Dodge Calls For More Disclosure

By Ross Hendin, Hendin Consultants

David Dodge, the current Governor of the Bank of Canada, made a few interesting comments at the closing speech for both the year and his career, choosing to spend some time discussing the future of the ABCP market. As this was more of a political and PR tactic than anything else, I think it's worth a second look from the political and PR perspective. This blog entry reflects on the article by Heather Scoffield that covers the story in Dodge Calls For More Disclosure In Structured Finance Products, from the Globe & Mail on December 10.

While I could go on about this article and the speech for a while, I'm just going to raise 3 points here worth considering. If this article is any indication, I wouldn't be surprised at all if a number of the groups involved in the ABCP issue have run to Ottawa lobby firms to voice their interests. I worry seeing this article that they may not be really considering a strategy for how to deal with the policy change, and are more focused on saying that the issue wasn't their fault.

1) Mr. Dodge makes a point of NOT blaming the rating agencies (READ: DBRS). He says: “Credit-rating agencies are not to blame for the lack of information about those highly structured products that were sold to highly sophisticated investors in the so-called exempt market,”. He then goes on to say that investors should have done better homework. Well, every investor I've spoken to about this so far has said to me that if every ABCP product had to have diligence like the equities they buy, the commercial paper would not be worth the effort. If I have to spend hours looking up several analyst reports and double-checking assertions, I need the returns to be worth the time. The point of having rating agencies is to do that homework for the investor. Now, I'm not saying that this is DBRS's fault (as it happens, I agree with Mr. Dodge that it isn't their fault, but for different reasons), but I want to be clear that with a statement like this, Mr. Dodge has adopted an advisors party line without really thinking through or explaining his reasoning in a way that the people who work in the industry can relate to.

2) The article goes on to report: "Mr. Dodge also suggested that asset-backed securities should carry a “certificate of origination” or some other type of brand or tag that would tell investors that the securities had been well-researched before they were sliced, diced and packaged up for sale to investors." Funny, I thought that was the point of a credit agency rating. What he should have suggested is a reform to the way these securities are reported - to quickly increase transparency for the investor. A new, re-branded certificate of quality is a consumer product approach to an industry and policy specific problem. To me, this is a disappointing, political response that also could have been better articulated, or presented in a way that makes sense for the investors.

3) This page is of the comments the article sparked. The site closes the conversation after 12 comments. I invite you to read them, as I think you will agree that if nothing else, they show real interest in the Bank of Canada's role and position on this.

What is this ABCP Worth?

By: Daryl Ching, Clarity Financial Strategy

December 14 will mark the end of the standstill period where investors have agreed not to force a default, conduit sponsors have agreed not to issue liquidity notices, foreign banks have agreed not to make margin calls on corporate CDOs and various parties have agreed not to launch what can be a hailstorm of lawsuits.

The ABCP restructure is extremely complex, involving many parties with conflicting interests. The parties include the Big 5 Banks, other Canadian financial institutions and non-bank securitization providers, a group of large foreign banks, investors ranging from small mining companies in BC to the largest pensions funds in Quebec, and more recently, the Office of the Superintendent of Financial Institutions and the Bank of Canada. To give an idea of just how many interests each group has, consider that just the banks were involved with the following: sale of commercial paper (distribution), liquidity provider, CDO underwriter, conduit sponsor and investor. The odds are stacked against Mr. Crawford’s committee.

On November 22, Mr. Crawford’s Pan Canadian Committee released the first comment on the restructure in months in a Financial Post article. The Committee disclosed two new pieces of information:

- The Committee is creating a liquidity tranche for investors in need; and
- The restructuring is scheduled to be completed by March 2008.

As a consultant, the two most questions I get most rfrequently asked are: 1) What are these assets worth? and 2) Who is to blame for the debacle? Today I will tackle Question 1.

