Clarity Financial Strategy still cautiously optimistic about successful restructure of ABCP

By: Daryl Ching, Clarity Financial Strategy

The more we read about the ABCP situation, the more signs we are receiving that this restructure may fall apart. As we had correctly pointed out on our blog on March 1, the Standstill Period is now being extended day to day, as the foreign banks do not wish to commit themselves any longer than that due to credit volatility. Purdy Crawford confirmed in an email to Brian Hunter’s Facebook group that investors should expect to sell their notes “at a significant discount to par.” A report from RBC's Mr. Andre-Philippe Hardy speculated that one of the foreign banks "has apparently become more nervous" and is no longer supporting the restructuring. If that is the case, "it could derail the restructuring," he said in a note last week. We have heard that BMO may be walking away from the table, in light of their current situation.

So where does that leave us? Is this Committee going to crumble? Are we going to see $33 billion of assets in fire sale? At Clarity Financial Strategy, we are still cautiously optimistic about a successful restructure, but before we go into our reasons, I want to reiterate the importance of the completion of this restructure.

An Event of Default and fire sale is an absolute disastrous scenario for all parties, maybe with the exception of lawyers. If this happens in today’s credit environment, we believe recovery value may be as low as zero for the synthetic CDOs, and we will all find ourselves in ABCP litigation for the next ten years. While I agree with Mr. Crawford that the restructured notes are likely to sell at a significant discount to par, I also believe that with a proper restructure with a margin facility, noteholders who hold the assets to maturity will receive close to par at maturity (with little interest).

So why are we still so optimistic about the restructuring? In December 2007, Mr. Crawford indicated that we had $12 billion of commitment for the margin facility, with a shortfall of $2 billion to be covered by the Canadian banks. In January 2008, Mr. Crawford mentioned that we had a commitment for 98% of the required amount, which would indicate about $13.72 billion. Now, we don’t know what the right number is, but let’s assume that we have $12 billion committed, without the participation of the Canadian banks. If Mr. Hardy is right and we may see one of the foreign banks walk away from the table, then let’s remove another billion and that leaves us with $11 billion committed.

As I have mentioned in previous blogs, nobody wants to see a meltdown. There is too much at stake, especially when considering that a fire sale could yield zero recovery. There are still a few possible outcomes to cover the required amount. Mr. Louis Vachon of National Bank has indicated that the Committee has alternative solutions, but would not go into what they were. Let’s do some thinking for ourselves: On a conference call in December, we learned that JP Morgan would top up the margin facility in the event that we had a shortfall if the Canadian banks did not participate. People have suggested that the credit market is much more volatile now and they may be reneging on their promise.

The one party with the most to lose is Caisse de Depot. With $12.6 billion of ABCP outstanding, Caisse cannot afford to see this restructure unwind. Caisse is currently participating in MAP 1 and has committed to post up to $8 billion for the margin facility. Will they not step in for another $3 billion to prevent the evaporation of $12.6 billion? Finally, I would not rule out the federal government. As an election might be right around the corner, they may be growing pressure for the government to step in and fund, despite their reluctance in the past. With the tragic stories coming from individuals on the Facebook page, who really should not have been sold ABCP in the first place and the possibility of a recession, those just might be enough factors to tip to government to feel the obligation to step in and top up the margin facility.

Finally, as I have also mentioned on a blog posted on February 27, the Crawford Committee has another option. The $14 billion margin facility is required to achieve a AAA rating. I am uncertain as to whether the rating agencies involved in the restructure have made any changes to their criteria for Leveraged Super Senior CDOs, but $11 billion of funding might get us to a lower rating. As Mr. Crawford has already indicated that the notes are expected to trade at a significant discount to par, does it really matter if they are AAA, AA, A or BBB? The important thing to do now is for the Committee to complete the restructure while we still have the bank counterparties at the table.

This arm twisting exercise of trying to force the Canadian banks has proved to be unproductive. However, it could be that if the Canadian banks do not participate in the margin facility, the foreign banks may feel that they are not obligated to do so as well. This may present complications for a successful outcome.

Crawford’s Committee should be shifting gears and the priority now needs to be getting a restructure completed as soon as possible in some form, not preserving the maximum value for noteholders. A fire sale would not only be detrimental for current noteholders but for the entire Canadian economy as well.

