For about 10 years, asset securitization has worked quietly in the background of Canada’s capital markets, providing a number of issuers with access to low-cost financing and offering investors attractive returns. Then, in the summer of 2007, the asset-backed commercial paper (ABCP) market virtually evaporated and more than $20 billion in securities went into default – the largest default in Canadian history.
Many people were surprised by the size of this $100 billion market and by its sudden collapse. They shouldn’t have been. The risks and the signs were there for those who understood what to look for. Our role, as legal counsel, is to ensure that our clients, who include a range of market participants, recognize the risks and to structure transactions that minimize their exposure. That does not eliminate the inherent risks in the asset-backed securities market, however, and many of those who ignored them found they did so at their peril. While some have searched to place blame, others are working towards a solution.
It seems likely that most investors will get their money back – eventually. It is also probable that the ABCP market will come back; it serves too useful a function to disappear. However, it is certain that the market will look significantly different in the future.
Like any market, the ABCP market consists of a number of participants. Issuers such as car manufacturers or credit card companies who need short-term financing place a number of their outstanding loans into a trust that may have holdings from a variety of issuers. These trusts, or conduits, are carefully constructed by legal counsel, assigned a credit rating by an independent agency, and have their debt securities backed by the acquired assets, and sold by sponsors – financial institutions ranging from the major banks to small investment firms – usually to larger, sophisticated investors.
The securities of the trust are sold for less than the face value of the trust’s assets to provide cover for possible defaults on some of the underlying loans. A key feature of ABCP is anonymity: buyers may know the trust issuing the paper but not the identity of the original asset sellers.
The benefit of this anonymity to the investor is that it limits exposure to individual issuers. On the books, the ABCP from each trust qualifies as a different investment. On the other hand, the investors don’t know exactly what is backing the paper they bought and this anonymity was the root of the crisis of confidence that undermined the market this past summer.
As the sub-prime mortgage market in the United States deteriorated, investors became concerned that their ABCP might include these mortgages. Although it was unlikely that most paper did, and although the mortgage market in Canada is structured quite differently, these concerns grew. The trigger was the required disclosure by one publicly traded sponsor that it had some exposure to U.S. sub-prime mortgages. Investor interest dried up, taking much of the ABCP market with it.
The short-term nature of ABCP means the underlying lenders are frequently issuing new paper to redeem the old. When there is no market for new paper, they face a liquidity problem. This is dealt with in the U.S. and Europe through relatively unconditional liquidity commitments from banks to prevent defaults. Canada’s system tolerated more conditional liquidity commitments. While not all sponsors took advantage of the ability to rely upon conditional liquidity, enough did that when investor interest dried up, billions of dollars of ABCP was pushed into technical default – technical in the sense that most, if not all, the underlying assets supporting the paper are still there, but they are not accessible until the paper is redeemed.
Fairly or not – and generally not – the finger of blame has been pointed at a number of ABCP market participants: the issuers; the sponsors; the single agency that assigned ratings to the paper; the banks for not providing sufficient financial backstops, although they have done more than they were obliged to do; and the portfolio managers who overlooked Rule One of investing which is safety first, ahead of looking for high return.
The fact is that the risks of ABCP were pointed out again and again, but many participants continued to believe nothing could go wrong – until it did.
Although the buyers of ABCP are a relatively small group of perhaps a few hundred sophisticated investors, the effect of the collapse of the market will be widespread. The paper found its way into pension funds, insurance investment portfolios and mutual funds held by most Canadians. How much it will be felt depends largely on the successful implementation of the recovery plan called the “Montreal Proposal.”
Whatever the outcome of the shorter-term fix, it is clear that changes will come to the ABCP market.
The need for short-term financing at reasonable cost will remain. Car companies and others who lack access to more traditional sources of credit will still need funds. Their loans will continue to be bundled and securitized as they have been for more than a decade.
However, it seems likely that the number of sponsors or conduits will be reduced to the larger players. There will be far more disclosure than there has been. Some aspects of the anonymity of ABCP will probably change. We are likely to find additional independent agencies providing second and third ratings on each issue. Canada has adopted the U.S. or global liquidity mechanism to extend credit to issuers as needed and to reduce the chances of future defaults. Most importantly, we will see far more education among investors and more rigorous analysis of their investment decisions in ABCP.
As the key element in the market – confidence – is restored over the next few years, we expect to see the market recover because, fundamentally, asset securitization fulfills an important role in the broader financial markets.
With the necessary changes, the asset-backed securities market will be back. In five years, it will probably be bigger than it was when 2007 began – but it will not be the size it would have been if this year’s crisis had been averted. Its growth was stalled by a crisis of confidence.