In order to answer the $35 billion question of "What are these assets worth?", we must answer this question with some more questions. Below are some of the key questions that should be asked of Purdy Crawford's Committee and the answers will have a material impact on the recovery value on the assets:

- The most difficult part of the restructure will be to address the margin calls that can be made by the foreign banks for corporate CDOs in an environment, where new ABCP cannot be issued. If investors are unable to post collateral for a margin call, this will result in an event of default and a firesale of the assets. How will the Committee prevent this from happening? There is speculation that either the triggers will be widened to a level where they are less likely to be triggered or the foreign banks will agree to waive them altogether. However, this leaves the foreign banks greater exposed to corporate credit market. It is not likely they will agree to these new terms without some form of compensation. That form of compensation is likely to come from the investors. For this reason, it can be assumed the investors will not receive par for their investments in leveraged super senior CDOs, as the value of the credit default swaps are generally lower in today's credit crunch environment, compared to when the transactions were first originated.

- Who will be providing the “liquidity tranche” and how will this work? The government? Banks? Who is willing to take on additional exposure to the ABCP? Will this be available on December 14 or March 2008? This might give investors immediate temporary relief.

- How bad will the US subprime market get? As of October 2007, the default rate (90 days past due) was at 16% on the US$1.3 trillion subprime mortgage market. Will Bush's plan to freeze subprime mortgage rates for five years be successful? This may have an impact on the 7% of US subprime assets embedded in the ABCP.

- At what rate will investors be compensated for the standstill period?

- What type of return can investors expect on the new longer term notes?

- Will the restructure come in a form of bonds, issued with a prospectus much like the asset backed securities term transactions or will they be privately traded?

- Who will be the administrator of the newly structured notes? Can the role of administration be passed on seamlessly without any interruptions? Any interruption in administration (investment of collateral, collecting on receivables from traditional clients, etc.) can lead to deterioration in recovery value.

- When will the Data Room be open to the public to facilitate secondary trading? The sonner this happens, the sooner we will some bids from potential buyers.

- Can all investors wait until March 2008 for the restructure to complete? Are we confident the restructure will complete by March 2008?

- Will the standstill period be extended until March 2008? Can the Committee get all parties who have been waiting patiently since August to waive their rights again for an additional three months?

- Most importantly, can the Committee successfully convince all parties to play ball, or will one significant stakeholder lay the hammer and not agree to the terms and conditions beyond December 14?

It should be apparent that the valuation of the assets is a very difficult question to answer. This is why we have seen write-offs on ABCP all over the map between 5% to 40%. For the parties trying to sell ABCP, it is important to remember that in an open market economy, the assets are only worth what buyers will pay for them. While the affirmation of AAA ratings by DBRS gives some investors comfort, it is not enough to solicit meaningful bids from buyers. We must all do our part to urge greater transparency and flow of information in the market. Not only wil this give the market a better idea of the value of the assets, but we will actually begin to see some meaningful bids from secondary buyers.

Daryl Ching
Clarity Financial Strategy

US Subprime Rate Freeze - Commentary

By: Daryl Ching, Clarity Financial Strategy

Date: December 7, 2007

On December 6, George Bush unveiled a plan to freeze interest rates on subprime mortgages for five years. Leading up to 2007, with a booming real estate market, US lenders have been aggressively offering mortgages with low teaser rates, that balloon to a regular variable rate after a certain period of time, usually two years. The intention was to attract borrowers with poor credit quality and offer them rates that they could afford initially. As rates have been resetting to normal levels, there has been an increase in defaults, as borrowers can no longer afford to make the higher mortgage payments.

US Treasury Secretary Henry Paulson told reporters that this plan will avoid foreclosures and give the nation a chance to work its way through the housing cycle. The US subprime mortgage market is estimated to be US$1.3 trillion. Reports have indicated defaults (90 days delinquencies) / foreclosures to be anywhere between 16-20% to date. There is estimated to be an additional $500 billion of mortgages resetting in 2008.

