How the lack of financial market regulations failed asset-backed commercial paper.

As the credit crisis continues to unfold, the international debate over the regulation of financial markets continues to escalate. Is such regulation appropriate or do financial markets operate on a “buyer beware” basis? The meltdown of the Canadian non-bank asset-backed commercial paper (ABCP) market is a case in point.

As the story goes, private firms sponsored ABCP vehicles, or conduits. But unlike banks, ABCP sponsors were neither regulated nor subject to any capital requirements. Conduits sold short-term notes to investors, marketing them as cash-like instruments. And they invested in longer-duration instruments, such as residential and commercial mortgages; some even in U.S. subprime mortgages.

In addition, many conduits were parties to credit default swaps, in which a protection buyer pays a premium to a protection seller. In exchange, the seller takes on the credit risk of an agreed-upon financial instrument. If a bank, for example, has loaned money to Company A and wishes to protect itself from the risk that Company A will default, it may enter into a credit default swap with a third party. The bank pays the third party a premium, and, if Company A defaults, the third party will pay the bank.

In many credit default swaps, the seller must also post collateral that matches the degree of default risk. And additional collateral must be posted at different trigger points. As many of the ABCP conduits in Canada were protection sellers, they had to post additional collateral as default risk rose.

Regulation Breakdown

The unravelling of the ABCP market features a number of regulatory failures. First, ABCP sponsors were unregulated. They had no capital to support the conduits they sponsored.

Second, conduits were unregulated. They mismatched assets to liabilities, issuing short-term notes while holding longer-term instruments. They also took on risk through credit default swaps.

Third, because there were no regulatory disclosure requirements, conduits were opaque. Investors did not know which assets backed which conduits. So, during the subprime crisis, noteholders exited the entire non-bank ABCP market, cashing out all of their non-bank ABCP.

Of course, conduits could not pay out noteholders because they relied on rolling over their short-term paper. Their backing assets were longer term and partially illiquid or of uncertain value. Conduits did, however, enter into liquidity agreements with banks. These were supposed to provide liquidity support, but each liquidity agreement was drafted differently and not subject to any regulatory standards. Banks argued that they were not required to provide liquidity under the agreements, and they were not challenged in court.

Meanwhile, the market’s perception of risks in credit default swaps increased, margin triggers were breached, and conduits had to post additional collateral. Because they were unable to issue new notes, they were unable to meet these margin calls.

Court Protection

In the end, conduits sought court protection under Canada’s insolvency laws. As a result of the conduits’ restructuring, most of their assets are being consolidated. Notes whose durations match those of the underlying assets are replacing short-term notes. And, margin triggers under credit default swaps have been changed, so that the posting of additional collateral is deferred. However, although their triggers have been restructured, credit default swaps are still the first-ranked obligation of the new consolidated conduits.

In the restructuring process, various players in the ABCP crisis have been released from liability, except for fraud. Sponsors, brokers, banks and rating agencies cannot be sued for negligence or breach of contract.

Ultimately, buyer beware is of limited utility. Buyers ordinarily practise due diligence and exercise their legal rights if they are misled. As the Canadian ABCP crisis demonstrates, however, those legal rights are only enforceable in a stable market. Lack of regulation led to a dysfunctional market in non-bank ABCP and, ultimately, to the evisceration of legal rights against those responsible for the meltdown. Only a firmer regulatory footing will prevent more of the same.

Murray Gold is a partner with Koskie Minsky LL P in Toronto. mgold@kmlaw.ca

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© Copyright 2008 Rogers Publishing Ltd. This article first appeared in the July 2008 edition of BENEFITS CANADA magazine.

 

Copyright © 2020 Transcontinental Media G.P. This article first appeared in Benefits Canada.

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