As everyone is now painfully aware, a liquidity crisis in the Canadian Asset Backed Commercial Paper ("ABCP") market commenced in August of last year, resulting in a number of large institutional holders of that paper putting together a rescue package. The package initially was called the "Montreal Accord" and has subsequently resulted in the filing of a Plan of Compromise and Arrangement ("Plan") under the Companies' Creditors Arrangement Act ("CCAA").
The concept of the Plan is to "term out" the affected commercial paper without, in the vast majority of cases, material reduction in value to any holder, provided they are prepared to hold the commercial paper to maturity. The ABCP market emerged because of a large demand from institutional investors and others for high-quality assets (as measured by rating agency criteria) with returns better than those of comparably rated government securities. Special purpose trusts were formed to issue short-term commercial paper to investors and use the proceeds to buy assets with the appropriate risk characteristics, resulting in yields consistent with the investors' expectations.
One of the issues that needed to be addressed within these structures was that the commercial paper was generally short-term in nature while the assets were longer-term. Liquidity facilities were arranged under which financial institutions agreed to provide funding to purchase commercial paper in circumstances where new investors were not available to cover any funding gap on the periodic turnover of the commercial paper.
In August of 2007, more investors wanted to sell their paper than wanted to buy and the providers of liquidity, by and large, were of the view that the circumstances required to take advantage of their liquidity facilities did not exist. The market froze. A lot of legal effort has gone into parsing the terms of the liquidity facilities and speculating as to whether "Canadian" as opposed to "global" language should have been used. That debate appears to be largely irrelevant as all of these markets have frozen, on both sides of the Canada/US border, regardless of the liquidity trigger events employed.
Historically, the types of assets purchased by these special purpose trusts were financial assets such as automobile leases, commercial mortgages, insured personal mortgages and other similar assets. Pools of these assets might achieve a credit rating higher than any individual asset because of the broad distribution of the payors of the assets both geographically and individually, and the existence of fairly reliable statistics on default rates for particular asset classes. However, the demand for ABCP outstripped the availability of these "traditional" assets and financial institutions began to assemble more exotic instruments that were intended to meet the necessary criteria.
Credit default swaps were often used to fill the asset gap for commercial paper. Indeed, traditional assets backed less than 20% of the estimated $30 billion dollars in ABCP that defaulted in August of 2007.
Credit default swaps used for these purposes were usually structured so that the protection seller was the special purpose conduit and the protection buyer was a financial institution. The protection being purchased was often protection against default of a slice of debt in a reference portfolio where the likelihood of default was extremely small, thereby meeting the rating requirements of the rating agencies. To satisfy the return requirements of investors, the credit default swaps were often significantly leveraged so that the protection seller would agree to pay 10 or even 20 times the default amount should default occur. After all, if the likelihood of default is so low that it is almost zero, ten times zero is still zero.
However, the risk of default was not zero and when the residential mortgage crisis occurred in the United States, it became clear that the lenders making the underlying loans had been overly aggressive in their lending practices. The potential for default in an asset category that had been quite small increased substantially. Not all reference assets in all the credit default swaps were related to residential mortgages, but some were and some of the debt obligations forming part of those reference assets were from entities engaged in the sub-prime mortgage market in some direct or indirect way and therefore were directly or indirectly affected by failures in that market place. Accordingly, the risk profile of the reference assets in the credit derivatives increased dramatically.
In the meantime, many credit derivatives were not fully funded. That is, the money raised from commercial paper offerings by the conduits and deposited with the protection sellers to cover the protection buyers' obligations, should a call be made under the relevant credit derivative, was not 100% of the amount that could theoretically be called. Sometimes the collateral amounted to 10% or less of the potential claim.
Under the derivative contracts, the protection seller's exposure is determined based upon what the protection seller would need to pay in order to replace the credit derivative that it has on its books. Accordingly, if on day one a protection buyer paid $0.20 for a million dollars in coverage for a super senior debt obligation having a notional amount of $10,000,000, but on day two that premium would only have purchased $5,000,000 of coverage, its exposure has increased by $5,000,000 and its collateral requirements increased accordingly. This relationship between market price and collateral resulted in significant shortfalls in the collateral underlying the credit derivatives backing the ABCP market.
The result is that if those collateral calls are actually made, all the cash that was contributed by noteholders will get swept up into the collateral calls. The credit derivatives will terminate and there will be no money to pay anybody except the investment dealers.
There are many other complex legal and accounting issues underlying the crisis, but the bottom line from a financial prospective is that the actual cash contributed by investors could easily melt away if the credit default swaps are permitted to terminate, without any actual losses being suffered.
It was not anybody's intention that the investors in ABCP should be left without any return on (or of) their investment, and it has been interesting to watch how these issues have been dealt with on both sides of the border. In Canada, at least so far, the CCAA has proven a very flexible forum in which to address the needs of a widely disparate group of investors and financial institutions resulting in a compromise which, while not to every investor's liking, provides for each investor to receive some return for its investment and, if the investors are prepared to hold these investments to maturity, potentially receive 100 cents on the dollar.
In the United States, a mechanism does not exist with the same kind of flexibility as the CCAA. There, the equivalent crisis has occurred in the auction rate note marketplace. Many class action suits and investigations are now underway, but it is very unlikely that any investor will receive anything like 100 cents on the dollar after legal fees. There has been criticism lately of the judicial activism apparent in the decisions rendered by Ontario courts in sanctioning and upholding the Plan. Some aspects of those orders are now before the Supreme Court of Canada. However, the results for all parties (other than class action litigators) are arguably much better under the Canadian system.
So what do we learn from all of this? A very clever lady of my acquaintance referred me to a poem by Kipling called Copy Book Headings. The point of the poem is that old sayings become old for a reason: they have proven true in many many cases. In this case, the appropriate saying might be, to paraphrase Warren Buffet, "Never invest in something you cannot understand." It seems unlikely that very many people understood the assets underlying the ABCP they purchased. Perhaps if they had followed Mr. Buffet's advice they would be happier (and richer) today.
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