I agree that this plan will temporarily slow down the rate of defaults and give the market some breathing space. Investors of Canadian ABCP with subprime exposure can stand to benefit from this plan, especially if the term to maturity of the assets is within a five year timeframe. However, we have to take a look at Bush's plan from several angles.

In order for this plan to work, the US government will need to receive some form of consensus from the investors who currently hold the subprime risk. Investors who had agreed to these investments had likely expected a greater pickup in return on their investments, which can only be received from higher mortgage rates. Also, in securitization transactions, a common form of credit enhancement to protect against losses is excess spread - yield on mortgages minus funding costs. For the borrowers who can afford to pay the higher reset mortgage rates, their proceeds will be used as a cushion for losses and will also help pay the higher returns to investors who have agreed to take on this risk.

Investors will have to decide if the resulting decrease in defaults more than offsets the yield they could have earned from borrowers who continue to make mortgage payments. A couple more important questions should be asked when thinking about the long term:

1) Are we not just delaying the inevitable? Paulson argues that by pushing the resets out five years, we may push them out to a higher point in the credit cycle. However, is it not the poor underwriting of mortgages that has led to this crisis and drop in housing prices in the first place? I can only believe that the delay will lead to the same problem in five years.

2) There is always the debate about whether government intervention, particularly bail outs are good for the capital markets. Have the various participants in the financial markets learned their lesson? Will we see this happen again within the next century? Do government bail outs encourage the market to continue its wreckless underwriting and help participants forget about the mess that has been created?

While I am convinced that this plan provides a bandaid solution that will limit defaults in the subprime sector into 2008, I am not convinced that mortgage rate freeze is good for the market in the long term. Sometimes, people only learn lessons the hard way, and that is to feel the pain of a loss from poor investment decisions.

Daryl Ching
Clarity Financial Strategy

Scotia Capital / Canaccord ABCP Lawsuit - Article and Comment

By: Ross Hendin, Hendin Consultants

Tara Perkins and Jacquie McNish wrote an article in today's Globe and Mail: Scotia Capital named in ABCP lawsuits

I think it's an article worth reading because it goes into a lot of the details that will become important as litigation continues to unfold in the case and after the Accord is voted on.
For readers of the Globe, I have already made a comment about the article.

But for the readers of the Clarity blog, I want point out a few other things:

1) The first and last paragraphs of this article are really the heart of the issue here. Scotia Capital may have known the market was heading for turmoil. They may have not just ignored this, but may have gone a step further by reducing the amount of paper they held while promoting the paper to clients. Now, as I often tell clients, there are two places that corporate legal cases are fought: the court of law and the court of public opinion. Even if Scotia Capital wins in court, they are going to have a challenge winning this one in the court of public opinion. This is a legal fight that should be in the public eye, and it seems very likely to me from a PR strategy perspective that Canaccord probably launched the suit in advance of the Montreal Accord deadline for the very purpose of getting advance media attention and trying to get the message out there that at least one group may have known about the ABCP meltdown before hand and did nothing about it. IF this is what they are trying to do, I commend them on the strategy and just hope now that they can get the message out more effectively. Scotia Capital also has a chance to use the spotlight to its advantage if it can figure out how to harness this action in its best interests. I think it can be done.

2) Branding, and the way you present yourself as a company, is critical at all times. Before anyone launches a litigation or an accusation, PLEASE for the love of your shareholders consider if your arguments or assertions in your legal filings (that go on the public recorded and may be exposed) are in line with what you hold yourself out to be. For example, click here to see the Canaccord Capital website. Beside the logo are the words "Independent Thinking". Their case is totally premised on the fact that they were told what to do and what to think by Scotia, they DIDN'T think independently, and they are suing because of it. More and more over the last number of years, companies have been realizing that the market and their clients are becoming more observant. Many of the most forward-thinking companies now make it a rule to hire a PR person to work with their lawyers (litigation communication) to translate between English and Legalese, and to make sure mistakes like this one just don't happen. There is a very famous PR case study called the 'McLibel' trial that comes to mind: McDonald's actually sued two people from Greenpeace. Even if they won the case, it doesn't matter - it was a PR disaster.