Mr. Crawford hosts press briefing on ABCP restructuring plan

By: Daryl Ching, Clarity Financial Strategy

Today, Mr. Crawford’s Committee held a conference call to provide an update on the ABCP restructure. The standstill agreement has been extended to February 22, and the restructure is still scheduled to be completed in March 2008. While the noteholders of Devonshire had previously elected not to participate in the Montreal Accord, they will now be considered for the standstill agreement. Bank of Montreal, CIBC, Royal Bank, Scotiabank have each agreed in principle, subject to the satisfaction of certain conditions, to participate in the margin facility. The Committee has appointed BlackRock to be Administrator and Asset Manager. The Committee expects to provide a restructure plan for investors to vote on by the end of February.

The press asked a series of questions to which most received indirect responses. There was no comment on the dollar amount committed by the banks or the conditions for them signing on. The committee has still not finalized the index that will be used for the spread-loss trigger. When asked who had seen the data at this time, Mr. Crawford commented “mainly JP Morgan” and the Committee went on to describe the process of the how the data will be released to investors in the future. When asked about TD Bank’s lack of involvement, Mr. Crawford responded with “No comment. They have been cooperative.”

However, there were a few issues that were clarified. While the Crawford Committee had promised a “liquidity tranche” to provide relief to the investors in the interim back in November, it has been confirmed that this will not be available before the conclusion of the restructure. Liquidity will only be offered at the close of the restructure, whether it is in the form of bonds to be traded in the secondary market or lending from financial institutions.

It was also clarified that if the Committee is successful in securing 66 2/3 majority, the terms and conditions of the restructure will be binding on all parties involved. In this scenario all the investors will have the benefit of the restructured notes and waive their right to sue the parties involved. This may be the answer to a very interesting question that I had. If the restructure proposal is being voted on at the end of February and you need to give everyone at least 30 days to review the proposal and vote, how does the committee still expect to complete the restructure in March? Is it because the Committee will achieve supermajority approval before the proposal is sent out for wide distribution to investors?

ABCP represents challange for accountants

By: Daryl Ching, Clarity Financial Strategy

Ken Mark, from the Bottom Line, a Lexis Nexis publication aimed at accounting and financial professionals, published a great article recapping the ABCP story. Click here to view the article. We have received numerous questions and interest in the ABCP situation from accountants. For the second consecutive quarter, auditors are still scratching their heads about how to value exposure to non-bank ABCP.

CNW Group has also released an interesting article “Canada's CAs call for clear disclosure of ABCP holdings”. What investors thought were high quality, cash equivalent investments are being restructured into long-term holdings with no clear indication of time to maturity or valuation. Crawford’s Committee holds the information and JP Morgan has completed its valuation of the assets. However, for reasons of their own, they have decided not to release this information to the public.

Accountants have been asking me how to value the non-bank ABCP. At this point, the simple answer is that they can’t, at least not in a meaningful way. We have seen corporate write-downs ranging from 5% to 40%. The only public trade that has taken place was by Westaim and we know they sold their ABCP for 70% of book value with some upside. While this trade sets a precedent, it does not set a market value for all instruments. The value of the ABCP will depend heavily on which trusts were purchased.

JP Morgan’s valuation will be very useful information, as it will provide some colour as to the anticipated recovery value on the assets if they are held to maturity. However, for companies looking to sell their restructured notes, there is great uncertainty about what the secondary market will look like. As the restructure is scheduled to close by the end of March 2008, it may take potential buyers a couple of months to digest the information in order to make meaningful bids. Therefore, we many see any trading until May 2008.

Unfortunately, in this vacuum of information, companies having to report their results are left in the dark, just as much as their shareholders. Substantial financial decisions and budgeting activities will continue to be put on hold until they receive more clarity from the Crawford Committee as to what these assets are truly worth. In the mean time, shareholders will need to settle with vague disclosures about ABCP holdings and a best guess at valuation, which may or may not reflect true value.

