves contain other CDOs. Investors do not have access to detailed information about the quality of the individual loans or their delinquency rates, and in the case of CDOs, the relevant details may be layers deep in documentation. This lack of transparency began because banks did not want their competitors to see details about the loans they were securitizing, and other conduit sponsors wanted to prevent competitors from easily copying their structures. Rating agencies and investors did not insist on change. This approach continued due to strong demand for these assets by investors who were willing to accept tight spreads and limited disclosure in a market hungry for yield.
The contagion effect of subprime mortgages arose due to widespread securitization that placed prime and subprime mortgages in the hands of investors who had no role in the origination of the loans, and thought they were buying controlled risk exposure to diversified portfolios of financial or synthetic assets through ABCP, CDOs, and SIVs etc. mortgages and mortgage-backed securities are held directly in conduits, and indirectly through CDOs that may hold additional mortgages. For some conduits, investors may only know that some assets are residential mortgages, with no assurance whether they are prime or subprime. In some cases, investors may be aware that a fraction of the portfolio is subprime mortgages, but have no information about the quality of the loans. The fear factor kicked in and liquidity deteriorated, as investors feared the worst in the absence of full disclosure. Conduit sponsors who underestimated the potential for a liquidity crunch and were slow to reassure investors (or may not have had reassuring information to offer) exacerbated this.
ABCP Market Dynamics
The U.S. and European ABCP markets are larger in absolute terms, but only a fraction of their CP markets: 50% in the U.S., and 30% in Europe. By June 2007, the $280 billion Canadian money market consisted of $117 billion ABCP, compared to $21 billion of Government of Canada T-bills and $56 billion of Banker’s Acceptances (BAs), and $60 billion in other Commercial Paper (CP). Trading volume in ABCP far exceeds volume in BAs or T-bills, roughly $40 billion per month compared to roughly $30 billion for BAs and $20 billion for T-bills.
For years, fixed income investors have faced low yields and tight credit spreads and have been on the hunt for extra yield. Many money market investors were keen to invest in high-quality assets that offered a spread despite ratings from a single rating agency and poor disclosure. Most global ABCP is sponsored by a major bank, which also provides a liquidity backstop. This type of bank-sponsored ABCP dominates the Canadian market. However, Canada also had a sizable market for independent conduits that drove most of the growth in Canadian ABCP since 2004. As of the end of 2006, independents were roughly 48% of the $117 billion of ABCP outstanding, up from roughly 15% of the market in 2004 (source: DBRS).
Bonds that are sold in Canada generally have ratings from at least two agencies. ABCP has been the exception with only one rating available. The other rating agencies clearly stated their opinions that they could not rate Canadian ABCP conduits since the liquidity provisions were inadequate by global standards. Prior to August 2007, investors did not vote in sufficient numbers with their dollars and insist on more than one rating. Deals were successfully sold with tight spreads, so there was no incentive for sponsors to change their single-rating approach.
Times have changed dramatically as DBRS has finally changed their standard to match the other rating agencies requiring global style liquidity for all ABCP. Banks are, and will continue to be under Basel II, required to provide capital reserves for this style of liquidity backstop since it means they bear more risk than with General Market Disruption style liquidity. This makes ABCP more expensive to issue. The evolution continues. The ABCP market may revive itself eventually, likely without third party-sponsored structures.
Major U.S. banks are creating a super fund to try to clean up the SIV market without taking the assets on balance sheet, but at this point the plan is to only buy high-quality assets into the fund and it is not clear how this will help. Some banks have taken assets back on balance sheet, and have funded in the term markets. In Canada, in the third quarter of 2007, 75% of new bond issuance was by banks. Along with fear and writedowns due to subprime and CDOs, this bank funding need has contributed to corporate bond spread widening, despite an absence of major corporate credit events.
Regulators and others who monitor or influence the financial markets are all looking for answers and responses. Disclosure is likely to be the main focus of their responses to facilitate smooth functioning markets without undue regulatory interference. The liquidity crisis has highlighted that investor due diligence is critical and that reliance on ratings alone for opinions about complex financial assets is insufficient for investment decision-making. Clearly, in order to conduct adequate due diligence, information is required. Investors have finally spoken with their dollars and markets are responding.