Canada: Collateral Matters - A Banking Law Newsletter

Last Updated: May 22 2009


  • Lending in Troubled Times
  • Insurance Matters: Good News for Lenders From the Ontario Court of Appeal
  • The CDS Contagion


By Aaron Collins


Likely the last thing you want to read is another article talking about how we are in the midst of a global recession. Such headlines are permeating the news day-in, day-out. However, putting aside the sting of twenty-four hour media hype about the depth of the financial crisis, there are definitely some practical considerations of which lenders should be aware in a down market, and some extra measures they can take to protect themselves. With this in mind, below is a broad overview of the warning signs that might show a borrower is in trouble, steps a lender should follow if a borrower has problems making payments, and information about insolvency and restructuring in general.


The first thing that lenders need to know is whether a borrower has started exhibiting any symptoms, or "warning signs," of problems in its business. It is impossible to create a definitive list of these warning signs, but there are several factors that tend to be common among borrowers experiencing financial trouble. These factors can be broken into two general categories – those at the market or industry level and those specific to the borrower.

At the market level, it is important to consider worldwide economic forces and industry trends. We are seeing global demand for almost every product or service adjusted downward. If a borrower's product or service is no longer required (or required by substantially fewer people), this will undoubtedly put a strain on its financial position. However, beyond just decreases in demand, it is up to a lender to keep informed of things like industry trends, government intervention and new competition for a borrower.

The best current example is the automotive industry. The 2009 projection for automobiles sold in North America is between 9 and 10 million units, down from 17 million units in 2008. Clearly, this fallout increases the chance that many manufacturers, as well as their suppliers and the ancillary service providers, are operating under an unrealistic business model. With an almost 50% decline in sales there is also likely to be a residual over-capacity in the industry. What's more, with the shift to "green" technology and planned government stimulus packages that focus on reshaping automotive production in North America, it appears that even when automotive sales do increase, there will have been major new developments and competition in the industry. These industry-level factors are all examples of things that a lender should consider when assessing not only the current viability of a borrower, but also whether that borrower has a future making its product or providing its service.

On a micro level, there are several individual factors that indicate a borrower has run up against a wall. Generally, when a borrower begins to run into cash shortages, its first instinct is to find a way to buy time, assuming that everything will work itself out if it just has a little longer to make up for shortfalls. This instinct leads to slow reporting, often of poor quality, and slow responses to any information requests. Usually a borrower knows that covenants in its loan agreement have been breached, so it sends out late reports with poor detail in hopes that it is able to buy some extra time. Keeping on top of reporting requirements and ensuring that borrowers stay in covenant are important tasks for a lender in a down market. It is tempting to believe that a borrower can make up for shortfalls with just a little more time, but by turning a blind-eye, the lender is only putting itself at risk.

Beyond making sure a lender gets all required information from its borrower, it is also wise to compare the information received to past trends. A lender usually has a wide array of historical information at its disposal and it should compare that information to current reports. Is the borrower continually hitting its credit limits, where it did not before? Has the historical frequency of inventory counts been reduced, in an attempt to hide excess inventory or accounts that are not being paid? Has the average age of a borrower's accounts receivable been continually increasing? Has a borrower radically changed its payment, purchasing or deposit patterns? Is the borrower subsidizing the business by letting employee source deductions or GST or PST payables fall into arrears? If the answer to some or all of these questions is affirmative, the lender should take a closer look at the borrower's business for potential issues.

In addition, if a lender has a particularly close relationship with a borrower, it may be attuned to some other borrower specific problems. A sudden change in ownership or management structure can signal a struggle between partners or shareholders which may be a result of financial difficulties. Similarly, a frequent change in accountants or auditors could suggest that the borrower is shopping its books around to find someone who will give a better picture of the business. If a lender becomes aware of a major lawsuit against the borrower, details regarding the nature of the suit, the amount at stake and underlying events should be sought. Is it a lawsuit that would cripple the borrower if an unfavourable judgment is obtained? Finally, certain personal problems (for example a divorce) or lifestyle choices of management not consistent with the borrower's performance (like purchasing a new Porsche when the business' sales are rapidly declining) may be relevant to determining if a borrower is about to default on its obligations.

In short, when assessing the ability of a borrower to meet its obligations, the more information a lender can gather, the better informed it will be, and the earlier it will be able to spot potential problems.


