Greed is certainly the deadly sin most responsible for creating the credit crunch, but an examination of investment dealers’ role in the seizing up of the asset-backed commercial paper market in Canada finds that sloth was probably their biggest vice.

As part of the regulatory post-mortem on the turmoil in Canada’s ABCP market, the Investment Industry Regulatory Organization of Canada has conducted a compliance review of the part played by investment dealers, both as manufacturers and distributors, of non-bank-sponsored ABCP that froze up in the wake of the U.S. subprime mortgage meltdown. The IIROC review found that the dealers’ involvement in the emerging segment was relatively modest; that they didn’t make much money from the business; and they put virtually no effort into vetting the products for their clients.

According to the IIROC review, only 26 firms had any role in either distributing or manufacturing non-bank ABCP — and just two of them as manufacturers. On the distribution side, eight firms didn’t sell any of the paper to clients; they just had principal positions. Of the rest, six firms sold ABCP to just institutional clients, nine sold it solely to retail clients and four firms sold to both types of clients.

On a dollar basis, IIROC found that dealers manufactured about $6.3 billion worth of the total $35 billion in non-bank ABCP that was outstanding when the market seized up. IIROC also discovered that dealers held about $6.6 billion on behalf of themselves and clients. Of that total, almost all of it (99%) was either held by the firms in their own accounts or was sold to corporate or institutional investors; only about 1% was for retail clients. Slightly more than 2,500 retail clients held $372 million of the troubled paper.

The retail exposure was also concentrated in just a handful of firms — five firms accounted for 95% of the retail accounts and one firm represented 63% of the retail business. Even within firms that did sell non-bank ABCP to retail clients, the trade was quite concentrated in just a few offices or with a few brokers, IIROC discovered.

The vast majority of brokerage firms didn’t sell non-bank ABCP to their retail clients, and when IIROC asked a few of them why, they cited two main reasons: the complexity of the product and the lack of profit opportunity.

Indeed, the money to be made in the non-bank ABCP business was rather modest, the regulator found. For the firms that manufactured the paper, the average net spread between the income generated by the underlying assets and the payouts to investors was 42 basis points (dropping to 29 bps after administrative costs). On the distribution side, the markup on retail trades ranged from 10 bps to 45 bps, which was often little more than enough to cover transaction costs.

The IIROC report reveals that firms that sold to retail clients “reported that third-party ABCP and money market trades in general were viewed as a loss-leader service to clients, enabling them to obtain additional yield on short-term cash positions.”

With the lack of profit these products provided, it is perhaps not surprising — albeit no more forgivable — that firms did so little to ensure they were suitable for their clients.

In fact, IIROC found that none of the firms that sold non-bank ABCP provided any training or special material to any of their brokers, supervisors or compliance staff on the subject of non-bank ABCP. Of the 16 firms that said they had product due diligence processes in place, none of them subjected non-bank ABCP to that process. Nor did the firms consider that there might be suitability issues associated with the sale of this paper to retail clients.

The basic reason for this apparent lack of attention to this new, highly complicated product is that firms didn’t see it as novel and complex. They regarded non-bank ABCP as just another money market instrument, no different from bank-sponsored ABCP, backed by the highest possible credit rating.

“They viewed third-party ABCP as a fungible money market instrument that had obtained the highest possible credit rating,” notes the IIROC report. “Therefore, no risk assessment or product review was required.”

The same attitude prevailed at the two firms that manufactured non-bank ABCP, the IIROC report notes. The firms that got into that business didn’t see non-bank ABCP as a new product; rather, they saw themselves as new entrants in an established business. Neither firm subjected non-bank ABCP to their product review process.

@page_break@Of course, in retrospect, it’s clear that this paper is not a simple deposit product. Unlike bank-sponsored paper, which is primarily backed by straightforward assets such as loans and mortgages, much of the third-party paper is underpinned by credit derivatives, which obscure the nature and performance of the underlying assets. Indeed, more than three-quarters of the assets underlying the non-bank ABCP were collateralized debt obligations. The result, as the IIROC report points out, is that the non-bank ABCP was effectively backed by liabilities rather than traditional assets.

This underlying complexity, coupled with the intricate structures of the ABCP, makes it exceptionally difficult for any ordinary investor to understand these products or their inherent risks.

Clearly, few firms understood them, either. The IIROC report notes that neither the brokers nor the chief compliance officers interviewed were familiar with the nature of the liquidity guarantees built into the non-bank ABCP; nor did they know the difference between the so-called Canadian liquidity arrangements and global-style liquidity arrangements. Rather, they just relied on credit ratings to assure them that the products were safe to sell.

This undue reliance on credit ratings is also something provincial securities regulators are focusing on. In early Oc-to-ber, the Canadian Securities Administratorspublished a consultation paper that proposes several reforms coming out of the credit crisis — chief among them is a proposal to take jurisdiction over the credit-rating agencies and establish a regulatory framework for their oversight, while also reducing reliance on credit ratings within securities regulation.

The CSA is also looking at an overhaul of the “exempt market” regime as the other major component of its proposed reforms. As the IIROC report points out, the non-bank ABCP was sold under the same exemptions that were intended for traditional commercial paper issues, and built in a reliance on credit ratings. The CSA paper proposes to revise the exemption regime so that the short-term debt exemption can’t be used to sell asset-backed debt.

The availability of these regulatory exemptions, the existence of high credit ratings and the ability to process transactions through the ordinary clearing and settlement system all contributed to the emergence of retail exposure to non-bank ABCP, says the IIROC report.

Furthermore, it reports that the majority of dealers that sold non-bank ABCP to retail clients “did not understand the underlying asset composition, liquidity risks and distinct rating methodology used for the structured financial assets underlying the ABCP. Instead, they relied on the product classification as a money market instrument, the securities distribution exemption and credit rating.”

This failure by dealers to understand what they were selling has led IIROC to make recommendations aimed at pushing financial services companies to take greater responsibility for the products in which they trade. These recommendations deal with product due diligence, transparency, conflicts of interest and reliance on credit ratings.

Simultaneously, IIROC is requesting comments on draft guidance dealing with best practices for product due diligence. It notes that concerns about suitability and conflicts of interest have arisen from the emergence of complex products such as non-bank ABCP and principal-protected notes that, first, do not seem to be properly understood by investors or dealers, and, second, have features that could be delivered by cheaper, simpler products.

There is no shortage of lessons to be learned from the credit crunch. But for dealers, the primary one is: don’t sell what you don’t understand. Although this lesson should be rather obvious, it’s too often forgotten. IE