ABCP Proposal to Offer Range of Losses - Commentary

By: Daryl Ching, Clarity Financial Strategy

Jacquie McNish and Boyd Erman wrote an article in the Globe and Mail today titled ABCP Proposal to Offer Range of Losses. The story reveals that recovery rates for the trusts range anywhere from about 50% for Apsley Trust to close to par for other higher quality trusts. While the Crawford Committee is still trying to win sufficient support to extend the standstill agreement until March 2008, they announced that they have Deutsche Bank AG on side, a party that is believed to be counterparty to half of the $25 billion of CDO transactions. The Committee revealed that although it has completed its assessment of the current value of the ABCP, it does not plan to release the information until the new year. The most interesting piece of news is that the plan calls for investors to swap their ABCP for two classes of notes that will be ranked senior or junior. Investors whose ABCP is backed by assets with higher market value will receive a higher portion of senior notes and those with harder hit assets will take more junior notes. The Committee has approached the banks to underwrite a market for these notes but they have not heard back from the banks.

While it appears the Committee is still struggling to get all parties to agree to an extension of the standstill period, getting Deutsche Bank AG on side is an important development. With the credit default swaps under water in today’s credit environment, the foreign banks who are swap counterparties to the CDO transactions can lay the hammer by making a margin call. In an environment where ABCP cannot be issued, this would result in an event of default and a firesale of the assets. It is relief to know that the Committee has Deutsche Bank’s support. I am confident that the Committee will round up the support required to continue the standstill period in order to continue the restructure into spring.

My interpretation of how the restructure will work is that the Committee will create a jumbo fund by amalgamating all the assets of all the trusts, with the exception of Skeena Trust that has been restructured separately. All the assets will be placed into two categories based on credit quality – senior and junior. The Committee will look at each trust and determine which assets belong in which category and assign notes accordingly to each investor. It is likely that the junior notes will be subordinate to the senior notes and take first losses.

This plan has its advantages and its disadvantages. Generally, investors will be better off, as all the assets will be pooled together to form greater diversification. However, this simplified approach also has its disadvantages and raises a lot of questions. Can we really separate all the assets into two categories? How will they be separated? Is a leveraged super senior corporate CDO that is levered five times in the same bucket as a CDO levered 40 times? Do all traditional securitization assets get thrown into senior? Does that mean that Canadian subprime mortgages are in the same bucket as a bank’s line of credits? What I am trying to get at here is that investors who bought very high quality trusts may receive more senior notes, but their assets may still be diluted with poorer quality assets. In the long run, some will be better off with this plan and others will be worse off.

I applaud Mr. Crawford’s committee for the progress made thus far. It appears they have had several successes including the restructure of Skeena Trust, the extension of the standstill period until now and a plan that may receive super majority support. Having said that, it would still be prudent for investors to fully understand the implications of this plan before signing on to the agreement. My opinion is that the assets cannot simply be sliced into two categories – good and bad. The complexities warrant more categories if we hope to have a more equitable outcome for all investors.

Finally, as the Committee has decided not to release any more information on the assets to facilitate a secondary market until the new year, I certainly hope that they provide some relief in the form of liquidity in the interim to investors who cannot wait until the spring to get some cash back.

Daryl Ching

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