If a borrower appears to be in trouble, there are several proactive steps a lender should take in order to better prepare for a possible default. First and foremost, a lender should assess its exposure. The first part of assessing exposure is to determine how much credit has, will and could be extended. The second part is to determine the value of the collateral held by the lender. A lender should determine what, in the worst case scenario, its realization would be on the assets over which it has security. Many assets are experiencing significant value reductions in this market, and what was once a $1,000,000 piece of machinery might now be worth a fraction of that. Comparing the amount of credit extended to a borrower with the amount available on a realization of that borrower's assets will arm a lender with a realistic view of the situation going forward, and help to decide how best to increase that realization.

At this point, a lender would be wise to have its security vetted to expose any deficiencies. Having a lawyer examine whether all loan agreements, security agreements, guarantees and mortgages were properly signed and registered may seem like an overly procedural step, but it is better to know early on that, for example, a guarantee was not signed or a PPSA registration was never completed. The earlier security deficiencies are discovered the more opportunities there are to address any such problems.

If these preliminary considerations show that there are issues with the loan, or warning signs are evident that a borrower is in financial trouble, it is tempting for a lender to unilaterally reduce the amount of credit available. However, lenders should be wary of any unilateral changes to a loan agreement, whether to credit available, pricing or reporting requirements. Just as the lender and borrower had to reach an agreement on the original terms of the deal, they will need to agree on any amendments to that deal. For this reason, an amendment should be sought to make any changes to a loan agreement. Such amendments might be easily obtained through the use of a forbearance agreement, which is another important preliminary consideration for lenders.

In a forbearance agreement, a lender agrees not to immediately enforce its security thereby giving the borrower time to bring covenants in line, find refinancing, make necessary payments or restructure its business. The benefit to the lender is that, in return for this extra time, the borrower may accept credit pricing increases or changes in credit limits, give additional security, pay forbearance fees, agree to increased reporting requirements, allow direct monitoring of its business or consent to new payment schedules. While not every case is a forbearance situation, given the obvious advantages and potential profit to a lender, the viability of the option should be canvassed before deciding to enforce on security.


If a forbearance agreement seems untenable for a particular borrower, enforcement may be the only option. The key to enforcement is that before any steps are taken, a demand for payment must be made. Careful consideration should be given to the language of the demand. We almost always recommend that demands be made in such a manner that payment is immediately due, so that a lender's options take effect without any intervening period. In addition, statutory requirements dealing with the length of notice to be given before enforcement under the Personal Property Security Act and the Bankruptcy and Insolvency Act (the "BIA") must also be met, depending on the enforcement option pursued.

Once demand has been made and the applicable statutory notice has been given, the choice of enforcement options should be based on strategy. The factors on which to base this strategic choice include: the remedies in the security agreement; whether any intercreditor agreements exist; if the lender subordinated its security to another lender; whether the borrower has outstanding source deductions or GST or PST payables; if there is a risk of becoming a successor employer; and whether the lender will need to appoint a receiver to preserve its security.

While the term "bankruptcy" is thrown around a lot, it is actually only one of four types of enforcement remedies available. A traditional "Bankruptcy" is administered under the purview of the BIA, and involves selling the assets of the borrower and distributing the proceeds among creditors on a pro-rata basis. In a Bankruptcy, the borrower's assets are transferred out of the hands of the borrower to a trustee in bankruptcy, either through a voluntary assignment by the borrower or a petition by a creditor. The trustee then becomes responsible for liquidating the assets and distributing the proceeds. Generally this remedy is reserved for a borrower whose business has reached a point where the only value left is in the assets themselves. The "fire-sale" nature of a Bankruptcy usually means that realizations are lower, which makes them particularly unattractive to lenders.

There is one very attractive feature about a Bankruptcy, however. When a borrower has significant outstanding GST or PST payables, those claims will be paid out to the Canada Revenue Agency (the "CRA") before secured creditors prior to a Bankruptcy, but after secured creditors post-Bankruptcy. This makes a Bankruptcy an attractive solution in situations where the borrower owes significant amounts to the CRA, as it can dramatically improve the realization by a lender.

Beyond a Bankruptcy, there are restructuring proceedings which protect a borrower from actions by creditors to allow it time to restructure its affairs and emerge with a viable business. To gain this protection and restructure its affairs, a borrower must either file a notice of intention to make a proposal (a "Proposal") under the BIA or make an application under the Companies' Creditors Arrangement Act (the "CCAA") to file a plan of arrangement (a "Plan").

While the nuances of Proposals and Plans are beyond the scope of this article, it is important to note that in these proceedings, actions against a borrower are stayed and a borrower will generally retain control over the business and attempt to make a deal with all creditors that will allow it to become profitable again. Often a Proposal or a Plan involves reductions in amounts paid on debts, additional financing, the sale of certain assets or businesses and other actions necessary to ensure the viability of the business. While secured lenders usually have significant control when a borrower attempts to make a Proposal or a Plan, it is important to have experienced legal counsel, as the number of parties involved, amount of time that can lapse and potential for disagreement can remove value from a borrower's business quite quickly, thereby lowering the value available to satisfy a lender's claims.

