The Canadian market for asset-backed commercial paper (“ABCP”) grew dramatically from $10 billion in 1997 to $115 billion in 2007. In that decade, the mix of assets underlying commercial paper changed as well. In 2007, collateralized debt obligations (“CDOs”) and residential and commercial mortgage-backed securities together comprised more than 50% of the underlying assets.
In particular, the growth of CDOs has been exponential. A CDO is a stand-alone, special purpose vehicle (“SPV”) that invests in a portfolio of assets. CDOs are different from mutual funds where all investors share in the risk and reward of the investments equally. In a CDO, the SPV borrows money by selling different classes of notes to investors, each class having a different risk/reward profile. If any of the assets in the underlying asset pool default, the lowest ranking note class is first to suffer a loss.
There is no limit to what financial architects can do with CDOs. Initially CDOs were structured as cash flow CDOs, because the SPV used the money received from investors to actually buy cash-generating assets, and used the cash to pay back the investors. In recent years, synthetic CDOs have become far more popular than cash flow CDOs. In a synthetic CDO, debt securities in a portfolio of assets are only referenced through credit default swaps (“CDSs”). Each CDS effectively transfers (synthetically) the risk of the portfolio of assets from a third party to the SPV, but not ownership of that portfolio. CDOs comprised of CDSs have risk characteristics relating to leverage, market-to-market, hedging, collateral quality and liquidity which are complex and difficult to mitigate.
Under applicable securities laws in Canada, ABCP is sold to investors pursuant to a short-term debt exemption from prospectus and registration requirements. The requirements are simply that the ABCP has a maturity date of less than one year from its date of issue, and that it is not convertible into other securities and has an approved credit rating from an approved credit rating organization. The short-term debt exemption was not intended for securities as complex as today’s ABCP.
About two-thirds of the issuers of ABCP in Canada are bank-sponsored conduits, and the remaining one-third of Canadian ABCP issuers are non-bank conduits. When troubles developed in 2007 in the Canadian ABCP market, the Office of the Superintendent of Financial Institutions Canada (“OSFI”) pointed out that it is not the role of OSFI to use its powers over banks to regulate capital markets. OSFI’s role is to protect bank solvency, not to tell Canadian investors what to invest in, nor to tell unregulated sponsors in the ABCP market how to go about their business. But the banks are key players in the ABCP market, both as providers of liquidity and as CDS counterparties, so OSFI does not take a totally “hands off” approach. Furthermore, mono-line insurers who are also CDS counterparties come under OSFI’s regulatory reach.
Since August 2007, ABCP issued by non-bank conduits has not traded, and discussions continue to restructure ABCP which has matured but no longer trades. The cost of this restructuring exercise is unknown, but will be substantial. The spark which caused this disruption in the Canadian ABCP market was worry about the inclusion of U.S. sub-prime residential mortgages in underlying assets of Canadian ABCPs. But the volume, complexity and value of the CDOs in ABCP portfolios is also a significant concern in Canada as well as the U.S. and Europe.
What can be done to make the Canadian ABCP market work more efficiently and protect investors? Here are two suggestions:
There needs to be better disclosure and transparency. CDOs are extremely complex products. People selling and buying ABCP typically do not understand the mix and complexity of the underlying assets. It should be mandatory that issuers of such products provide offering memoranda which contain full, true and plain disclosure about the ABCP securities being offered, their underlying assets and the risk profiles of those assets. Dealers and other distributors of ABCP must be satisfied with and take responsibility for disclosure documents and other marketing materials which incorporate materials provided by issuers of ABCP. There should also be continuous disclosure requirements.
The unfettered use of credit derivatives needs to be studied. Supporters of CDSs argue that they offer greater liquidity and flexibility than underlying cash investments, such as bonds issued by the same referenced credit entity. But since CDSs are synthetic derivatives, physical assets do not form a constraint, and the notional value of CDSs on particular referenced entities is often a substantial multiple of the outstanding debt of that entity. The rating agencies work with the financial architects of these products, and cannot be relied upon as the sole check-and-balance in the CDS markets. OSFI and regulatory bodies in other countries are developing capital adequacy standards to regulate investments by banks and other financial institutions in CDSs. The securities commissions in Canada should also be considering whether legislative limits or safeguards need to be developed to protect investors in ABCP having CDSs in their portfolio investments