Thursday, December 6, 2007

Investors should not lose sight of credit risk, says Bank

By: Daryl Ching, Clarity Financial Strategy

Date: December 6, 2007

Tara Perkins wrote an article today about a paper publicshed in the Bank of Canada's Financial System Review. Click here to view the Globe and Mail article

This article starts off by addressing the Asset Backed Commercial Paper debacle and stating that “investors need to accept responsibility for managing credit risk in their portfolios.” It suggests that investors cannot fully push off accountability to the rating agencies who rated the ABCP. I wholeheartedly agree with this statement. At the end of the day, the rating agency provides an opinion on credit quality based on relevant facts they have available to them. When situations change, like the recent market disruption, they revise their criteria to reflect a change in environment.

Investors do not sue research analysts for placing a "buy" rating on a stock if it plummets. Auto purchasers do not take action on consumer reports if they put out positive reports on a car and the engine breaks down. At the end of the day, much like other reports available in public, the rating agency provides an opinion. It is ultimately the responsibility of investors to understand the rating methodologies and convince themselves that they are comfortable with their investment decisions.

If we think back to the market disruption, there were no downgrades of any ABCP conduits at the time and no sign of credit deterioration in the trusts. The market disruption of the non-bank trusts was as a result of a loss of investor confidence from the buzzword "subprime". Can you blame the rating agency for not predicting a mass exodus of ABCP investors when there was no reason from a credit perspective to panic? It has been pointed out that DBRS may have been wrong on the General Market Disruption liquidity protocol, as some banks did not fund emergency liquidity in August. However, until the courts confirm that the banks were right not to fund, the verdict is still out on that issue as well.

I also agree with the comment in the paper that government regulation of the rating agencies could stifle innovation and development of the financial markets. The rating agencies are closer to the market having constant interaction with various participants and are in a better position to rate structured products than the government. I think the best approach for development of the capital markets is to learn from our mistakes and make changes going forward. As a result of this debacle in Canada, investors will need to be more savvy and will demand more transparency. DBRS has revised their criteria to require global style liquidity for ABCP conduits. This opens the door for other rating agencies to come in and rate the paper. Having a second opinion from another rating agency on ABCP will add a layer of scrutiny and provide greater comfort to investors as well.

As we watch the evolution of the ABCP market, it will be interesting to see how things unfold and how the market looks next year this time. At the very least, I certainly hope we have learned a couple key lessons:

1) More transparency and more disclosure will be required.
2) Investors need to do their homework and are accountable for all their investment decisions.

Daryl Ching
Clarity Financial Strategy

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