The final piece of the insolvency puzzle for lenders is the receiver. A receiver is appointed privately or by court order as a lender's agent to control a borrower's assets. The powers of the receiver are largely driven by the order granted by the court (or the agreement which allowed for the receiver's private appointment), but usually include provisions allowing the receiver to take control of, and sell, the assets of the borrower. When used on its own (that is, outside of a Bankruptcy or where the borrower is attempting to make a Proposal or Plan), appointing a receiver is often a costeffective remedy for a secured creditor such as a lender to take possession of a borrower's assets and realize on them because it avoids the government fees associated with a Bankruptcy, Plan or Proposal. However, receivers can also be appointed during a Bankruptcy, Plan or Proposal by a lender, giving the lender more control over those proceedings.


It is important for a lender to watch for the "warning signs," especially in down markets, because of the increased number of loans that will experience financial difficulty. While the type and number of warning signs will vary depending on the size of, reports from and relationship with the borrower, a lender should take care to be well informed of a borrower's affairs. Moreover, a lender should also give thought to what preliminary considerations are relevant to its situation, such as, for example, what it stands to lose if a borrower defaults, and whether a forbearance agreement is an effective solution to the borrower's problems.

Finally, a lender must be aware that there are several steps to the enforcement of its security, and strategic choices should be made about these steps. There is no single correct enforcement proceeding for every lender in every situation. The choice of best enforcement proceeding will depend on, among other things, the type of borrower, who has security, the amount of credit outstanding and the nature of the assets involved. The complexity of these proceedings and the rewards for early identification of problems make it important to engage an experienced insolvency lawyer from the beginning of the process. Experienced counsel can help uncover these warning signs early, make the best strategic choice for enforcement based on preliminary considerations and, ultimately, maximize the lender's realization.

INSURANCE MATTERS: Good News for Lenders From the Ontario Court of Appeal

By Deborah Holbrook


In our June 2008 Collateral Matters newsletter, Andrew Biderman and Maurice Audet cautioned lenders about the February 2008 decision of the Ontario Superior Court in GE Canada Equipment Financing G.P. v. ING Insurance Company of Canada1. In that case, the court held that, where a third party obtains insurance on collateral over which a lender has a prior and perfected security interest and the third party does not name the lender as a loss payee on the policy, the insurer's salvage rights in the collateral may rank ahead of the lender's security interest in the collateral if the third party collects on the insurance policy. This decision was particularly concerning for lenders who frequently finance vehicles or other equipment for lessors, as it meant that the lenders needed to ensure that they were added as insureds, loss payees or beneficiaries on all insurance policies over the collateral, including policies held by third parties with whom lenders had had no business dealings at all. The good news for lenders is that this decision has recently been overturned by the Ontario Court of Appeal.


GE Canada Equipment Financing ("GE") financed several vehicles for Brampton Leasing and Rental Limited ("Brampton"), a leasing company who, in turn, leased the vehicles to third party lessees. The conditional sales contracts that governed the financings provided that GE would retain title to the vehicles until they were fully paid for by Brampton, that Brampton was required to obtain comprehensive insurance on the vehicles for their full replacement value, and that GE was to be named a beneficiary on those policies. Brampton complied with its obligations under the conditional sales contracts and GE properly perfected its purchase money security interests ("PMSIs") in the vehicles in due course.

In the normal course of Brampton's business, Brampton leased the two vehicles in question to third party lessees. The lessees, in turn, obtained their own insurance on the vehicles through ING Insurance Company of Canada ("ING"), wherein the lessees were named as lessees and insureds and Brampton was named as lessor and loss payee. GE was not referenced in the ING insurance policies.

Both vehicles were ultimately stolen. The third party lessees and Brampton completed proof of loss claims; however, in so doing, Brampton misrepresented to ING that no person, other than the insureds, had any interest in the vehicles and, further, that there was no lien, collateral mortgage or conditional sales agreement on either vehicle. As a result, ING paid the insurance proceeds, being the cash value of the vehicles, to Brampton and the third party lessees in exchange for Brampton's agreement to transfer title to the vehicles (which it did not have) to ING. As a result, and pursuant to Statutory Condition 6(7) passed under the Insurance Act,2 ING became entitled to the salvage value of the vehicles in the event that either of them was recovered.

