Sunday, November 18, 2007

The black box explodes

From Saturday's Globe and Mail
November 16, 2007 at 9:47 PM EST

Shortly past 8 a.m. on an already sweltering August Monday, a small team
of financiers hurried down a flight of stairs in one of Montreal's most historic
office buildings to watch a modern disaster unfold.
The men, senior executives with National Bank Financial, were hurrying to a
cavernous room on the main floor of the beaux-arts Sun Life building where
more than 100 traders buy and sell billions of dollars of stocks, currencies
and debt instruments every day. Leading the group was Ricardo Pascoe, a
wiry, soft-spoken derivatives specialist who was named co-chief executive
officer of National Bank of Canada's securities arm a year earlier. At his side
was his top legal executive, Brian Davis.
Mr. Pascoe whisked the group past long lines of noisy trading desks to a
normally quiet corner where a half dozen men and women were feverishly
working the phones. The traders were seeking buyers for a Byzantine class
of short-term debt called asset-backed commercial paper. Known by the
clunky abbreviation ABCP, the paper had become a money market darling in
the past decade, accounting for more than 30 per cent of Canada's $360-
billion short-term debt market.
The 30-day and 60-day notes paid interest generated by bundles of mortgages,
car loans and other debts pooled in special vehicles called conduits or
trusts. These conduits were hard to understand, even by many lawyers and
bankers, but the lack of transparency never seemed to bother investors, who
snapped up the notes because they offered some of the highest interest
rates going, boasted the best credit ratings and were sold by the world's
leading banks. MORE...

1 comment:

Daryl said...

The ABCP debacle has been described as one of the greatest financial crises Canada has ever seen. However, unlike other financial crises, this is one that is not easily understood by the public because of the complexity of the structures that are behind the commercial paper.

Before we can really understand what happened, we need to look at simple economics and see what has happened in the stock market.

Some of us go to business school understanding the fundamentals of investing involve an analysis of a company’s financials, the management team and some key metrics like the P/E (price to earnings) ratio. If this is truly the secret to winning in the stock market, why are equity analysts consistently wrong with their picks? What was it about the fundamentals that caused technology stocks to rise 10-15% each day back in 1999? Why is it that when a strong economic report comes out about Canada’s employment figures or GDP, the stock market tanks as investors are concerned about the Bank of Canada raising interest rates?

In my economics 101 class, I was taught about the theory of efficient markets: financial markets are "informationally efficient" and prices accurately reflect all information available in the market.

Some mutual fund managers later explained to me that there has been a large increase in retail investing, which means that the market is comprised of many unsophisticated investors who do not take sufficient time to perform the due diligence required to make prudent investment decisions. As a result, important decisions are being made solely on reaction to news, instinct, word of mouth and emotion. Anyone who has been in a relationship knows that when you act on emotion, you don’t act rationally. Perhaps this explains the irrationality of the stock markets, but certainly the large institutional investors are doing their due diligence, right?

Bringing this concept back to the ABCP world, investors were generally large institutions with deep pockets, so we’d assume that they were doing their due diligence properly… Sadly, it has been noted recently that there was a lack of transparency about the underlying assets backing the ABCP. In fact, investors did not even find out until this summer that there were sub-prime mortgages underlying the ABCP. As a result of this information, they panicked and stopped buying, only to realize a couple months later that they panicked about the wrong thing. To their horror, they later learned that there is greater concern with structures backed by risky credit default swaps that will be difficult to restructure by the Montreal Accord.

Was there sufficient disclosure in the ABCP market for investors to make prudent investment decisions? No. Is it the investors’ responsibility to ensure sufficient disclosure is provided by investment banks? Absolutely. The securitization industry is over 20 years old in Canada, and investors have had plenty of time to demand it. The truth is that many investors relied solely on a high rating from DBRS, and not only was full material information not available in this market, investors did not demand for 20 years.

This has led to other arguments about how this could have been prevented. Some argue that if there was more transparency, investors could have done analysis and foreseen this. I have heard some argue that a national securities regulator in Canada could have prevented this disaster.

That’s about as true as Elvis being alive and well and living just outside Ottawa. The problem is not with the assets. The market fell apart when investors acted emotionally and lost confidence.

The investment banks and DBRS create models for each securitization transaction. Methodologies are publicly available for each asset class. Each transaction is backed by a pool of assets, such as credit card receivables, auto loans or mortgages. Based on historical data, the models will generate expected losses for each transaction based on past performance. The rating agency will then demand ways to protect against the expected losses. Protection against these losses is available through issuing subordinate notes, a letter of credit from a bank or additional reserves. In order to get a AAA-rating, credit protection must cover losses, which differs for each asset class. For example, in some traditional asset classes, credit enhancement must be four times expected losses, so that there is excess capital to cover up to four times the loss. Taking this system and applying it sub-prime mortgages for example means that these assets can also be enhanced to a AAA level, because there is money in place to protect against the expected losses.

Sadly there are no financial models available that can prepare the industry for investor confidence or irrationality.