Few winners have emerged from the seizure of the asset-backed commercial-paper market in Canada. And there’s been no shortage of blame since credit tightened around the world, liquidity evaporated (particularly in the Canadian ABCP sector) and financial markets threatened to suffocate in mid-August.
David Dodge, governor of the Bank of Canada, said in a mid-September speech to the Canada-United Kingdom Chamber of Commerce in London that blame for the crisis falls on everyone from lenders and loan packagers to credit rating agencies and investors. Knowing they intended to securitize their loans and get them off their books, lenders didn’t have much incentive to assess their borrowers’ credit, Dodge said. These loans were then packaged into complex structured products, given questionably high credit ratings and sold to careless investors.
In the speech, Dodge pleaded for more market transparency. “Vendors of financial instruments need to structure these investments in such a way that market players can clearly see what they are buying. Credit-rating agencies need to indicate clearly that their ratings for highly structured products should not be used with the same degree of certainty as their ratings for conventional, single-name issuers. At the same time, investors will have to take on more responsibility for diligent research so they can better understand the nature of their investments and demand greater transparency,” he said.
Investors should not rely on rating agencies, Dodge added: “They must do their homework and make a concerted effort to understand what they are buying. However, this can only be successful if they have access to all the information they need.”
But, amid all the blame for the market turmoil, praise should go to those who helped firms avoid it. Regulators are rarely recognized for their role in facilitating business but, according to a recent report from Blackmont Capital Inc. , they deserve acclaim for saving some firms from the ABCP market turmoil. Blackmont credits the regulatory framework that enables firms to issue guaranteed investment certificates, providing lenders with a consistent, low-cost source of funding. That allows those lenders to avoid resorting to the ABCP market to finance their lending activities. The report, which focuses on the fortunes of the so-called “specialty lenders,” points out that some of these firms haven’t had to look to more exotic products to fund their lending because they were able to issue GICs.
In the past few years, it notes, the rates paid on GICs dipped lower than comparable bond rates. Five-year GICs, for example, have been paying 60 basis points to 70 bps less than five-year bonds. Moreover, spreads between GIC rates and mortgage rates have widened.
In contrast, for firms that funded their operations through ABCP, the consequences of the market disruption have been unpleasant. For example, in mid-September, Xceed Mortgage Corp. announced it was temporarily suspending its dividend, and warned that earnings will probably be affected by its exposure to ABCP.
Other firms seem to have found that the credit-market disruption is, in turn, effectively derailing their business models. It is also holding up a planned merger between Credit Union Central of British Columbia and Credit Union Central of Ontario. The two organizations have delayed the closing of their deal — which was slated for Oct. 1 — until the end of the year, saying that the trading halt in non-bank ABCP makes it impossible for the centrals to accurately value their operations.
Before the credit crunch took hold, few firms looked upon the regulatory regime with fondness. Indeed, the Blackmont report says, the firms covered by the Office of the Superintendent of Financial Institutions complained about submitting to its scrutiny, lamenting that regulators don’t understand their businesses and only get in the way. “Rarely was the regulatory regime spoken of in a positive way,” it notes.
However, this latest market stumble may convince some firms that regulators serve a valuable business purpose after all, now that the price of risk is rising and the availability of cheap and easy credit is shrinking. The report notes the liquidity crunch in the ABCP market has caused some to worry whether these specialty lenders will have trouble finding funding for their operations or, at least, that their funding costs will rise.
The solution for firms with these concerns, it says, may be submitting to regulation. “Despite the cost of regulation, we believe being regulated resolves these concerns [about the price and availability of funding],” the report finds. “Furthermore, we believe the market turmoil has triggered an increase in demand for Canada Deposit Insurance Corp. insured deposits, actually improving availability and keeping funding costs in check, emphasizing the potential advantages of being regulated.”
@page_break@It appears that firms that rely on GICs could look upon their regulators even more fondly in the months ahead, as the GIC market benefits from the pain being felt in other parts of the credit market.
With the uncertainty created by the liquidity crunch in the ABCP market, investors are looking for safer alternatives. For evidence of this, look no further than the traditional rival for GIC business — mutual funds — which had a brutal sales month after the credit crunch took hold. According to the latest data from the Investment Funds Institute of Canada, the industry saw its first month of net redemptions since 2004 with $1.5 billion in redemptions in August following net sales of $3 billion in July.
With fear gripping the markets, investors fled riskier products in general in August. And it didn’t help that some money market mutual funds were highly exposed to ABCP. Notwithstanding the fact that several firms stepped up to buy out their funds’ exposure to ABCP (ensuring unitholders don’t lose anything as a result), investors were still spooked.
As they reconsidered their portfolios, investors dumped all sorts of assets that suddenly seemed risky. Not only did this hurt money market funds, but it also thumped equity markets which, in turn, hurt fund sales.
According to IFIC data, slightly more than $900 million was redeemed from money market funds in August, and another $633.4 million flowed out of long-term funds. Canadian equity funds saw $578.5 million in monthly net redemptions and foreign equity funds saw net sales drop to $25.5 million from $600 million in July.
This negative reaction to products that suddenly seem risky is boosting demand for safe products such as GICs (which are backstopped by the CDIC). This could push the rates lenders have to pay on these products even lower, Blackmont says.
The report also notes that investors are largely locked into GICs. So, there is little risk that investors will destabilize a firm by making a run on deposits. This recently happened at one of Britain’s biggest mortgage lenders, Northern Rock PLC. In spite of the Bank of England stepping in to provide funding and Britain’s Financial Services Authority attesting to its fundamental soundness, clients descended on the firm, withdrawing their deposits.
Regulators don’t always know best and more regulation isn’t necessarily a solution. In some areas, regulators may still unnecessarily constrain business or add excessive administrative burdens. Indeed, as Blackmont notes, complying with the regulatory regime required to issue GICs is no easy task. To get into the business, firms must acquire a bank or trust licence, which is not a simple process and can take years to complete. And submitting to banking legislation and OSFI’s oversight can limit the kind of lending firms can do. “As a result,” it says, “many specialty lenders’ business models may not work under a regulated structure.”
But the current market environment reminds us that regulators can save the day when market conditions turn nasty. IE
Market turmoil highlights important role of regulators
The regulatory framework, enabling financial institutions to issue GICs, spared some firms from being burned in the credit crisis
- By: James Langton
- October 2, 2007 October 2, 2007
- 12:43