Brampton did not notify GE of the theft of the vehicles and did not remit any of the insurance proceeds to GE. GE only learned of the thefts when it attempted to enforce its rights against Brampton when Brampton finally defaulted in its obligations under the conditional sales agreements. GE further learned at that time that ING had indeed recovered and assumed title to both vehicles and had subsequently sold one.

On the grounds that its PMSIs had priority over ING's rights to salvage in the vehicles, GE demanded that ING surrender to it the one vehicle and deliver to it the proceeds of the other. ING refused and GE commenced litigation.


The Ontario Superior Court of Justice ruled in favour of ING, holding that ING's salvage rights in the vehicles, which it held pursuant to Statutory Condition 6(7), had priority over GE's PMSIs in the same vehicles due to the fact that subsection 4(1)(c) of the Ontario Personal Property Security Act ("PPSA") specifically provides that the PPSA does not apply to transfers of interest or claims under insurance policies:

4.(1) Except as otherwise provided under this Act, this Act does not apply, ...

(c) to a transfer of an interest or claim in or under any policy of insurance... 3

The Court concluded that

[a]s a matter of priority, the PPSA, in effect, has stated that GE is not to have priority over transfers of interest to ING by reason of the operation of Statutory Condition 6(7) which is incorporated into insurance policies.4


On February 25, 2009, the Ontario Court of Appeal unanimously overturned the Superior Court's decision, finding that GE's PMSIs did have priority over ING's salvage rights in the vehicles. The Court of Appeal found that subsection 4(1)(c) of the PPSA neither alone nor in conjunction with Statutory Condition 6(7) constitutes an exception to the general rule set out in the PPSA that "a security agreement is effective according to its terms between the parties to it and against third parties."5 The Court concluded that, while subsection 4(1) acts to relieve certain creditors of the obligation to register those interests under the PPSA, it does not relieve those creditors from the obligation to be mindful of other PPSA-protected interests and it, in no way, acts to resolve priority disputes between creditors. The Court further held that, while Statutory Condition 6(7) gives insurers salvage rights in cases where they have paid out the cash value of lost collateral, it does not give insurers salvage rights above and beyond those originally held by the insured:

In other words, Statutory Condition 6(7) does not increase the rights of an insurer against third parties beyond those enjoyed by its insured, or create new rights in the insurer not previously possessed by its insured. The 'vesting' of salvage rights that occurs under statutory condition 6(7) involves the conveyance of salvage rights as between an insurer and its insured. That transfer may be subject to the interests of the insured's secured creditors.6

In the result, the Court awarded GE proceeds of the one vehicle and possession of the other, together with its costs on both the underlying application and the appeal.


The Court of Appeal's decision certainly acts to put lenders' minds at ease when it comes to financing and securing collateral that may be insured by third parties. Strictly speaking, the outcome is that it is not necessary for lenders to be named as insureds, loss payees or beneficiaries under third party insurance policies for their security interests to be protected. However, it should be noted that in its concluding observations, the Court pointed out that, had GE taken such steps and/or required that Brampton provide it with copies of all third-party insurance policies, it would have avoided the dispute with ING from the outset. Accordingly, while these measures may not be strictly required, they are nevertheless in the best interests of all parties involved in such financing arrangements and are, therefore, recommended.


By Sam Billard And Aaron Collins


There is no question that the economies of Canada and the United States are in recession and that it is a different kind of recession than we have seen in the recent past. It is, in large measure, resisting the efforts of governments to respond.

This article will suggest that one of the reasons that this recession will be different and potentially more difficult to address is that the credit markets have changed substantially, even fundamentally, since the last severe recession. Those changes, together with the wide-spread use of synthetic securitizations funded by credit default swaps, led to the current credit crisis.


Over the past thirty years credit markets have evolved substantially. The key features of that evolution are as follows:

1) New Intermediaries The last 30 years have witnessed the disintermediation of banks. One element of that process is that savers have turned away from banks as their repository of choice for savings. The alternatives to banks as savings holders include mutual funds, pension plans and insurance companies, as well as private equity funds and hedge funds.

2) New Lenders Another development in credit markets is the emergence of significant lenders that are not banks. Virtually all of the sub-prime mortgage lending in the United States was originated by non-bank financial institutions like Countrywide Financial Corporation, Long Beach Financial (owned by Washington Mutual), First Franklin (owned by Merrill Lynch), WMC Mortgage Corp. (owned by General Electric) and BNC Mortgage LLC (owned by Lehman Bros.). Most car loans and leases are advanced by captive finance subsidiaries of the manufacturers like GMAC. Equipment leasing and lending is, similarly, dominated by finance subsidiaries of manufacturing companies. GE Capital started this way and then branched out to become a significant provider of asset based loans at first, and then of all types of lending. These non-bank lenders, in turn, often financed their lending through some kind of securitization. Often the new intermediaries have been significant sources of financing both directly and indirectly.