Turbulent times put rating agencies to the test

By: Daryl Ching, Clarity Financial Strategy

Yesterday, the TSX saw the largest one-day drop since the September 11 attacks. The TSX has dropped over 1,500 points over the last week, with a minor recovery today after the Fed’s surprise announcement of a 75 basis points rate cut. Stock markets all over the world have experienced extremely volatility as fears of a US recession are looming. Several corporate entities have fallen victim to the global credit crunch. Quebecor World announced yesterday that it will be filing for creditor protection. Credit insurers like ACA are hanging on by a thread.

Clarity Financial Strategy recently published a white paper to explain the spread-loss trigger in the ABCP restructure proposal. The largest component of the ABCP is directly linked to corporate credit defaults swaps, which make bets on corporate defaults. Mr. Crawford’s Committee has the challenge of setting a trigger so that the chance of a draw on the margin facility will be extremely remote. The probability of a draw is directly linked to corporate credit performance.

The rating agencies will be put to the test with the ABCP restructure. Have they sized the spread-loss trigger at a level that can withstand today’s current credit environment? Is the margin facility large enough to cover the potential defaults? JP Morgan as advisor is currently faced with a very difficult task. They need to size the spread-loss trigger large enough that a chance of draw is a remote, but at the same time, keep the bank counterparties happy that they are sufficiently protected. The bank counterparties that sold the CDOs prefer a smaller trigger so that they can draw on the margin facility to protect themselves against corporate defaults in the event that the markets experience greater volatility.

Eerie silence into mid-January

By: Daryl Ching, Clarity Financial Strategy

We are 20 days away from the standstill period deadline and there has still been no confirmation from the big banks to step up for the margin facility. One can only assume that this negotiation is as difficult as we had suspected back in December. It is very difficult to determine to what extent each bank was involved in the frozen ABCP market. Banks could have participated in several ways: provide liquidity, provide hedging for traditional securitization deals, selling ABCP and acting as counterparties for CDO transactions. With TD Bank clearly announcing their reluctance to participate due to their non-involvement in the market, this has opened up a can of worms as the banks start pointing the finger at the negotiation table, arguing about who is more responsible.

In a blog that I posted on January 2, I pointed to several articles written by the Star, National Post and Globe and Mail that identified the “mystery banker” backing the margin facility. During Mr. Crawford's conference call on December 24, he announced that a foreign bank would be willing to step in with approximately $2 billion to top up the required amount for the margin facility in the event that we have a shortfall from the Canadian banks. At that time, the Committee refused to identify the banker. The bank was later identified to be JP Morgan by the press. Furthermore, the Committee was criticized for the potential conflict of interest, as JP Morgan is the financial advisor negotiating the size and the fee of the margin facility and the only party with access to the data.

Mark Boutet, a spokesperson for the Committee responded by saying, “If there is one, JP Morgan has committed to look the world over to find financing for this and to deliver the market for it.” As it is January 11, and we still have not received a commitment from the big banks, I certainly they hope that the Committee has fulfilled their promise and reached out to other global institutions that may be less exposed to CDOs. I also hope that they are providing sufficient data to these institutions to help them get comfortable with the risks of the margin facility. The deadline is fast approaching and we are running out of time.

Issues for investors to keep in mind as the deadline approaches

By: Daryl Ching, Clarity Financial Strategy

As we move closer and closer to the standstill deadline of January 31, there are some important outstanding issues that all participants need to keep in mind.

1) How are we going to address administration? Currently all the conduit sponsors continue to administer their own assets - this includes wire payments, collecting from traditional receivable clients, investing collateral, resetting swaps, monitoring events of termination, and the list goes on. Essentially, these are necessary functions to keep the cash flowing in and out of the system, and to maximize recovery value on the assets. Can it be expected that all the non-bank sponsors will stay solvent for 7-10 years just to perform this function? Coventree recently announced in a press release that they will be closing their Capital Markets business unit and that there can be no assurance that Coventree's revenue will continue to be sufficient to cover the costs of continuing to support the restructuring efforts.

From an administration perspective, the economics really only make sense for one party to take over the entire $33 billion portfolio. As Coventree currently administers the majority of the assets, they would be the most practical choice, as it would be the most seamless transition. The other alternatives would include selecting another non-bank conduit sponsor or appointing a completely new administrator. The administrator will be paid a fee, likely in the range of 5 to 10 bps to perform this function. However, it is an important aspect of the restructure and we need to understand how this will be addressed by the Committee.

