Wednesday, December 19, 2007

A Few More Reasons For Greater Transparency

By: Daryl Ching, Clarity Financial Strategy

Sean Silcoff from the Financial Post wrote an article today called "ABCP Creates Acid Test for Auditors". The article comments on the fact that auditors are not being given the tools to properly value companies with ABCP exposure. The fact we have seen write downs from 5% to 40% is testament to the fact that everyone is making different assumptions and nobody really knows what the ABCP is worth. More and more investors that I speak to are admitting that while they previously thought they understood the investments, there appears to be a lot of complexities that they could not have grasped without being in the industry with a structuring role. With the lack of transparency, this is absolutely true and I have been providing the advice required to help them understand the various structures and make strategic decisions.

As financial statements are supposed to provide a snapshot of a company's financial health, there are repercussions of being too conservative or too aggressive with the write-down. If a company writes down too much, they may create future profits. If a company writes down too little, they could be subject to a greater loss in the future.

This uncertainty has led to major inconveniences for a wide array of institutions. A merger of the British Columbia and Ontario central credit unions has been put on hold. Companies will have trouble planning a budget for the New Year due to the uncertainty of when they can sell their frozen assets and for how much. This may lead to a delay on important projects and purchase decisions. Investors cannot make prudent investment decisions, as they have to question the financials for all companies holding ABCP. The list goes on.

I have seen people refer to the ABCP as toxic waste and junk assets. Let's keep in mind that 97% of the assets continue to be affirmed AAA by DBRS. The subprime component represents about 7% of the total non-bank ABCP. While I have heard estimates of a 50% write-down on all subprime, that would be convenient but not right. Let's not forget that subprime origination activity was significantly more aggressive in 2006 with teaser rates and very low down payments. The subprime mortgages originated in 2003 and 2004 were to borrowers with low credit scores, but required sizable down payments and did not offer introductory teaser rates. Instead of asking "How much subprime do you have?", sophisticated investors should be asking "In what year were the subprime mortgages originated? What is the average LTV? What percentage of the portfolio has teaser rates? What is the delinquency and default rate?"

The point I am trying to make is that not all subprime is bad. The expected loss is derived from a combination of two components: default frequency and loss severity. Default frequency is simply what percentage of the subprime borrowers default on their mortgages? Loss severity is a reflection of the recovery value from selling the properties net of selling costs. So let's take another look at this 50% write-down. Are we assuming that 100% of the subprime borrowers will default with a 50% recovery on real estate? Is that reasonable? We need to start assessing the quality of assets with real data, rather than attaching a value based on a buzzword.

I hope that a lesson that has been learned from the entire ABCP debacle is that investors need to be more sophisticated and industry participants need to offer more transparency. The good news is that JP Morgan has completed their valuation assessment and is in a good position to reveal anticipated recovery values. This is probably the best available indicator of what the assets are worth. Again, even when the data does become available, I strongly urge investors to seek a second opinion, get educated by an expert and perform their own analysis and convince themselves that they are comfortable with the values.

The Crawford Committee had indicated a hesitation to disclose the information to prevent professional investors from profiting from trading against some of the positions. I think the concern here is that buyers may short positions in order to compress the value of the assets, in order for them to buy in cheaper. Would that not be offset by the influx of investors globally who are interested in buying the assets when information becomes available? The most important reason as I have mentioned in a previous blog is to provide a secondary market for the smaller investors who are in dire need of cash. With TD's reluctance to get involved in the non-bank ABCP market, we can anticipate that there will be less funds overall made available by the big banks to help solve the problem. The funds will likely be used to fund a margin facility for the availability of collateral if margin calls are made for CDOs. What this means is that investors are not likely to receive any liquidity relief before March 2008. For all the reasons I have mentioned above and in previous blogs, it is more clear to me now than ever before that there needs to more transparency and the data should be made available to the public.

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