3) New Funding Tools Securitization structures have emerged as a significant financing tool. The idea is to transfer underlying debt obligations (assets) into a trust or other special purpose vehicle and then issue bonds or notes out of the special purpose vehicle to pay for the assets. The bonds or notes are securities, so the process of transforming untraded and untradeable debt obligations into tradable debt instruments came to be known as securitization. In the mortgage and equipment finance businesses the debt obligations were secured and became know as collateralized debt obligations (CDOs).

Often securitizations were "tranched" into pools of varying risk with only the least risky or "senior" portions being sold, generally to conduits that relied upon some of the new intermediaries described above to purchase the notes they issued. The new intermediaries were willing purchasers of highly rated, short term debt with a better yield than treasury bills, so there was great innovation in the types of assets that might be securitized. Automotive loans and leases, credit card obligations, residential and commercial mortgages, consumer loans; even royalties from songs and movies have been securitized. The most recent and controversial development in securitizations was the introduction of "synthetic" securitizations, which received their income not from income-producing obligations like loans but through credit default swaps referencing loans.

4) Credit Default Swaps Credit default swaps (CDS) permit parties to take a position on the credit markets very precisely and relatively cheaply. The parties to these transactions need not have any exposure to the underlying obligation. The basic transaction is: the protection buyer pays the protection seller a fee in return for the protection seller agreeing to pay the protection buyer a significant amount of money if sufficient credit events occur in a particular debt obligation or a pool of debt obligations known as "reference assets".

There is no natural limit to the size or number of CDS-based securitization transactions because there is no direct link to any underlying activity. In contrast, CDO's and other forms of direct securitization are limited by the amount of obligations transferred to the conduit.

In a traditional securitization, the holders of the notes have recourse to a pool of particular debt obligations which have certain characteristics that caused a rating agency to assign a relatively high rating to the likelihood of their collective performance, at least at one point in time. Synthetic securitizations, on the other hand, are indirect. The conduit relies on its counterparty to pay in the ordinary course. If the reference assets do not perform, the CDS terminates, payments are exchanged and the deal is over. There is no recourse by the conduit or its noteholders to any underlying assets.

Warren Buffet famously termed derivatives "financial weapons of mass destruction" in the Berkshire Hathaway annual report for 2002 because, in part, he felt they might lead to a concentration of risk. He said then, "Large amounts of risk, particularly credit risk, have become concentrated in the hands of relatively few derivatives dealers, who in addition trade extensively with one another." CDS became that weapon, although perhaps in not quite the manner foreseen by Mr. Buffet, because they exposed a very large number of financial markets participants to significant losses as a result of the failure of one market: the US sub-prime mortgage market.

The following charts attempt to illustrate the differences between traditional and synthetic securitization.

A traditional securitization can be described as follows:

A synthetic securitization can be described as follows:

The second securitization is "synthetic" because no assets are transferred: the Conduit owns nothing but its interest in the CDS.

In a traditional securitization, if the Conduit has purchased bad assets, it still has assets and will be able to pay something to noteholders. In a synthetic securitization, if the CDS terminates, the collateral is applied and the transaction winds up: unless there was excess collateral, the noteholders get nothing back.


One feature of the credit crisis we face is that it shows up first in a loss of confidence in financial institutions by other financial institutions. This is reflected almost immediately in a widening of the spread between the rates offered to financial institutions (the BA rate in Canada and Libor in the United States) as against the relevant treasury bill yield. There was relatively low volatility in this relationship in Canada until August of 2007, while the turmoil started a little earlier in the US and was indeed an established concern at that time.

This credit spread is one of the problems with the current crisis. While government efforts to lower rates clearly have an effect, it is often contradicted by a spike up in the rates charged to financial institutions for their day-to-day funding. This is because rates are often lowered to mitigate the effects of negative events in the financial markets. Those same events cause unaffected financial institutions to become worried about the exposures their affected colleagues have to the mortgage industry and other areas of a deteriorating economy. A solvent bank does not want to lend a lot of money to a financial institution that may file for protection the next day. This causes Libor and the BA rate to rise at more or less the same time as the regulated rates fall.

