When the Canadian asset-backed commercial paper (“ABCP”) market froze in August of 2007, we learned that some investors believed that they were investing in safe, short-term investments. And so, when investors, large and small, allege that they believed they were making investments “as safe as cash” and, instead, face complete illiquidity and potential loss of principal, regulators and legislators are forced to take notice.
What went wrong? It seems that both distributors of ABCP and investors relied on the high credit rating of the ABCP and its exemption from certain securities law requirements to conclude that the product was suitable for everyone. But how could an investment that proved to be so risky have received a high credit rating? What does a high credit rating mean? It means that the risk is very low that the issuer will not pay back interest and principal. In the case of the frozen ABCP, the credit rating proved to be meaningless.
Another serious issue was the lack of information about underlying assets of ABCP issuers, making risk assessment both before and after the freeze in the ABCP market difficult. The sudden scarcity of investors willing to invest in new ABCP was apparently caused by concerns that the ABCP issuers might be holding high-risk mortgages that were beginning to default.
And at the heart of the seize-up of the ABCP market was the fact that liquidity facilities were not available, as expected, to ensure that ABCP could be redeemed at maturity. ABCP, with the type of liquidity facility in issue (referred to as a “general market disruption liquidity facility”), was rated by only one credit rating agency, DBRS Limited, due to the restrictive wording in the liquidity facility agreement. Liquidity would only be provided if there was a general market disruption which meant that commercial paper could not be issued at any price by any issuer. Certain liquidity providers took the view that there had been no general market disruption and refused to make liquidity available. Since the ABCP crisis, DBRS Limited no longer provides ratings for ABCP with a general market disruption liquidity facility.
Now what should regulators do?
Securities Law Exemptions: Securities law needs modification to ensure that ABCP and other complex products cannot be sold to everyone without a prospectus. This involves removing the availability of the short-term debt exemption from prospectus requirements for ABCP and similar complex products. (It could still be sold to institutions and high net worth individuals without a prospectus under the accredited investor exemption.)
Product Due Diligence: The due diligence procedures of investment dealers need improvement to ensure that they appropriately categorize products and provide adequate information to customers to allow them to determine if the product is suitable for the customer’s particular investment objectives and circumstances.
Credit Ratings in Securities Law: The ABCP crisis has demonstrated that the use of credit ratings in securities law requires modification. Securities law includes many references to credit ratings, making certain exemptions and categorizations dependent on those ratings. One likely regulatory response is to restrict the use of credit ratings in securities law to plain vanilla securities of established operating businesses with assets. Credit rating agencies could continue to offer ratings for more complex products to customers, but such ratings would not be incorporated into securities law. If a credit rating agency believes that a new entity that relies entirely on short-term paper to finance long-term financial assets merits its highest credit rating, investors could choose whether or not to rely upon that rating. However, such ratings would not form the basis for an exemption from securities law requirements, such as prospectus disclosure requirements.
Registration of Credit Rating Agencies: It appears the time may have come to require registration of credit rating agencies, as is the case in the United States, to ensure that certain standards are met. Such standards would address disclosure of conflicts and, potentially, disclosure of certain securitization information, including the nature of underlying assets of an ABCP issuer. If registration were required, Canadian regulators would be able to take action, if necessary, to enforce those standards. However, regulators will wish to avoid becoming de facto rating agencies themselves or becoming intensely involved in the whole rating process, for example, by regulating methodology. Instead, the restriction of the use of credit ratings in securities law and the registration of credit rating agencies appear to be appropriate compromises.
The above regulatory responses, among others, are currently being considered by Canadian regulators. In the meantime, the ABCP restructuring plan has been completed. It now remains to be seen how the replacement of ABCP by long-term notes that match the maturities of underlying assets will work out for investors. Are the underlying assets, indeed, high quality assets? Will the ABCP investors ultimately be made whole? Only time will tell.