Wednesday, December 12, 2007

Skeena Fix Not So Easy, After All - commentary

By: Daryl Ching, Clarity Financial Strategy

Boyd Erman of the Globe and Mail published an article about the progress of the ABCP restructuring. He indicated that Skeena Trust, a trust sponsored by Edenbrook Hill Capital and Dundee Securities Corp., which the public widely believed would be restructured in short order with full recovery on principal and accrued interest, could still lose two cents to the dollar. It is being restructured into a 9-year bond issued by White Knight Investment Trust. Skeena Trust is comprised of six leveraged super senior CDO transactions, some of which have been levered over 40 times. The Globe indicates that the haircut is due to further deterioration in the credit markets and the "banks squabbled over which would absorb losses and take on risks as part of the conversion of the trust's derivative assets to more stable contracts."

This is an indication that the market is not willing to pay par for exposure to CDOs. With respect to leveraged super senior transactions that reference credit default swaps, it can easily be assumed that the reference portfolio of corporate names is worth less today in our current credit environment than it was when these transactions were first originated. This sets a precendent for all other trusts with leveraged super senior CDOs.

Despite the deterioration in the credit market, the CDO transactions would have been fine with a functioning ABCP market. Many of these CDO transactions have "mark to market triggers", in which investors would have to post collateral if there was deterioration in the value of the credit default swaps. Like putting up more cash for a margin call when you buy stocks, investors would have simply issued more commercial paper and posted cash. The only impact this would have had on investors would have been a compression in yield due to a lower leverage factor, similar to the fact that you would receive a lower return on your stocks. However, in today's credit environment where ABCP cannot be issued, investors would have to find other ways to post collateral if a margin call is made. This would result in additional exposure to the assets, and this environment, investors are reluctant to take on any more exposure than they have to. Like the stock market, if investors are unable to post collateral on a margin call, the foreign banks have the right to sell the credit default swaps in the open market, make themselves whole and return whatever is left to the investors.

It is interesting to note that White Knight Investment Trust is not subject to any collateral calls by the banks. The banks that provided backup liquidity to Skeena Trust include Bank of Nova Scotia, ABN Amro Bank NV and HSBC Holdings PLC. However, there are only two swap counterparties in relation to the transactions. While the swap counterparties would likely be willing to waive margin calls if they themselves were investors, they would not be incented to waive margin calls for other investors involved without some form of compensation. It can be assumed that a haircut of the accrued interest and some principal (2 cents to the dollar) was required in order to negotiate the waiver of the margin call. However, it is great news that the margin calls have been successfully waived and the investors no longer need to worry about posting collateral for a mark to market trigger. Despite the loss of two cents in principal, I commend Mr. Crawford's committee for the successful restructure of Skeena Trust.

It is also interesting to note that the ABCP will be converted into new bonds issued by "White Knight Investment Trust" and will be rated AAA by Standard and Poor's and DBRS. This gives us a new piece of information about the restructure. It seems likely that the restructured notes will come in the form of a bond offering with at least two ratings. This should not come as a surprise, as investors will take more comfort in a second opinion from another rating agency. ABCP trusts in the US and Europe have at least two ratings. I anticipate we will start seeing at least two ratings on all ABCP trusts going forward, as one of the structural changes to the securitization industry in Canada.

This news confirms that the ABCP restructure continues to remain a great challenge for the Crawford Committee. It is also unfortunate that a precedent has been set that it will very difficult to obtain par on the new bond offerings. It is now more important than ever, that buyers and sellers seek the expertise required to get comfortable with the valuation of the assets before making any decisions to trade. However, there is light at the end of the tunnel, and hopefully this sets a precedent more successful restructures to come.

Daryl Ching

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