PD16

Asset Backed Commercial Paper

Lessons in risk management to be learned

Stuart Wason

June 19, 2008

2

ABCP Conduit

• An ABCP conduit is a Special Purpose Vehicle (SPV) that issues commercial paper and uses the proceeds to purchase assets such as– Trade receivables

– Credit card receivables

– Auto and equipment leases

– Mortgages

– Other types of assets

• The payments that are collected from the purchased assets are used to redeem the commercial paper at maturity

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Simple ABCP Transaction Structure

SellerABCP

ConduitInvestors

assets

asset

cash

securities

cash

Ass

et re

turn

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ABCP Conduit

• In recent years, many ABCP conduits purchased longer-term assets such as:– Mortgage-backed securities (MBS)– Commercial loans– Collateralized Debt Obligations (CDOs)– Collateralized Loan Obligations (CLOs)

• By the end of 2006, a number of conduits had been created to act as “arbitrage vehicles” in which the conduit purchases longer term, higher yielding assets in the public fixed income market

5

Asset Collateralization Structure

Seller SPV Investors

assets

asset

cash

securities

cash

Ass

et re

turn

Creditguarantor

6

ABCP Market Structural Issues

• Lack of transparency

– Investors received only basic or minimal information as to what assets they were really buying

– In most cases, the only information available was in the form of rating agency reports which outlined the asset class composition of the program, not the actual description of the underlying assets

7

ABCP Market Structural Issues

• Asset / liability mismatch

– Programs are founded upon funding of long-term assets with short-term debt (ABCP)

– To address this, conduits relied upon the liquidity providers to support the repayment of notes if access by the conduit to funds becomes an issue

– There was a lack of transparency in respect of who provided what support to which tranche or structure

• This information was only available to the conduit and the rating agency

8

Liquidity facilities

• “Global Style”– Liquidity provider backstops the conduit in times of

liquidity stress

• “Canadian Style”– Rely on a broadly defined “market disruption” clause

as the trigger for liquidity support

Bank sponsored conduits were largely supported by global style facilities provided by large domestic banks, while Canadian style arrangements were in place at non-bank sponsored conduits, often provided by international banks

9

Simple ABCP Transaction Structure

SellerABCP

ConduitInvestors

assets

asset

cash

securities

cash

Ass

et re

turn

Bank

liquidity

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Rating ABCP

• Moody’s and Standard & Poor’s refused to rate Canadian non-bank sponsored ABCP because they carried “Canadian style” and not “global style” liquidity guarantees

• DBRS did rate these securities and was the only public source of information about them

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Rating ABCP

• Moody’s and Standard & Poor’s appear to have been correct

– When the non-bank sponsored ABCPs experienced severe liquidity problems their claims on their liquidity providers were not honoured because it was claimed that since the bank-sponsored structures were still sound, a general market disruption had not occurred

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The troubled asset class - U.S. subprime mortgages

• In the early years of this decade, small banks and mortgage brokers began to issue residential mortgages with very low (subprime) interest rates for an initial period but renewable at considerably higher rates (~10% or more)

• Underwriting standards weakened and mortgages were issued for 100% or more of the property’s value

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The troubled asset class - U.S. subprime mortgages

• The issuers did not intend to hold the mortgages– The mortgages would be securitized– The issuers received fees for the issuance and

would receive fees for administering the loans

• The issuers had little or no incentive to require borrowers to have a good credit record– Many loans were made to poor credit risks

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The troubled asset class - U.S. subprime mortgages

• As mortgages came up for renewal at considerably higher interest rates and monthly payments, many borrowers defaulted

– The tendency to default was increased by the fact that many borrowers had virtually no equity in their homes

– Since major Canadian non-bank sponsored ABCP was heavily invested in U.S. subprime mortgages, once news of the increasing defaults surfaced in mid-2007, the market for these assets dried up.

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Problem: Investors

• ABCP was purchased based upon ratings alone, with little or no understanding of the underlying assets

• Difficult to determine exactly who holds these assets– Some regulated FI’s certainly held them

• Some exposure came from being middle-men– Reputation risk

– Exposure to credit guarantors of the basic securitizations

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Problem: Accounting

• Fair value accounting relies upon deep and liquid markets existing

• What do we do when markets dry up?

• Models are not an acceptable alternative since there is little sound basis for the assumptions needed

Markets are not always rational!

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Risk Management

• Limits on asset classes and exposures

• Look to underlying assets, understand the risks

• Evaluate the security of counterparties

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Securitization of Insurance Risk

• Establish a special purpose reinsurer

• SPRV receives premiums, pays claims

• SPRV’s capital supplied by outside investors

• Major issues– The ownership and structure, including capital

structure, of the SPV, – The degree of risk transferred

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Insurance Securitization Structure

Insurer SPV reinsurer

Investors

policies

Mortality risk

Reserve relief

bonds

cash

Creditprovider

claims

premiums

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Insurance Securitization

• The creditor is effectively an unregulated reinsurer

• The underlying assets are opaque to most investors

• Certain tranches could be packed with substandard lives – potentially as toxic as subprimes

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Insurance Securitization

• Very active market in the U.S.– Primarily driven by a desire for reserve relief,

particularly under Guideline XXX

• No such structure as yet in Canada– OSFI has received three applications– Two were denied and one was withdrawn

Discussion