Vol 5 (2008) - Issue 6

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ABCP Crisis: The Canadian Solution

These are tumultuous economic times in North America and throughout the world. As the United States continues to struggle to stabilise its failing economy and allay the fears of anxious investors, Canada has taken a step towards restructuring, at least part, of its financial crisis. Canada’s unique solution to its assetbacked commercial paper (‘ABCP’) crisis is unique and innovative, but is not without controversy.

Background to the ABCP crisis in Canada

In Canada, ABCP is issued by two groups: (i) banks, and (ii) third parties (non-banks). The restructuring of the ABCP market in Canada involved paper issued by third parties totaling approximately USD 32 billion.

Prior to the collapse of the ABCP market, these third parties, also known as ‘Sponsors’, would create trusts or ‘Conduits’ to make ABCP available to inventors at attractive interest rates. The Sponsor would arrange for the purchase of the assets held in the Conduit and promote the sale and distribution of the ABCP issued by the Conduit. A Conduit is a special purpose instrument, usually in the form of a trust, which is created as a legally distinct entity from the Sponsor. ABCP is issued by a Conduit pursuant to a trust indenture which appoints a trustee to serve as trustee for the investors. The money generated from the sale of notes is used to purchase assets to be held by the trustees of the Conduits. The indenture limits the repayment under each note to the assets held by the trust for that series of notes.

ABCP typically has a short term maturity date (usually between 30 and 90 days) but the underlying assets have longer maturity dates. In Canada, much of the ABCP is backed by traditionally reliable assets, such as credit card receivables, auto loans, and conventional mortgages. The value of each note is directly connected to the value of the underlying asset.

When the paper matures, the Conduits are required to have sufficient funds to satisfy the investors. The fact that the maturity of the notes and the underlying assets are mismatched did not hinder the ABCP market initially. Many investors did not require repayment of the paper on maturity and instead, reinvested or ‘rolled’ their ABCP on maturity. Funds were also generated by the Conduits by issuing new tranches of ABCP, the proceeds of which were used to pay the holders of the maturing paper when required.

In order to provide additional security for investors, many of the trustees of the Conduits entered into arrangements with liquidity providers (‘Liquidity Providers’) in respect of certain series of notes. These arrangements were typically made with third party lenders who agreed to provide funding to repay maturing ABCP note-holders in case of a ‘market disruption’.

Among the multitude of low-risk investment opportunities, ABCP was billed as being second only to government paper in terms of its likelihood for repayment. In Canada, ABCP is rated by the Dominion Bond Rating Service (‘DBRS’). Prior to the collapse of the ABCP market, most of Canada’s ABCP was given the highest rating awarded by DBRS. Shortly thereafter, DBRS announced that it would review its rules for grading ABCP in Canada.

The cause

As a result of the subprime mortgage collapse in the United States, many Canadian investors began to question the liquidity and value of the assets backing their commercial paper. Most investors are not aware of the nature of the assets underlying their commercial paper. The lack of transparency resulted, in part, because of the fact that the assets underlying the paper were purchased contemporaneously with the sale of the paper itself. Due to this lack of transparency, investors assumed the worst and stopped buying and reinvesting in ABCP. As Conduits were thus unable to generate further funds, this subsequently resulted in a lack of available funds to repay maturing ABCP.

Many Conduits looked to the Liquidity Providers to fund the shortfall. The Liquidity Providers, in response, advised the non-bank Sponsors that a ‘market disruption’ had not occurred and that the terms for provision of liquidity had not, therefore, been met. As a result, they refused to cover the shortfall. It was clear that the bottom was going to fall out of the ABCP market and that holders of non-bank ABCP were not going to be repaid upon maturity. In other words, the non-bank ABCP market instantly became insolvent.