Canada: Canadian Approach Saves $32 Billion Asset-Backed Commercial Paper (ABCP) Market

The credit crisis that has affected Canada, the United States, and the rest of the world in recent months has its roots in an esoteric financial market known as asset-backed commercial paper (ABCP).

The collapse of this market effectively removed hundreds of billions of dollars of assets from financial institutions in North America. The loss of these assets essentially prevented financial institutions from borrowing money at the same interest rate, or in the same quantity, as they did before. In addition, U.S. banks that had chosen to inject an inordinate portion of their investment capital into these assets found themselves unable to meet their own debt obligations to other financial institutions, and soon either sought protection from their creditors under the U.S. Bankruptcy Code Chapter 7 and Chapter 11, or were gobbled up by their creditors, or were rescued by large cash injections by the U.S. government.

The Canadian approach to this crisis was far different. Through a negotiated consensus, the stakeholders in Canada reached a standstill agreement which ultimately was incorporated into a court order. As a result, the fallout in Canada from this market failure was relatively inconsequential.

In order to understand the nature of the ABCP market, one must go back several years to a booming American economy, particularly the booming housing market. From 2004 onwards, "teaser mortgages" were being offered to first-time buyers at interest rates below prime. In addition, many of these teaser mortgages had removed the obligation of the new mortgagor from paying any principal in the first year and required interest only. These were commonly known as sub-prime mortgages.

Many of these first-time mortgagors/borrowers were often under-qualified, or completely unqualified, to receive mortgage funding. These individuals were often referred to as "Ninjas," literally meaning "No Income, No Jobs, and No Assets".

Many of these sub-prime mortgages were either issued by, or guaranteed by, two U.S. reserve agencies, Freddie Mac and Fannie Mae.

The banks would bundle up in portfolios certain income-producing assets, such as the sub-prime mortgages, Visa card debts, car leases, accounts receivable by way of securitization, and other collateralized debt obligations, and would sell these portfolios to special-purpose third parties known as "conduits".

The conduits would receive cash for an ABCP note which represented a short-term investment, usually by a financial institution. With the money that the conduits received from the notes, they sought to purchase portfolios which stood as security for the repayment of the notes. As Mr. Justice Robert Blair of the Ontario Court of Appeal explained in the court's judgement on the issue: "Financial institutions that sold or provided the conduits with the assets that secured the ABCP were known as 'asset providers'. To help ensure that investors would be able to redeem their notes, 'liquidity providers' agreed to provide funds that could be drawn upon to meet the demands of the maturing ABCP notes in certain circumstances. Most asset providers were also liquidity providers and many of the financial institutions were also holders of ABCP notes."

The final piece of the puzzle was provided by the rating agencies which classified these notes as investment grade.

In addition, investors often bought insurance to hedge against any failure by the assets or the liquidity providers.

The premiums paid to the insurer, and the insurance back, were collectively known as credit default swaps. Soon this insurance instrument itself became part of the ABCP market. In Canada, as of August, 2007, investors had placed over $116 billion in Canadian ABCP. In the U.S.A., it was closer to $1 trillion.

The Canadian market was divided into bank-sponsored ABCP and non-bank-sponsored ABCP. The value of the non bank sponsored ABCP market was $32 Billion and it was this market that triggered the ultimate demise in the overall Canadian ABCP market in or about August, 2007. Provided that investors were willing to roll their ABCP notes over, or buy new ABCP notes, to replace maturing notes, the ABCP market was stable. However, beginning in the first half of 2007, the economy in the United States was shaken by what is referred to as the sub-prime lending crisis.

As long as housing prices continued to rise, the security behind the sub-prime mortgage made it a relatively safe investment. However when the housing boom cratered at the beginning of 2007, these sub-prime mortgages went into default and foreclosures failed to yield sufficient funds to pay back the mortgage loan. In fact, more often than not, the foreclosure sales yielded no results at all.

The U.S. sub-prime lending crisis had an impact in Canada because Canadian ABCP investors became concerned that the assets underlying the ABCP notes had either included U.S. sub-prime mortgages or overvalued assets like U.S. sub-prime mortgages. Even though the ABCP market in Canada had little or no sub-prime mortgages in it, the lack of transparency in these financial instruments made it difficult for investors to know its constituent elements.

The crisis was exacerbated as many of the assets backing the ABCP notes were generally long-term, such as residential mortgages and auto loans. In essence, because of their long-term nature, there was an inherent timing mismatch between the cash they generated and the cash needed to repay maturing ABCP notes. As Mr. Justice Blair explained: "When uncertainty began to spread through the ABCP market, investors stopped buying the ABCP notes and existing note holders stopped rolling over their maturing notes. There was no cash to redeem these notes. Although calls were made on the liquidity providers for payment, most of the liquidity providers declined to fund the redemption of the notes, arguing that the conditions for liquidity funding had not been met in the circumstances. Hence, the liquidity crisis in the ABCP market."