The reason Canada has a problem is, in part, amplification of the sub-prime mortgage problem through credit default swaps. At this juncture we need to take a detour into the asset backed commercial paper (ABCP) market in Canada. We know quite a bit about the non-bank ABCP market because of the recent successful restructuring of that market by the Pan-Canadian Investors Committee led by, among others, the Caisse de dépôt et placement du Quebec (CDPQ) and the Desjardins Group. A certain amount of what happened has become public because of the availability of court documents relating to that restructuring.


The largest consumers of asset based commercial paper in Canada, it turns out, were pension funds and other nonbank financial institutions. The CDPQ had very large exposure with over one third of the defaulted commercial paper on its books. The current Quebec Minister of Finance, Monique Jérôme-Forget, was reported in the Globe & Mail on January 16, 2009 to have said, "it is clear that they were fooled by this product, that they didn't understand it...they relied on credit rating firms who had the mandate to evaluate them".

The management of CDPQ was and is a well-educated and intelligent group. Indeed, the reason they had so much ABCP on their books is that they had developed a very profitable arbitrage procedure under which they bought bankers' acceptances, sold them in the repo market, and then used the proceeds to buy ABCP which paid a slightly higher rate. This is a simple arbitrage play if there is no credit risk. ABCP and BAs were similarly rated, so it would be logical to assume that there was no risk differential to justify the rate spread. It turned out that the rate spread significantly under-priced the credit risk differential, so arbitraging the spread turned out to have been a mistake.

On August 13, 2007, CDPQ, among others, began to worry that they were over-exposed to ABCP and decided to cash out their exposure. The stated reason for their concern was that there was some sub-prime exposure in the assets that supported the ABCP they held. Subsequent analysis revealed some direct exposure, but not a great deal. However, that analysis was only completed as a consequence of a thorough review of all of the portfolios in contemplation of a restructuring of the ABCP market. That took over six months and the report was issued to noteholders in March of 2008. By then the damage had been done and the crisis had altered substantially.

When an institution with over one third of a market decides to exit, that is going to make waves. Unsurprisingly, other potential market participants were also concerned about sub-prime exposure and so did not want to purchase the paper that CDPQ was selling. The result was frozen markets and a complex restructuring plan that has cost tens of millions of dollars in fees and yielded, for CDPQ at least, a less than totally satisfactory result.

The interesting point from the perspective of this article is that the vast majority of the assets backing the commercial paper purchased by CDPQ and others were credit default swaps. About $25 billion of the total $32 billion in restructured commercial paper was backed by CDS.


When investors started to get worried about sub-prime lending they focused on the institutions with large sub-prime direct exposure or with subsidiaries with direct sub-prime exposure. The chart below gives a sense of how the US investment banking industry was exposed to this market.

To illustrate, suppose that a hypothetical investment bank's sub-prime mortgage subsidiary had originated $500 billion of sub-prime mortgages which the investment bank had repackaged as CDOs and sold the higher rated tranches (the "AAA" and "AA" tranches). Suppose the 'at risk' portion retained by the investment bank (often referred to as the BBB tranche) is $100 billion or 20% of the portfolio and that is sitting on its books somewhere earning a very nice return.

Now suppose that the investment bank had taken the BBB tranches from a number of CDOs and repackaged them as a new CDO, often referred to as a CDO². This is a lot of otherwise lousy risk, but under the model used by rating agencies to predict default levels, not all of it would default. In addition, the buyers can be protected by an insurance policy purchased from an insurance company. Often these insurers were specialists in this market and so were highly exposed to it. Once again, the investment bank holds the new BBB tranche, which is riskier than the original BBB tranche but pays an even higher return.

However, the methodology applied by rating agencies to addressing the risk of this exposure is flawed because it assumes that sub-prime mortgages will be riskier than regular mortgages, but not a lot riskier so default rates might go to, for example, 5% rather than the default rates on regular mortgages of less than 2%. It turns out that sub-prime mortgages are a lot riskier. The Wall Street Journal reported on February 26, 2009 that Moody's Investor Service is reporting that 42% of 2006 vintage sub-prime mortgages are at least 60 days delinquent, in foreclosure or held for sale. That means that the whole of the investment bank's BBB tranche is worth little or nothing. The whole CDO² is, of course, worthless unless the insurer can pay. Can they?

The insurer has limited capital and had not expected to pay anything. It thought it had lain off its exposure by buying an off-setting credit default swap from the investment bank (about which there is more below). When it becomes clear that most of their sub-prime insurance exposure will be called, their liquidity dries up and they have no assets with which to pay claims. AIG is an example of an insurance company with a lot of this kind of exposure and is the largest single recipient of US government relief funds. It has also recently reported the single highest quarterly loss in US history.

