Unraveling Canada's Asset-Backed Commercial Credit Crunch

UNCLAS SECTION 01 OF 03 TORONTO 000430 SIPDIS SIPDIS SENSITIVE DEPT PASS USTR FOR MELLE, MENDENHALL, SULLIVAN TREASURY FOR INTERNATIONAL AFFAIRS (FAIBISHENKO) COMMERCE FOR 4320/ITA/MAC/WH/ONIA (WORD) E.O. 12958: N/A TAGS: EFIN EINV ETRD PGOV CA SUBJECT: Unraveling Canada's Asset-Backed Commercial Credit Crunch REF: Toronto 422 Sensitive But Unclassified -- protect accordingly. ¶1. (SBU) SUMMARY: By agreement among the players, the Canadian non-bank asset-backed commercial paper (ABCP) market, which was valued at C$40 billion in August, is frozen until December 14. Canada's market for ABCP sold by non-bank dealers ground to a halt in mid-August after Toronto-based Coventree Inc., and other ABCP sponsors, failed to roll over their maturing ABCP debt because of fears of exposure to bad credit in the U.S. sub-prime mortgage market. ABCP holders have been left carrying billions of dollars of commercial paper they cannot redeem. While a team of investors, bankers and lawyers is working (with the approval of regulators and the central bank) to thaw the non-bank ABCP market through restructuring, market watchers fear the trouble could spill-over into the C$80 billion Canadian bank-sponsored ABCP market (C$1 = US$1.03). Further analysis of the ABCP market crisis may prompt revisions to Canadian banking regulations to provide greater protection for consumers. END SUMMARY. -------------- Background -------------- ¶2. (SBU) Between 2000 and August 2007 the Canadian ABCP market grew faster than in other countries, doubling in size to C$120 billion. Even before problems surfaced in August, the Canadian ABCP market was disproportionately larger in the Canadian financial system than the U.S. ABCP market in the U.S. system. Commercial paper is short-term debt issued by banks or corporations. Asset-backed commercial paper is debt in the form of mortgages, car loans, or credit card receivables which has been repackaged and sold to investors by a bank or another financial company. ¶3. (SBU) The commercial paper market ran into trouble around the world when the U.S. sub-prime mortgage market plunged in the summer. Investors, anxious about the Canadian ABCP's possible exposure to sub-prime mortgage problems, stopped buying ABCP investment instruments, leaving ABCP holders (or conduits) unable to make the required interest payments to their investors. The conduits in turn went to their banks for funding, but the banks refused to provide it. The ABCP holders had understood that their maturing notes carried liquidity guarantees, but certain foreign banks, including ABN Amro, Barclays, Deutsche Bank, and HSBC, were less accommodating than expected. In the U.S., financial institutions that had provided liquidity guarantees did not have as much latitude to withhold funds because those guarantees were broader than those that were required in Canada. ¶4. (U) In what is known as the "Montreal Accord," on August 16 Canada's five largest banks -- Royal Bank of Canada, Toronto-Dominion Bank, Bank of Nova Scotia, Bank of Montreal, and Canadian Imperial Bank of Commerce (CIBC),along with the somewhat smaller National Bank of Canada -- pledged their support to the C$80 billion market for ABCP which they had sponsored (the so-called "bank sponsored" ABCP). However, this left the smaller, remaining C$40 billion market for "non-bank" ABCP still dysfunctional (NOTE: The so-called "non-bank" market includes paper sponsored by institutions which may be called "banks" but are not among Canada's Big Five. END NOTE). -------------- Immediate Fallout -------------- ¶5. (SBU) Toronto-based Coventree Inc. was Canada's largest non-bank issuer of asset-backed commercial paper. The company's woes became public in August when it could not find new buyers for several billion dollars-worth of asset-backed loans that came due. Last month, Coventree announced it was slashing 30% of its workforce (about 25 jobs),and would close its Denver office in an effort to cut costs to help weather the disruption of the ABCP market. Coventree has also scaled down its office space in Toronto. The workforce reduction, including severance, reportedly will cost the company about C$1 million. Coventree reportedly holds an estimated C$16 billion in outstanding debt and could face an after-tax loss of about C$3.5 million if it is forced to write off its ABCP-conduit loans. Coventree reportedly administers about C$7 billion worth of frozen notes. -------------- Bank Exposure TORONTO 00000430 002 OF 003 -------------- ¶6. (SBU) Canada's big banks appear to be buying up some of the ABCP that they sponsored. Bank of Montreal (BMO),Canada's fourth largest bank (market capitalization about C$33.2 billion) reportedly has been one of the biggest players in Canada's bank-sponsored ABCP market. Market analysts speculate that BMO may have bought back billions of dollars worth of bank-sponsored ABCP since the August market meltdown, as evidenced by BMO's balance sheet increasing by C$22 billion (or 6%) in August. Approximately C$13 billion of the increase was in debt securities, where analysts speculate the bank repurchased some of its own bank-sponsored ABCP. Montreal-based National Bank's (Canada's sixth largest bank, with a market capitalization of C$9.6 billion) balance sheet also expanded significantly in August. At that time, National Bank announced it was buying back about C$2 billion in non-bank ABCP held in money market mutual funds by National Bank and Toronto-based Altamira Investment Services, which is owned by National Bank. -------------- Finger-Pointing Ensues -------------- ¶7. (SBU) According to market analysts, the narrowness of the Canadian definition of "market disruption" caused the problems in the Canadian market. The narrow definition enabled liquidity suppliers, such as banks, to avoid fully backing their ABCP except in the most extreme circumstances. Foreign financial institutions like Barclays and Deutsche Bank comprised 90% of the non-bank-sponsored Canadian ABCP market. These foreign banks reportedly exploited the opportunity to make large profits at low risk in the Canadian ABCP market -- earning fees by nominally guaranteeing liquidity without ever having to formally set aside assets or capital to actually supply the liquidity. -------------- Investor Committee Sorting out the ABCP Mess -------------- ¶8. (SBU) The August 16 Montreal Accord was originally signed by the major financial players owning, financing, and issuing non-bank ABCP. These players agreed to a 60-day freeze of activity in the market so that a solution to convert short-term paper into longer-term notes could be worked out. ¶9. (U) As part of the August 16 "Montreal Accord," a pan-Canadian investors committee was formed to restructure the ABCP market. On October 15 the committee extended a 60-day market standstill to December 14 in order to complete their market restructuring proposals. Just before the October 15 extension, negotiators convinced half a dozen non-bank sponsors and trustees of Canadian ABCP, including Coventree, to join the Montreal Accord, giving participating banks short-term protection against sponsors triggering loans or liquidity agreements that back ABCP. ¶10. (SBU) Under the agreed freeze, key holders of the affected financial instruments cannot demand access to their capital for at least 60 days. Original backers of the accord included: ABN AMRO Bank, Barclays, Quebec's Caisse de dptt et placement du Qubec (manages public pension plans in Quebec, and is the largest Canadian investor in non-bank ABCP),Quebec-based Desjardins Group, Deutsche Bank, HSBC, Ottawa-based PSP Investments (invests and manages Canadian public sector pension plans),Merrill Lynch, and National Bank. Third party conduits affected by the Accord include: Apollo Trust, Apsley Trust, Aria Trust, Aurora Trust, Comet Trust, Devonshire Trust, Encore Trust, Gemini Trust, Ironstone Trust, MMAI-I Trust, Newshore Canadian Trust, Opus Trust, Planet Trust, Rocket Trust, Selkirk Funding Trust, Silverstone Trust, Skeena Capital Trust, SLATE Trust, Structured Asset Trust, Structured Investment Trust III, Symphony Trust, and Whitehall Trust. -------------- One Third-Party Conduit Fixed -------------- ¶11. (SBU) C$2.1 billion Skeena Capital Trust, a conduit sponsored by Toronto-based Dundee Wealth Management, was the first ABCP conduit to be "fixed" by the investors committee. The committee promised October 16 that by the end of October, Skeena holders will receive their return on capital, plus interest, minus an undisclosed restructuring cost. As part of the plan, Bank of Nova Scotia and Dundee Wealth will take newly issued notes, backed by Skeena's assets. The 21 other conduits remain frozen until December. During TORONTO 00000430 003 OF 003 the restructuring period, market watchers are worried that hedge funds and other speculators could take advantage of the complex and illiquid situation by trying to reap profits from short-selling the assets underlying the ABCP trusts. -------------- Risky Investment -------------- ¶12. (SBU) In October, superintendent of Canada's federal Office of the Superintendent of Financial Institutions (OSFI) Julie Dickson defended her office, which had been criticized in connection with the Canadian asset-backed commercial paper (ABCP) credit crisis. Dickson blamed investors for buying ABCP based on only one credit rating agency - Toronto-based DBRS Ltd. Elsewhere, including in the U.S., investors require at least two ratings. Other international credit rating agencies refused to rate Canadian ABCP because the Canadian interpretation of "market disruption" (which would formally require ABCP-backers to provide liquidity) was narrower and only applied if the ABCP market totally dissolved. Institute for International Finance (IIF) director Philip Suttle reportedly blamed Canadian banks and regulators, as well as market participants and the industry as a whole, for the Canadian ABCP market troubles this year. ¶13. (SBU) On October 17, DBRS said that 75% of the third-party ABCP market is backed by complicated financial structures known as collateralized debt obligations (CDOs),while only about 23% of the market is backed by "traditional" assets like mortgages and auto loans. C$1.8 billion (7%) of the CDOs relate to U.S residential mortgage-backed securities (RMBS) assets, many of which were downgraded by Moody's earlier this month. ¶14. (SBU) COMMENT: In mid-October, outgoing Bank of Canada Governor David Dodge, in Washington for World Bank and IMF meetings, told the IIF that credit market problems should be solved by "natural market forces" rather than regulatory intervention. He argued that investors should demand greater rates of return in exchange for "opaque" products. The result, he said, would be issuers producing more transparent products, not unlike the ingredients provided on consumer packaged goods. Incoming Governor Mark Carney, who takes over from Dodge in February 2008, has identified the credit crunch affecting the ABCP market as one of his first orders of business. Further analysis of the ABCP market crisis may prompt revisions to Canadian banking regulations to provide greater protection for consumers. END COMMENT. NAY