2) Bush's plan to freeze subprime mortgage rates for five years will have a direct impact on the subprime assets and an indirect impact on all other assets. While this plan has been met with a great deal of criticism, it might actually be of benefit for the ABCP noteholders. To the extent this plan actually delays defaults, noteholders with shorter term assets will stand to benefit. ABCP noteholders in all tranches should be watching this plan closely, as defaults in the subprime sector will also have an impact on corporate risk.

3) In a recent press release, Strategem Capital announced it will take another writedown of its asset-backed commercial paper holdings and warns it may not be able to make distributions if a new March restructuring deadline isn't met. Strategem Capital has been conservative writing down the ABCP 40% and potentially increasing that writedown to 45%.

I get the impression from conversations with various investors and press releases that investors expect to receive all their money back on March 2008. Let's keep in mind that when the restructure is complete and prospectus-like disclosure becomes available, it will still take time for potential buyers to digest all the information, run their analysis and make a bid - potentially months. If they choose to hire experts in the industry to provide clarity, this time can be cut much shorter. However, potential sellers of the new notes need to keep a couple of things in mind: they should not expect to sell as soon as the restructure is complete unless they are willing to take a deeper discount and the secondary market may price the new notes below JP Morgan's valuations. From a buyer perspective, the assets have been tainted as distressed assets, and the market perception will likely be that buyers need to earn a premium to purchase these notes, even if they are investment grade.

Yet another reason for transparency - JP Morgan identifed as mystery banker

By: Daryl Ching, Clarity Financial Strategy

For those of you who just got back from holidays and are catching up on the ABCP story, there was an interesting development last week. During Mr. Crawford's conference call on December 24, he announced that a foreign bank would be willing to step in with approximately $2 billion to top up the required amount for the margin facility in the event that we have a shortfall from the Canadian banks. At that time, the Committee refused to identify the banker. The Financial Times named this mystery banker as JP Morgan in an article written by Bernard Simon on December 26. (Click on links to view articles) The Star, National Post and the Globe and Mail were able to confirm this and wrote articles on this topic last week as well.

For those of you who are interested in the commentary on the restructure proposal released on December 23, feel free to watch my interview on BNN last week or visit my previous blog entry for a recap.

With the lack of transparency from the Committee, all measures should be taken to avoid any conflict of interest. JP Morgan, the sole financial advisor with access to the Data Room is in the best position to negotiate the best deal for the investors. When negotiating credit facilities, rating agencies and bank counterparties will always ask for as much credit enhancement as they can get, as more credit enhancement only improves the quality of the rating and the credit position of the bank counterparties. The role of the financial advisor is to act as an intermediary, and structure a transaction that addresses these concerns with a reasonable amount of credit enhancement, that also takes into account the needs of the investors. While a larger margin facility provides more protection, this also results in higher fees, which ultimately results in greater costs to the investors. If JP Morgan stands to earn $32 million / year ($2 billion at 160 bps) on the margin facility, this begs the question about whether there should be more scrutiny in this process.

The Committee indicated on a conference call that with the new spread loss triggers, the chance of a draw on the margin facility will be very remote. If that is the case, 160 bps is a very lucrative standby fee. For clarification, this is only a standby fee. If a margin call is made and the facility actually gets drawn, I anticipate the drawn fee will be based on the Prime Rate, but the Committee has not disclosed this rate as of yet. To put things into perspective, General Market Disruption liquidity facilities, which were considered remote risk, in a functioning ABCP market were previously priced between 10-15 bps. I believe the high spread is a result of two factors: 1) Not enough transparency - for the same reason that we are not seeing bids from potential buyers of ABCP for more than 50 or 60 cents to the dollar, banks are being asked to participate in the margin facility with very little information, 2) The Committee has asked parties to participate that are reluctant to do so, because they are already overexposed to ABCP, have liquidity problems of their own and have a gun to their heads from shareholders not to take any more, like the big banks in Canada. I suspect that opening up the Data Room would bring more financial institutions to the table, if they have the ability to assess for themselves, the risk on the margin facility, especially if JP Morgan has already made themselves comfortable to step in.