Our investment bank is very highly levered. Many sources report debt to equity ratios of 30 to 1, but Bear Sterns was reportedly operating at close to a 50 to 1 ratio before being subsumed. The investment bank is publicly traded, so its financial information is public. Some smart analysts start looking at the numbers and ruminating about insolvency. The suppliers of short term funding, being largely other financial institutions, stop lending. The investment banker does not have sufficient committed liquidity to stay in business, so it calls upon the Chairman of the Federal Reserve Board, looking for a lifeline.

The Chairman is a strict free marketer who used to be an investment banker and is concerned about the "moral hazard" which might result if investment bankers can count on being rescued regardless of their business practices. She refuses to help and the investment bank files for protection. Once the investment bank is gone, the insurer has no hedge against its risk, which now looks like a very bad underwriting decision indeed.


There was a lot of demand from the new intermediaries for short-term, high quality commercial paper that paid better than the obvious alternative, treasury bills. The investment bankers could sell anything they could package. They were all involved in the mortgage business, not because they understood mortgages or home ownership, but because they needed assets to securitize to create the commercial paper being demanded.

However, it turns out that there is a limited supply of securitizable assets, even if lending standards are relaxed as dramatically as the sub-prime lenders chose to do. CDO²s help, but they are complex, expensive and many buyers failed to see how the risk had been truly mitigated. The answer was credit default swaps.

The beauty of the CDS is that no new assets are required. The tedium of actually finding people to incur an obligation that can be securitized is replaced by the simple expedient of referencing a publicly traded and rated debt obligation or a pool of them, and either buying or selling protection on a portion of that debt obligation or pool of obligations. A conduit established to issue commercial paper could sell protection under a CDS, usually to an investment bank, pledge the cash raised from the sale of its commercial paper as collateral, and receive a payment for providing that protection.

The payment was based upon the nature of the reference obligation or obligations and the degree of subordination, all of which were infinitely variable or "bespoke". Ideally the investment banker would have someone on the other side of these trades that would buy protection from the investment bankers. That made the whole deal perfect: the investment banker makes a fee for structuring the trade, manages the collateral and makes a spread on that, and sells protection to a third party, earning a spread on the return it pays to the conduit, all with little or no apparent risk and no capital employed.

The purchasers of protection from investment bankers were often other investment banks and hedge funds who were looking for a way to "short" the credit risk in the pools or to balance their portfolios. And why would anyone want to "short" debt markets? Because the assets in the pools are often debt obligations of investment banks, CDOs, CDO²s, and insurance companies, all of whom are deeply engaged in the sub-prime mortgage market. We understand that both Bear Sterns and Lehman Bros. were active market makers in the CDS market.


The beauty and the fatal flaw of CDS is that there is no limit on the amount of protection that can be sold on a reference asset. CDS are purely a method of taking a position on a market just like you would take a position on the outcome of a hockey game. The bookmaker (protection seller) sets the price based upon the risks associated with the teams and the odds change with time. There is no limit on how much can be bet on the game. At its peak at the end of 2007 the global CDS market had a notional value of nearly US$60 trillion. By way of contrast, the budget of the US government for 2008 was US$2.5 trillion.

This is not a hockey game, however, and what is being bet are people's retirement savings. Those savings are exposed to credit events in a relatively small number of reference obligations. When Lehman Brothers filed for protection, we were told by an informed source that Lehman debt of one form or another figured in reference pools of over 90% of the CDS pools of which they were aware. Large insurance companies like AIG that had written a lot of CDO² insurance were a little less ubiquitous, but nonetheless a frequent reference entity. Fannie Mae, Freddie Mac, Glitner Bank, Kaupping Bank and Landsbanki with exposure to the US or their own domestic sub-prime markets also were common reference entities. When Lehman Bros. filed for protection, a lot of CDS's were much damaged. Even if there was no default, no one wanted commercial paper funded by a CDS that was very close to being terminated.

Where a CDS fails, the collateral is at risk. That is to say, the contract provides that if there are credit events over a certain level in the reference obligations, the protection seller (meaning the conduit) pays. The conduit's obligations are normally limited to losses and the amount of money it has, but that is all it has. CDS conduits that fail have very little left to pay their noteholders and no other assets.

A CDS does not need to require payment by a protection seller as a result of realized losses in order to create a problem. One of the biggest issues in the ABCP restructuring was collateral calls resulting from an increase in markto- market exposures rather than actual credit events leading to losses in excess of the engagement point. In March of 2008 it was estimated that 93% of the assets subject to the ABCP restructuring had either exceeded a collateral threshold or were within 10% of that threshold. Where would a conduit get money to post collateral? However, if the collateral was not posted, the CDS would terminate and the collateral already posted would have largely disappeared. This provided a significant incentive to the restructuring.

