Wednesday, November 21, 2007

Will the Montreal Accord fly?


From Wednesday's Globe and Mail

Asked why it wrote down its asset-backed commercial paper by only 8 per cent, Groupe Desjardins told us, among other things, that it thinks the Montreal Accord restructuring effort will succeed.

National Bank, another signatory to the accord, gave its ABCP portfolio a 27-per-cent haircut, and hasn't said that it doubts the outcome of the accord.

You hope it works out for the sake of the investors holding the bag, but the odds don't look particularly good at the moment.

About three-quarters of the $33-billion of third-party ABCP sold to investors is of the synthetic variety, meaning, for example, that the conduits investors put money into are built from various kinds of interest-bearing securities and derivatives like credit default swaps. And almost 60 per cent of the total ABCP is leveraged, meaning through the use of derivatives, there are more assets in a conduit than investors put in money.

Here's the problem, according to people we spoke to: When the conduits entered into swap agreements, their counterparties - typically foreign banks - were essentially given first claim on the assets of the conduits in the event of a problem. If the value of the assets backing up their investment deteriorated, they could place a margin call forcing the conduit (or its sponsor) to add more collateral. Conduits would do this by tapping the capital markets for more money, which would have been possible in normal times. But of course now the markets are not functioning at all and the plan is to morph the commercial paper into 10-year notes with floating interest rates.

Under the circumstances it's a fine idea except for those pesky counterparty agreements in the leveraged conduits: They don't just go away for free.

The only logical trade would have been to ask the counterparties to drop the right to demand more collateral in exchange for not having to provide liquidity, but as it happens the liquidity agreements were so weak that there was effectively no risk of them ever being triggered. The banks weren't going to trade something that had very little risk to them for something that exposed them to great risk.

(The irony of course is that these banks win if credit quality drops but don't suffer if, as has happened, market liquidity dries up, even though the two problems can be closely related.)

With commercial paper, as mentioned, a margin call could be met by issuing more paper (in a normal market). But once converted to floating-rate notes, the situation becomes static: There's no easy way to raise more collateral. So the protection of that margin call disappears. Therefore, there doesn't appear to be any motivation for the foreign banks to play ball, and given that more than half the commercial paper is leveraged, it's hard to see the Montreal Accord succeeding. More...

1 comment:

ClarityFinancialStrategy said...

The propsoal put forward by the Monreal Accord is to restructure the ABCP to match the maturity of the assets, which means that investors may wait up to ten years to receive their money back. It was recently announced that the restructure will complete by the end of March 2008. The committee has also chosen to withhold information in the Data Room to prevent secondary trading.

It appears that progress is being made and I applaud the efforts of Committee on this difficult restructure. Having said that, we still seem to be missing the principles of something our nation is very proud of – capitalism and an open economy. Whether an investor holds $1 or $1 billion of ABCP, it seems counterintuitive to say that they are not allowed to sell their assets. What the Pan Canadian Committee is missing is a second option for investors to sell their assets immediately in the event, they cannot wait until March 2008. In order for this to happen, the Committee must release the information in the Data Room to the public to allow meaningful secondary bids. As the assets continue to be of strong credit quality (DBRS has affirmed 97% of the assets to be AAA, 2% to be AA and 1% to be BB), there is certainly demand from various hedge funds and fixed income portfolio managers to buy the assets. However, they cannot do this without information. By providing data, secondary investors will have the tools to conduct prudent analysis for their investment decisions and offer bids higher than 50 or 60 cents. With multiple bids, this will enhance the pricing on these investments and at the end of the day, investors who cannot wait any longer have a choice to sell their assets or not.

As an individual who has invested over six years in this industry, I feel a personal responsibility to see a fair resolution for all investors. Fair to me means the ability to make a choice between working with Committee or selling the assets in a secondary market. Let’s level the playing field for all investors let’s back to the fundamentals of an open market that we are all proud of in Canada.