Ross Hendin is CEO of Hendin Consultants, and is a Senior Advisor to a leading multi-national PR firm. With strategic communication experience in more than 20 countries around the world, Ross specializes in litigation, financial and political strategic communication. He has advised companies in the ABCP niche since 2006. Hendin Consultants has offices in Toronto and London, UK.

Hendin Consultants is on the web at http://www.hendinconsultants.com/.
Email Ross at ross@hendinconsultants.com.

Investors should not lose sight of credit risk, says Bank

By: Daryl Ching, Clarity Financial Strategy

Date: December 6, 2007

Tara Perkins wrote an article today about a paper publicshed in the Bank of Canada's Financial System Review. Click here to view the Globe and Mail article

This article starts off by addressing the Asset Backed Commercial Paper debacle and stating that “investors need to accept responsibility for managing credit risk in their portfolios.” It suggests that investors cannot fully push off accountability to the rating agencies who rated the ABCP. I wholeheartedly agree with this statement. At the end of the day, the rating agency provides an opinion on credit quality based on relevant facts they have available to them. When situations change, like the recent market disruption, they revise their criteria to reflect a change in environment.

Investors do not sue research analysts for placing a "buy" rating on a stock if it plummets. Auto purchasers do not take action on consumer reports if they put out positive reports on a car and the engine breaks down. At the end of the day, much like other reports available in public, the rating agency provides an opinion. It is ultimately the responsibility of investors to understand the rating methodologies and convince themselves that they are comfortable with their investment decisions.

If we think back to the market disruption, there were no downgrades of any ABCP conduits at the time and no sign of credit deterioration in the trusts. The market disruption of the non-bank trusts was as a result of a loss of investor confidence from the buzzword "subprime". Can you blame the rating agency for not predicting a mass exodus of ABCP investors when there was no reason from a credit perspective to panic? It has been pointed out that DBRS may have been wrong on the General Market Disruption liquidity protocol, as some banks did not fund emergency liquidity in August. However, until the courts confirm that the banks were right not to fund, the verdict is still out on that issue as well.

I also agree with the comment in the paper that government regulation of the rating agencies could stifle innovation and development of the financial markets. The rating agencies are closer to the market having constant interaction with various participants and are in a better position to rate structured products than the government. I think the best approach for development of the capital markets is to learn from our mistakes and make changes going forward. As a result of this debacle in Canada, investors will need to be more savvy and will demand more transparency. DBRS has revised their criteria to require global style liquidity for ABCP conduits. This opens the door for other rating agencies to come in and rate the paper. Having a second opinion from another rating agency on ABCP will add a layer of scrutiny and provide greater comfort to investors as well.

As we watch the evolution of the ABCP market, it will be interesting to see how things unfold and how the market looks next year this time. At the very least, I certainly hope we have learned a couple key lessons:

1) More transparency and more disclosure will be required.
2) Investors need to do their homework and are accountable for all their investment decisions.

Daryl Ching
Clarity Financial Strategy

Perimeter ABCP: Market Update

Click here to view Perimeter's newsletter

Perimeter Financial has released a newsletter through their Markteplace Update on the progress that has been made thus far. A few interesting conclusions can be drawn from the information provided:

1) There is still a large discrepancy between the bids and offers. This is likely due to the lack of information available on the assets.

2) A common question being asked is "What do these transactions mean?" This speaks to the fact that investors are still not receiving adequate responses to their questions on the underlying structures. It would be prudent for investors to seek professional advice from individuals who have had a structuring role in the industry to fully understand what they have purchased.