In the U.S.A., the ABCP market investor did nothing in the early stages to try to address the inherent problems and the impending crisis. Instead, right until this market completely collapsed, investment banks such as Lehman Brothers were buying ABCP on margins equivalent to 30-1. Notwithstanding the warnings of some of America's most successful investors, such as Warren Buffet who referred to these investments as "weapons of financial mass destruction", the U.S. financial institutions watched as the market collapsed and also watched their own demise. AIG, one of the world's largest insurance companies, was a major player that provided the credit default swaps and invested heavily into this market. By the middle of September of 2008, they were on the verge of bankruptcy. Under 80% of the common shares of AIG are now owned by the U.S. government, which paid $85 billion as a rescue plan for AIG. Fannie Mae and Freddie Mac, who have trillions of dollars worth of sub-mortgages, were similarly bailed out by the U.S. government. Investment banks such as Lehman Brothers and Bear Stearns no longer exist, as they either went bankrupt or were gobbled up by their competitors. Large and substantial savings banks such as Washington Mutual and Wachovia had their existence terminated and/or were gobbled up by their competitors.

The destruction and chaos in the United States was averted completely in Canada, mostly as a result of the nature of the Canadian financial market, which is much more concentrated than in the United States and has a much smaller number of institutions and other stakeholders.

When in August of 2007 the market was on the verge of collapse, Canadian financial institutions did not sit back and do nothing. In fact, they proactively sought measures to resolve the crisis. This culminated in the now-historic Montreal Protocol, which is essentially a standstill arrangement orchestrated by numerous participants in the ABCP market, including asset providers, liquidity providers, note holders and other financial industry representatives. Under the standstill agreement, the parties are committed to restructuring the ABCP market with a view, as much as possible, to preserving the value of the assets and the notes.

A committee known as the Pan-Canadian Investor's Committee was struck. It was made up of 17 financial and investment institutions. Mr. Purdy Crawford was named as the committee's chair.

In order to ensure that the Montreal Protocol was both binding and enforceable, the committee devised a creative approach, implementing the restructuring statute known as the Companies Creditors' Arrangement Act, a statute ironically born shortly after the great depression in Canada. This statute, although skeletal in its provisions, was used by both counsel and the Ontario courts to craft a plan that saved the market and probably saved several large financial institutions from sharing the same demise as their American neighbours.

The plan that was devised by the Pan-Canadian Investor's Committee had two important elements to it:

  1. Those parties holding ABCP notes would have these notes deferred for payment until the underlying asset matured. In other words, the plan stipulated a match between the due date of the note and the due date of the asset underlying the note. This compromise also eliminated a substantial portion of interest, and in some cases, a reduction of the amount of principal. None of these notes could be called immediately, or were due immediately.
  2. The other salient point of the plan involved the releases of officers, directors and financial institutions involved in the ABCP market. These releases were for the benefit of participants in the ABCP market, but who were not directly involved in the actual application to the court.

Much has been written about these third party releases and the fraud carve-out that ultimately emerged, but what is essential to note is the
creativity and the prescience of the courts in dealing with complex financial restructuring and, of course, the cooperation demonstrated by all stakeholders in the ABCP market, many of them competitors.

The meeting to approve the plan was held on April 25, 2008 and the vote overwhelmingly supported it, with 96% of the note holders
voting in favour. Following the successful vote, the applicant sought court approval for the plan.

On June 5, 2008, Mr. Justice Colin L. Campbell of the Ontario Superior Court of Justice, who heard the application, issued his reasons for approving and sanctioning the plan on both the jurisdiction and the third party releases. His decision was appealed and the appeal was heard on June 25 and 26, 2008. The Court of Appeal supported the decision of the lower court and issued its reasons August 18, 2008.

In coming to the decision to dismiss the appeal, Mr. Justice Blair stated, with respect to the jurisdiction under the CCAA:

"An interpretation of the CCAA that recognizes its broader socio-economic purposes is apt in this case. As the application judge pointed out, the restructuring underpins the financial viability of the Canadian ABCP market itself."

In coming to the conclusion that the plan was fair and reasonable and that the application judge's sanction of the plan was proper, Mr. Justice Blair stated:

"Here the debtor corporations being restructured represent the issues of more than $32 billion in non-bank sponsored ABCP notes. The proposed compromise and arrangement affects the entire segment of the ABCP market and the financial markets as a whole. In that respect, the application judge was correct in adverting to the importance of the restructuring to the resolution of the ABCP liquidity crisis and to the need to restore confidence in the financial system in Canada."

Subsequently, leave to appeal to the Supreme Court of Canada was denied.

No one can say with certainty that the deferred long-term notes will, in fact, be honoured by the assets backing them, nor can one say with certainty that there will be no fall-out in the Canadian financial system as a result of the ABCP market.

However, one can credit the Canadian stakeholders for the manner in which they came together to seek compromise and consensus and to use the courts in a constructive, creative fashion to resolve issues and to save the ABCP market without asking for, or receiving, a single dime from the Canadian government or from the Canadian population.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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