The ABCP fallout is still a burning issue in Canada, and pension fund managers and administrators are in the hot seat to explain what went wrong.

Our own asset-backed commercial paper (ABCP) crisis continues to unfold in Canada, with pension funds apparently holding some of the non-bank paper that is currently frozen as attempts are made to restructure these investments. The non-bank ABCP trusts appear to be insolvent—unable to meet their obligations as they become due—and the purpose of restructuring is to avoid a liquidation in an illiquid and uncertain market, hoping that time will allow the underlying assets to recover their values.

In Canada, we have two main types of ABCP: one, paper unconditionally guaranteed by a bank and two, paper subject to a more limited form of guarantee, known as “non-bank ABCP.” This second type of ABCP has become a serious problem for investors. Since the non-bank ABCP yielded more basis points than conventional money market instruments with comparable terms, many pension funds, corporations and individuals purchased the paper as a substitute for short-term money market instruments.

But the non-bank ABCP also came with considerable risks, as the current debacle demonstrates. And those involved in making the non-bank ABCP investments now face some difficult questions about precisely which assets backed this paper and the nature and extent of the bank guarantees supporting these assets—not to mention who was responsible for making inquiries about the nature of these assets, the risks they entailed and the limited guarantee that stood behind them.

Most pension fund investments in non-bank ABCP were made by professional money managers with mandates that include money market instruments. Pension fund administrators may well have created these mandates, believing that short-term money market investments were the “safe” component of their asset allocation.

Now pension fund administrators will be asking what inquiries their managers made before they decided to invest in non-bank ABCP. Did they know the nature of the instruments in the non-bank ABCP trusts? Did they know that the trusts were exposed to U.S. subprime mortgages, or to other debt or derivative instruments with considerable risk? Did they know the durations of the investments held in the trusts?

Investment managers will refer to the high ratings given to the non-bank ABCP by independent rating agencies. Apart from the questions these ratings raise about the agencies themselves, money managers must still answer the question: was it prudent to rely only on the agency’s rating, if no further inquiry was made into the assets held in the ABCP trusts and if the risks being assumed by these managers, on behalf of their pension fund clients, were largely unknown?

Canada’s own non-bank ABCP crisis illustrates some important aspects of the new world of pension fund investing. The range of investments for pension funds was once limited to bonds, equities with established dividend records, real estate and foreign assets. Today, the financial instruments available to and used by pension funds are much more complex, and risks of gain and loss are defined and allocated between different types and classes of investors in much more complicated ways than before hedge funds, credit default swaps and collateralized debt obligations came into existence. This complexity requires a new degree of care and diligence, with different skills required to assess the risk and opportunity implicit in the new assets.

The non-bank ABCP crisis is a warning of what can go wrong with new and complex financial innovations. But more importantly, it underlines the need to understand the material characteristics and risks of potential pension fund investments— as well as the dangers of not undertaking this due diligence. Murray Gold is a partner with Koskie Minsky LLP in Toronto. mgold@kmlaw.ca

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© Copyright 2007 Rogers Publishing Ltd. This article first appeared in the December 2007 edition of BENEFITS CANADA magazine.