3) Another anonymous comment cited in the newsletter is "All my assets are AAA, I wouldn't accept any haircut beyond 5%." Because investors have purchased AAA investments and those investments continue to be affirmed AAA, investors continue to believe they should not accept any bid too much below par. This comment reiterates that investors are continuing to rely on the AAA rating. My advice for investors is that they need to learn about the assets, methodologies on ratings and figure how to determine for themselves that the assets are still AAA. Without a real understanding of the assets are structured, AAA is a relative term.

If there is one lesson to be learned from this entire situation, it is that investors need to do their own due diligence for all investment decisions.

Daryl Ching
Managing Partner
Clarity Financial Strategy

What can we expect with the Montreal Accord on December 14?

By Daryl Ching
Clarity Financial Strategy

It should be apparent that many questions still need to be answered when assessing the outcome of the ABCP restructure, and all these questions have implications on recovery value of the investments. It appears in a recent report issued by Purdy Crawford's Committee that progress is being made and I applaud their efforts on this difficult restructure. Having said that, we still seem to be missing the principles of something our nation is very proud of – capitalism and an open economy. Whether an investor holds $50,000 or $1 billion of ABCP, it's counterintuitive to say that they are not allowed to sell their assets. What the Pan Canadian Committee is missing is a second option for investors to sell their assets immediately in the event they cannot wait until March 2008 or possibly longer. In order for this to happen, the Committee must release the information in the Data Room managed by Ernst & Young to the public to allow meaningful secondary bids. As the assets continue to be of strong credit quality, there is certainly demand from various hedge funds and fixed income portfolio managers to buy the assets. However, they cannot do this without information. By providing data, secondary investors will have the tools to conduct prudent analysis for their investment decisions and offer bids higher than 50 or 60 cents to the dollar. With multiple bids, this will enhance the pricing on these investments and at the end of the day, investors have a choice to sell their assets or not.

In various press releases, I have seen potential buyers labeled as “debt vultures” and making an effort to “exploit those in need of liquidity”. I have a hard time trying to understand how secondary trading in ABCP is any different than any other market. Let’s take an example where Mutual Fund Corp., a conservative fund manager is holding XYZ Corp. that is suddenly downgraded below investment grade on negative earnings. Due to Mutual Fund Corp.’s conservative investment guidelines, they are forced to sell XYZ Corp. The likely buyers will be other funds that take greater risks, in hopes of high reward. It is likely that Mutual Fund Corp. will sell XYZ Corp. at a discount from its original purchase price. However, Mutual Fund Corp. is likely thankful of an open market system and the fact that they were able to dispose of their assets.

Despite strong affirmed ratings by DBRS, the ABCP can clearly be classified as distressed assets. There is no liquidity in the ABCP market and there are so many uncertainties about the outcome of the restructure. It is only fair that potential buyers of ABCP need to be compensated for the lack of information available and the uncertainties that exist. It is for this very reason that potential buyers ask for a purchase price at a discount to par. A trade will take place between a seller who cannot wait for the restructure to complete or does not have the risk appetite for the uncertainties ahead in the restructure and a buyer who can wait and does have the appetite. However, we should all be glad that there is an investor base willing to buy the distressed assets when an efficient ABCP market does not exist.

Despite the lack of information, I remain confident that the Pan Canadian Committee will be successful in the restructure. Whether this takes place in March 2008 or later remains to be seen. The restructure will result in the ABCP being converted to long-term notes to match the maturities of the assets. When this happens, I expect there will be much more information and help for market participants to assess the value of the assets. I anticipate that we will find that the trusts are of varying quality, and some will price closer to par than others. However, I am also hopeful and optimistic that for those investors who just cannot wait, there an opportunity for them to sell their ABCP well before March 2008 either privately or through the Perimeter Financial trading platform.

As an individual who has invested over six years in this industry, I feel a personal responsibility to facilitate a fair resolution for all parties involved. At the very least, fair to me means full transparency and full dissemination of information that is available to all parties involved to level the playing field so that everyone can make informed decisions.

Daryl Ching
Clarity Financial Strategy
http://www.clarityfinancialstrategy.com/