the black box

Essay text:

through ABCPs; this caused a sudden loss of confidence and contraction of the ABCP market due to decreased demand coupled with excessive supply • With no investors buying the paper, issuers were left unable to raise the necessary funds for the two-thirds of $33 billion ABCP currently maturing • If the investors had known accurately about the underlying assets of the commercial paper, they would have been able to weigh the risks of the U.S. subprime crisis on Canadian markets appropriately (Exhibit 1) 2 - The regulatory issues: • The ABCPs had built in a variety of insurances against disaster, including emergency liquidity support agreements for trusts by banks in the case of liquidity problems • However, the conditions of these agreements, drafted by OSFI, favour the creditors by the general wording of the conditions in which a bailout was necessary: a “general market disruption” • Two of the world’s biggest rating agencies (Standard & Poor’s and Moody’s) refused to grade the ABCP for fear that banks would get away with never fulfilling emergency liquidity agreements because of the wording • The fact that world leading rating agencies refused to grade these investments should have been an indication of risk to Canadian investors, however they continued to buy ABCP • Due to the regulatory environment favouring the interest of the creditors, investors were highly exposed to credit risk by their investments not being backed by third-party guarantors in certain instances • ABCP trusts were not able to fulfill their maturity obligations through emergency liquidity support agreements either 3 - The structure of market issues: • The Bank of Canada had pointed out the weaknesses of the Canadian system and major banks had stopped selling the paper • Having known this, issuers should have prepared a well thought-out backup plan which didn’t rely on emergency liquidity or selling paper in case of a downturn in the market • When disaster struck they had no escapes roots and were left with huge debt with no incoming cash flows • There was a lack of “safety nets” such as valuable income generating assets backing the paper and substantial cash reserves within the trust • The action of La Caisse (controller of one-third of the ABCP buyer’s market) dictated investor confidence in the market; investors perceived La Caisse scaling back of purchases of ABCP as a loss of faith in the market, and demand weakened • Independent ABCP trusts put their investors in a large amount of risk by dealing exclusively with a market whose movement relies largely on the investment decisions of a few major buyers • Lack of a backup plan was especially important for independent trusts who did not have diversified business lines to cushion losses on ABCP 4 - The investor confidence issues: • Because the precise nature and risk of these transactions concerning ABCP were not fully disclosed to investors, there has been a negative impact on trust between some investors and their long-time dealers • Even though certain trusts have very little exposure to the subprime mortgage crisis, investor confidence in ABCP as a whole is tainted due to fears of “what else is in the black box?” • If the trusts cannot gather the funds to pay off the two-thirds of $33 billion ABCP maturing, they would be liquidated and these assets sold in a market already facing a credit crunch, leading to investors likely not being able to recover their full investment