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Corporate Corner: Asset-backed commercial paper

There has been a lot of press recently about the credit crunch in Canada and the United States. Sub-prime mortgages, asset-backed commercial paper (ABCP), and the restructuring process surrounding the non-bank ABCP market in Canada have occupied a lot of media space. This article will attempt to give an overview of the issues.

At it’s simplest level, ABCP refers to short term debt instruments issued by entities (usually trusts in Canada) called special purpose vehicles or SPVs (“conduits”), which are designed with a view to funding themselves with ABCP. The idea is to create a vehicle that will hold financial assets off the balance sheet of the originator.

So for example, a company that finances a lot of cars for its clients using lease financing can take the leases off its balance sheet by selling them to a conduit. The conduit raises the money to pay for the leases by issuing ABCP.

These structures benefit the originator of the asset sold to the conduit because often the assets are more credit worthy in isolation than the originator is, taken as a whole. Going back to our example, the auto dealer that originated the leases will have all kinds of other businesses and issues associated with its ongoing operations which would make financing challenging.

However, the leases it writes form a pool of fairly homogenous legal contracts with a diverse community of obligors that are fairly easily analyzed and can attract favorable funding terms.

These structures also benefit investors in ABCP because they give investors access to the types of assets, like leases, that would normally be reserved to banks and other large financial institutions. Those assets deliver higher rates of return than most other types of investment. If the underlying pools of assets are sufficiently strong, the ABCP issued can be very highly rated by credit rating agencies, meaning the potential for default is very low. This tends to increase investor confidence and funding costs.

However, there are potential challenges in these structures. First, ABCP is typically short term in duration, while the financial assets of the conduits that issue ABCP are typically longer term, with maturities of three to five years. This issue is addressed with liquidity lines, addressed in more detail below. The second issue is the quality of the underlying assets. Events can occur that can affect the underlying quality of the asset pool.

This issue is generally addressed by the related analysis and level of credit enhancement required to achieve the credit rating. Short-term investors are not very concerned about long-term declines in asset value, as they can liquidate their investments quickly, at least in theory.

We now shift focus to the U.S. sub-prime mortgage market and how that has implications for the Canadian ABCP market.

The U.S. sub-prime mortgage market delivered high returns because the underlying assets - mortgages issued to parties who would not normally qualify for conventional financing - were inherently risky. Much of the funding for this business came from the U.S. ABCP market. A lot of the risks associated with the sub-prime mortgage market were distributed to investors through sophisticated financial products known as collateralized debt obligations or CDO’s.

By way of example, suppose you had a pool of mortgage loans to sub-prime borrowers. One way to distribute risk of default is to sell off the portfolio in tranches priced in accordance with the likelihood that a default will occur.

If you have $100 in total mortgage loans and you expect a two-per-cent default rate, the party bearing the risk of the first $2 of loss will need a return in excess of 100 per cent. However, the party bearing the last $2 of loss will only need a very small return, as the chance that all $100 will be lost is very remote.

In a low interest rate market, investors looking for a return are trying to find ways to increase the returns on relatively safe assets. Using the tiering strategy discussed above, a portfolio of relatively risky assets can be added to a portfolio of relatively strong assets, thus increasing the yield without significantly increasing the overall credit risk associated with the entire portfolio.

These highly structured products were put together and sold to Conduits, some of which would contain nothing but CDO’s designed to achieve maximum returns with the highest possible credit ratings. A great many of these structures used sub-prime mortgage CDOs to enhance the rate of return.

CDO structures permit the creation of super-senior tranches where the risk of default is very low indeed. Payments with respect to these super-senior tranches are very low, but a purchaser could enhance its return by leveraging its participation by factors of 10 or more. These types of investments are what is referred to as “leveraged CDO positions.” Leverage is very good in good times and very bad in bad times.

The markets for conventional mortgages and automotive leases, the traditional assets of ABCP conduits, are fairly mature in Canada and the demand for short-term debt products with enhanced returns is fairly high. The ABCP market in Canada moved heavily towards CDO investments to meet that demand. According to the Dominion Bond Rating Service, approximately 68 per cent of the assets in the non-bank ABCP conduits is made up of CDO-type investments.

The actual composition of assets in any particular conduit is not a matter of public record. ABCP trades under prospectus exemptions to sophisticated investors and the conduits do not necessarily reveal details of their asset holdings, although they do provide monthly summary reports with varying degrees of disclosure.

Investors were asked to rely upon the credit ratings provided by DBRS and the existence of various mechanisms to either provide liquidity or substitute for liquidity in the event of market disruption.

This brings us to liquidity. When a conduit structured its offering to investors it would seek liquidity facilities to either purchase its ABCP or provide it with funding to itself purchase ABCP in circumstances where there was a market disruption. These liquidity facilities were provided by individual banks and individually negotiated.

