The shape of investing will probably change as credit markets work to restore confidence in the wake of the U.S. subprime loan fiasco and the Canadian asset-backed commercial paper collapse. As a result, debt instruments that will replace derivatives are going to be familiar, transparent and reliable.

The reaction to the fancy finance that dominated the markets prior to this summer’s correction is already underway, says Randy LeClair, senior vice president and portfolio manager at AIC Investment Services Inc. in Burlington, Ont.

“The credit crises in the U.S. and Canada will drive people back to basics,” he says, “[such as] good old Government of Canada bonds, provincial bonds and investment-grade corporate bonds without embedded options. The market is swinging back to simplified forms of debt with lower risk profiles.”

But problems will result from this shift. “The supply of government bonds is limited and there has to be room for older people to buy bonds for their retirement,” LeClair says. “There is talk on Bay Street that a category of insured mortgages called Canada mortgage-backed securities (CMBS), which trade like Government of Canada bonds with a small spread of five to 12 basis points over federal debt, could replace derivative products. There are questions about the covenants on the CMBS issues as to whether guarantees are direct and solid or just implied and, therefore, soft. But the consensus is the backing of the bonds with the full faith and credit of the Government of Canada is solid.”

This new or clarified federal policy is being publicized by the Department of Finance. In a March memorandum on federal debt strategy, Finance Minister Jim Flaherty acknowledged CMBS debt would be on the same plane as the debt of other Crown corporations, such as Business Development Bank of Canada and Export Development Corp. All Crown debt would be unequivocally backed by Ottawa.

As the supply of bonds backed by the full faith and credit of the Government of Canada grows, there will be less need for investors to reach for derivatives, LeClair says. This is good news to a bond market that — starved for long-term, high-quality bonds — reached too far down the barrel.

Shaky bonds will be driven out of the market by a Darwinian process of eliminating shaky debt devices. Among the species at risk will be securitized collections of debt in which the underlying assets are other collections of unwanted debt that could not be sold — collateralized debt obligations (CDOs) squared, as bond traders call them, which are actually junk derivatives of other junk derivatives.

“The market is going to shun funny bonds with fancy names,” LeClair says. “Even the ABCP market, which is about as large as Canada’s T-bill market, is going to be stuck. It won’t grow because of loss of confidence. The banks have bought back some of their ABCP. But investors are going to be hesitant to buy new paper that may get orphaned. The new fashion in debt will be no acronyms, no funny names, no stories — just plain vanilla bonds. The point will be to avoid future crises of confidence.”

It is helpful to study the development of the crisis that materialized in July. What triggered it was not the existence of subprime debt, but the abandonment of rigorous credit analysis and the distancing of borrowers from creditors.

The debt markets became less an ivory tower of dull but serious accountants, economists and debt analysts working on finance and more of a free-for-all in which any kind of debt was snapped up by investors and institutions eager for yield.

But, without good analysis, investors sometimes paid top dollar for bonds and collateralized notes that should have been priced for the high-yield market. At the bottom of the debt and derivatives pyramids were U.S. loans to people who could not afford houses by conventional credit standards.

The dubious loans were originated for fees by mortgage brokers. The loans were then sold to banks, packaged and securitized by Wall Street and, finally, sold to end-buyers who could not easily find out what was in those packages. Investors buying loans, especially those of a subprime nature, paid too much for poor loans. The market meltdown was driven by a bond price correction.

@page_break@Canada’s ABCP mess began as a variation on this idea: stuff a trust with credit card receivables, mortgage interest flows, ship leases, whatever. Structure it so top levels get the cash, the next levels get what is left and so on down to the bottom tranches — aka “toxic waste” — that would be lucky to get paid. The final move securitizes and sells the packaged loans to investors who don’t know what they contain.

The search for yield made bond buyers and debt investors complacent in valuing credit risk, says Michael McHugh, a portfolio manager at Dynamic Mutual Funds Ltd. in Toronto. “That complacency showed up in narrowing credit spreads and growth of structured credit. The trend was interrupted by a deterioration of credit quality in credits that held structured products. The crisis came to a head when holders of ABCP wanted to cash out and found they couldn’t, even though the assets backing their paper was usually solid.”

What the investment bankers — who engineered what ex-junk bond king Michael Milken called the “democratization of finance” — forgot was that in making credit more available, they set a bizarre chain of events in motion. More credit allowed consumers to buy more houses, raising house prices as long as owners and lenders could keep the Ponzi scheme going.

As a result, the back-to-basics trend is underway.

“Until people forget about the current crisis, there will be a strong preference for simplicity,” says Brad Bondy, vice president of fixed income at Genus Capital Management Inc. in Vancouver. “But when the market returns to more tolerance for CDOs and other structured products, investors will want to look through the instruments to content and to the ultimate borrowers. Until now, some CDOs have been blind pools. When the CDO market revives, there will be fewer buyers. Burned once is burned too often.”

Adds McHugh: “Investors will put more emphasis on credit quality and liquidity than raw yield.” IE