Thursday, January 17, 2008

ABCP Exit Strategy

By: John Sokic, Clarity Financial Strategy

Today Merrill Lynch announces an $11.5 B write-down. Yesterday, it was Citibank's turn with an $18 B loss. Major Banks and brokers are seeking overseas capital to shore up their balance sheets. Bond insurance companies are hanging on for dear life. The cause for all of these problems appears to be the leverage in the system created by structured financial products.

For example, SIV products in the US are flatlining at the moment. The Financial Times published an article, "SIV's don't rollover, they die". As they fully unwind, a large glut of CDO and subprime product will flood the market. SIV triggers require a forced sale but who will purchase their assets? So many former participants have been burned or 'snake bit' already. The effect is so widespread that only 'virgin' players and their capital will be stepping up to the plate. I see this happening very slowly over time.

The world of rating CDOs is changing. The Financial Times released another article, "Brace yourselves: S&P adjusts risk models". Rating agencies are changing parts of their methodology such as their loss curve assumptions. Too little, too late of course. However, something must be done. Rating agency credibility has taken the biggest hit in their histories. It is clear that many people were wrong in the way they chose to analyze these CDO deals. So we have to completely change our views. Going forward, only those that understand where things went wrong and come up with a totally new way of analyzing these transactions will succeed in this market going forward.

CDO issuance has grind to a halt. The market for structured products has become a distressed one. However, there is no precedent in financial history for a distressed market this large. In Canada, we have a relatively conservative financial profile with very little of these problems. Our structured finance market never really developed to any kind of scale.

We did, however, create a large market for ABCP. The non-bank variety heavily reference US assets. So we do share in their pain. For those embroiled in the situation, what is the best course of action? What is our exit strategy?

The exit will be much more difficult to achieve than most parties currently believe. Given the situation in the US, how do investors in Canadian ABCP expect to find buyers for their holdings? According to the restructure proposal issued late in December by the Crawford commitee, roughly half of investors in the large CDO pool are going to self-fund for margin calls. To self-fund, investors would have to have a very high credit rating or capital base. Agencies would not allow a weak link for the new restructured notes, such as a small, unrated company that promises to pony up for margin calls.

Self-funding implies a certain commitment to hold the restructured notes to maturity. There appears to be no plan to unload the notes as soon as a secondary market opens up. These investors have that luxury. What about the typical corporate treasurer, responsible for funding the operations of his or her company?

Whether we like it or not, the structured finance world is front and centre for everyone involved in the finance industry (and well beyond). Many participants find themselves buried beneath a mountain of distressed, complex assets with acronyms they have never heard of. Education is the key. Only with knowledge of the situation, of the product spectrum and our local Canadian manifestation, will participants have the tools needed to dig their way out.

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