Monday, January 7, 2008

Is the Canadian ABCP Market dead?

By: Daryl Ching, Clarity Financial Strategy

With the recent debacle, investor perception of all ABCP is probably equivalent to that of junk bonds. Corporate treasurers and CFOs who are receiving pressure from their boards or even worse, have lost their jobs may never return to the market to purchase these investments again.

Boyd Erman of the Globe and Mail recently published a blog, "What's left of Canada's ABCP market is holding up as U.S. meltdown continues?". Not including the $33 billion of frozen assets, there is still $80 billion of ABCP outstanding that continues to roll, down only 7% from its peak in August. As of December 19, the ABCP market in the US had plunged 36% from its peak. Most of the ABCP was issued by Structured Investment Vehicles (SIVs) that issued short-term commercial paper and purchased higher yielding long-term assets. We have learned that the SIVs in the US had massive exposure to the $1.3 billion US residential subprime market. As a result, US banks have bailed out their conduits by taking assets back on their balance sheet in a large way.

Canada is a very different story. Even the majority of the $33 billion of frozen assets are of good quality, but that is not the focus of this piece today. Due to the noise and loss of investor confidence created by the recent debacle, the bank ABCP conduits continue to trade at premiums today, roughly 50-60 bps higher that August. According to DBRS, while the non-bank ABCP conduits had 78.8% exposure to CDOs and 8.2% exposure to US subprime (there is overlap of 5.7% between these two asset classes), the $80 billion ABCP market that is generally sponsored by large banks has 3.4% exposure to CDOs and no exposure to US subprime assets at all.

For the first time in twenty years since the origination of the Canadian ABCP market, we are seeing some unprecedented events:

1) A market disruption actually happened, liquidity protocols and structures to the test that have only had theoretical constructs up to this point.

2) The first ABCP conduit was downgraded by DBRS – Apsley Trust.

3) More scrutiny from the government: The Bank of Canada and the federal government are getting involved influencing the ABCP restructure as well as calling for a national securities regulator. The Ontario Securities Commission is demanding more disclosure from the big banks for their ABCP conduits. The Canadian Securities Administrators announced that they are exercising more scrutiny on financial reporting of ABCP exposure.

4) ABCP conduits have moved from the traditional General Market Disruption liquidity protocol to Global Style Liquidity.

5) US rating agencies are coming north: RBC Capital Markets and Scotia Capital have announced that they have added a Moody’s rating to all their ABCP conduits. Deutsche Bank launched a new conduit, Okanagan Funding Trust, the first Canadian ABCP conduit to be rated by S&P.

Now back to my original question – will the ABCP market die? Quite simply put, the ABCP market is far too important as a funding source for corporations to fail. What we are seeing is massive correction in methodologies and pricing. Investors need to reevaluate the risk and return and decide if they ever want to return to this market. With more rating agencies providing an opinion, we may see new entrants. The Canadian Pension Plan Investment Board (CPPIB) recently announced that it has purchased $6 billion of bank ABCP.

When the dust settles, I believe we will see the following changes:

1) All ABCP conduits will have at least two ratings.

2) With the additional costs of rating agencies and the capital required for global style liquidity, corporations should expect their cost of funds for securitization facilities to rise, which ultimately will result in higher borrowing costs for consumers.

3) To fill the void of short-term ABCP, new types of products will be originated, possibly medium-term notes, asset-backed securities bonds or unrated securitization products.

4) Interest on ABCP will probably remain higher than the extremely low levels experienced prior to August.

5) We will probably not see any CDOs or structured products originated for quite some time and the ABCP market will be predominantly conservative traditional securitizations structures.

6) Most importantly, there will be more transparency and investors who purchase ABCP will need to figure out how to model these transactions to make themselves comfortable that they do in fact possess the risk characteristics that they are comfortable with.

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