Other than JP Morgan, are there any other parties at the table that can determine if $14 billion is a reasonable amount for a margin facility or if 160 bps is fair? Unfortunately, with the exception of the financial advisor, I have reason to believe that the participants in the industry who have the skills to assess this do not have access to the Data Room. JP Morgan holds all the cards in this negotiation process and no second opinion will be offered. Furthermore, by the time, we all have access to the data, terms and conditions will likely have been finalized by the Committee by approval of the super majority of the trusts. Let's not forget that some of the large institutional investors like La Caisse de Dépôt et Placement du Québec and Desjardins Financial Group have a considerable amount of voting power with their holdings, are self-funding the margin facility and do not even need to worry about the margin facility fee.

This is the reality and I have come to accept the fact that negotiations will continue to take place in a vacuum. I have also come to the realization that super majority approval for most of the trusts can be can be reached by a small concentration of investors. Therefore, JP Morgan has a fundamental responsibility to remain in a position where a conflict will never come into question with a role as important as the sole financial advisor, especially with closed door negotiations. The next step is for the Committee to be more forthcoming with information in order to welcome other institutions to the table. This may even result in lower fees than 160 bps. While we would all like to see a deal get done, I would still like to see a properly negotiated transaction with sufficient credit enhancement to protect the bank counterparties, but at the same time, creating the best value for the investors, by minimizing the costs, which will minimize their losses. Unfortunately, we will not know how well the deal is structured until the data comes out. For now, we have to rely on what we are being told by the Committee, which is not very much.

Light at the End of the Tunnel

By: Daryl Ching, Clarity Financial Strategy

It sounds like we are seeing some real progress from Crawford's Committee. It was announced yesterday that Skeena Trust was successfully restructured with 98.7% of the principal and accrued interest as of August 15 being returned to the noteholders. John Greenwood of the Financial Post, wrote an article called ABCP Proposal Could Come Within 10 Days announcing that a restructure proposal with valuation of the holdings provided by JP Morgan could come within 10 days.

As I believe Mr. Crawford has learned his lesson from previously over promising and dissapointing the market, we have seen a recent reversal to under promising and over delivering. Earlier, Crawford announced that the Skeena Trust restructure may not complete by year end and that losses may exceed 2%. Now, people will applaud the completion of the restructure with a 1.3% loss.

Crawford’s Committee received some pressure the Canadian Securities Administrators as they revealed that they would be exercising more scrutiny on how public companies disclose their exposure to ABCP. Accurate disclosure can only come from full transparency on valuation from Crawford’s Committee. There is another strategic incentive for the restructure proposal to come out in December, similar to having an announcement on Friday at midnight. The note holders of ABCP are trying to wrap up for year end and go on their vacations for the holiday season. After four months of stress and uncertainties, sellers of ABCP may choose to ignore the fine print and sign on the dotted line to be done with the situation altogether. However, as a consultant I can only urge sellers and potential buyers not to make the same mistake twice. While it would be convenient to accept the proposal with JP Morgan’s valuations, investors will be doing themselves a favour by seeking the expertise and taking a second opinion to ensure they are getting a fair deal.

In order for an announcement to be made with terms and conditions, Crawford’s Committee must finalize negotiations with foreign banks on the conversion of mark to market triggers to spread loss triggers on the CDOs and secure the liquidity required from the big banks to fund a margin facility for potential collateral calls. With this recent announcement, I am confident that they are close to finalizing these arrangements and we will be hearing about the proposal soon. I continue to hope that some funds will be available as loans to the smaller investors to give them temporary relief as we wait for the conclusion of the restructure scheduled for March 2008, but I think investors should prepare for the fact that this may not be made available.

There has also been some great news for the unfrozen ABCP, which represents about $87 billion in Canada. Deutsche Bank launched a new conduit, Okanagan Funding Trust, the first Canadian ABCP conduit to be rated by S&P. RBC Capital Markets announced that they have added a Moody’s rating to all three of their conduits. The Canadian Pension Plan Investment Board (CPPIB) has purchased $6 billion of bank ABCP. This demonstrates the resilience of the ABCP market and a very positive sign that it will survive through the turmoil. Altogether, this has been a great week for the securitization industry.