There emerged two basic types of liquidity facility:

(a)    So-called “Canadian style” liquidity, which provided for funding in circumstances of “general market disruption” (variously defined); and

(b)    So-called “global style” liquidity, which provided for funding in circumstances where the conduit itself was unable to issue commercial paper.

Liquidity facilities with Canadian-style triggers were fairly inexpensive because it was felt that it would be pretty unlikely that there would be a general market disruption. This, in fact, proved to be the case. On Aug. 13, many of the non-bank ABCP conduits declared that they were unable to purchase maturing notes with funds from replacement purchasers of notes. Most liquidity providers felt that there was no legal requirement for them to provide liquidity because some of the conduits, those sponsored by domestic Canadian banks, were able to fund their commercial paper obligations: there was no general market disruption.

Under the terms of the documentation that establishes the conduits that issue ABCP, the parties agree not to petition the conduits into bankruptcy while any notes are outstanding. Accordingly, the note holders did not have access to the public insolvency process and the conduits themselves had no incentive to use it. This fact led to the creation of the Montreal Accord led by the largest holder of non-bank ABCP, the Caisse de Depot et Placement du Quebec.

Under the Montreal Accord, the holders of sufficient notes to control the conduits that issued the ABCP entered into an agreement to attempt to restructure the short term ABCP as medium-term floating rate notes (FRNs). The idea is to have the term of the notes span the life of the assets in the conduits.

The Montreal Accord was necessary because investors in non-bank ABCP decided not to purchase or roll their holdings because of nervousness about the presence of CDO’s in the asset structure of the conduits and the fact that it was pretty difficult to tell how much of the exposure to CDOs was really exposure to the sub-prime mortgage market in the United States.

Various parties have since variously estimated the extent of that exposure but it does not appear to be more that seven per cent. Even at seven per cent, the majority of the exposure appears to be in senior or super senior tranches of the sub-prime investment category.

This should not ultimately be very vulnerable to total loss. Accordingly, DBRS has largely maintained its rating of the conduits notwithstanding that there is no liquidity. It appears that the assets themselves continue to perform as expected, so the ultimate solvency of the conduits does not appear to be in question.

However, the process itself poses challenges. Some of the ABCP did not have liquidity facilities, but were extendable. In other words, if a market was not available on the maturity of the note, the term of the note was extendable and the interest rate raised. Some of the conduits do not have sufficient revenue to cover the cost of this increased rate.

In addition, the burden of funding the process associated with the Montreal Accord must be considerable, consisting as it does of the most senior accounting and legal professionals on Bay Street. It is interesting to note that the Skeena conduit, which is the only Canadian conduit to have been successfully restructured, saw investors basically get their money out except for a fairly significant charge for “restructuring expenses”. Skeena was easy. The remaining twenty or so conduits will be a much greater challenge and involve much greater legal and accounting time and energy.

Having said that there may be no ultimate insolvency risk in the conduits does not mean that the value of the underlying assets is stable. CDO prices have risen considerably, by a factor of four or five times, since Aug. 13.

If the conduits wished to sell their CDO assets in the current market, those assets would be worth considerably less than they were worth on the day they were acquired.

The decline in value is magnified for leveraged positions. It is difficult to estimate the extent of the decline, but the CICA has recently stated that holders of this class of ABCP in general should be thinking about discounts in the 15 to 20 per cent range when reporting the value of these assets on their balance sheets. It is hard to tell whether this guidance is conservative or not, because there is no market.

That brings me to the final point of this article. The committee established under the Montreal Accord to manage this process has stated that it does not wish this commercial paper to trade until the conversion to FRNs has been accomplished. There is no legal restriction on the trading of these instruments. However, the committee has made it difficult to obtain information regarding the underlying assets of the conduits in what appears to be an effort to make it difficult or impossible for holders to trade.

This approach is distressing. Last time I checked, this was a free market economy, not one being run for the benefit and convenience of institutional investors.

However, there is free market light on the horizon. A small Toronto brokerage has indicated that it will list the ABCP issued by the remaining non-bank conduits. This should provide a forum in which willing buyers can at least exchange information with willing sellers. DBRS has also published more detailed analysis of the assets underlying the remaining non-bank conduits.

While not complete disclosure, this information may be sufficient to allow a market to emerge. Sellers will face a disadvantage because they will be unable to provide detailed information on the assets in the conduits whose ABCP they hold. There will doubtless be a price associated with that lack of clarity, but there is a reasonable chance that trading at some level will occur. If that happens, we may start to see market discipline imposed upon this process.

Sam Billard is a partner at Aird & Berlis LLP practising primarily in the debt finance area.

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