Below is a simplified representation of a CDS reference asset list:

Reference Assets in $3 Billion Notional Reference Portfolio are:

Have already experienced Credit Events:

$100 million of Lehman Bros.
$100 million of Fannie Mae
$100 million of Freddie Mac
$100 million of Countrywide
$100 million of Radio Shack

Will likely experience Credit Events or are at significant risk:

$100 million of AIG
$100 million of Washington Mutual
$100 million of Bear Sterns
$100 million of Citibank
$100 million of Bank of America

$2.0 billion of other, potentially performing assets

Suppose the above reference asset list relates to a super senior credit default swap with an engagement point (the point at which the protection seller pays) of 15%, so the swap terminates and the protection seller pays if there are credit events with respect to reference entities resulting in losses of over $450 million.

In the above reference portfolio, there are $500 million of reference assets that have experienced credit events. If the losses do not equal or exceed $450 million, they are close.

For leveraged CDS (and some of them were levered as much as 20 times), there would be margin calls. Each deal is different, but generally the swaps are marked to market and an estimate made of the anticipated loss requiring funding based upon the make-up of the reference assets and the then current view of the long-term credit worthiness of the reference entities. With these reference assets, this swap would likely require additional collateral.


The result was a flight to quality in the form of US treasury bills by any of the new intermediaries that did not have their funds tied up in commercial paper markets. That not only drove down yields but increased the demand for the US dollar. More importantly, it stopped all commercial paper markets in their tracks.

Not all commercial paper conduits are funded by CDS. Some of them, like those sponsored by the auto makers, are funded by loans and leases on automobiles. Those assets have performed well, but there is no market for their commercial paper. And there is no telling how these assets will perform in the future as the economy spirals down.

That is a problem for the holders, but it is a bigger problem for the businesses that rely on this form of liquidity. For example, it is estimated that North American auto sales in 2009 will be 10 million units, down from 17 million units in 2008: and those estimates are falling. There are many reasons for this steep and very disruptive decline, but one of them is that financing has all but dried up for new car buyers. GMAC and others cannot sell their commercial paper. If they cannot sell commercial paper, they cannot fund loans and leases.

What this means to Canadian businesses is that there are a lot fewer lenders out there now. Many US banks and nonbanks cannot fund new loans and are now out of business, at least temporarily. Canadian banks are not so exposed to sub-prime problems, but they too relied on commercial paper conduits for some of their business lines and those conduits can no longer raise money. Those bank-sponsored conduits, and their losses, will eventually end up on some bank's balance sheet. This is one of the concerns that have led to the decline in financial institution equities: it is hard to figure out the quantum of that exposure because the conduits, by design, are not on the banks' balance sheets. Citibank, for one, was very active in the securitization market.

Nancy Hughes Anthony, President and CEO of the Canadian Bankers Association, said in a recent speech that Canadian banks have historically funded only 50% of the credit needs of Canadian business. Although bank lending to business was up year over year by 13%, Canadian banks alone cannot fill the gap. When asked how much of the new "lending" resulted from Canadian banks absorbing the obligations of their sponsored securitization conduits, Ms. Hughes Anthony was unable to comment.

It also means less economic activity: fewer people engaged in the building and selling of cars, less demand for materials, less goods and services demanded by people no longer working. The steep decline in the US housing market has a similar chilling effect on economic activity generally. The world economy is deleveraging and that will be painful.

In addition to the banks, other potential sources of financing like insurance companies, pension plans, hedge funds and private equity funds are absorbing large losses from commercial paper and other investments and have largely withdrawn.

When supply is reduced and demand remains fairly high, one can expect prices to rise and lenders to be more careful about the quality of their credits. That means that commercial borrowers can expect to pay more and to face stiffer terms. Marginal businesses will be unable to find credit or be driven to more expensive forms of capital like asset based lending, mezzanine lending or equity markets.


The very widespread use of credit default swaps to fund commercial paper conduits and the extent to which the reference assets focused on financial institutions damaged by the sub-prime mortgage crisis resulted in an amplification of the American sub-prime problem by making the problem of over-exposure by American financial institutions a problem for all purchasers of commercial paper, meaning most pension plans and insurance companies. The losses suffered by these entities are real and will result in less liquidity in the financial markets without in any way addressing losses arising from the sub-prime mortgage crisis.

The withdrawal of these significant players from financial markets and the virtual elimination of the commercial paper market leads to even greater credit constraint, which then imposes further damage on the economy.

There is no easy or cheap solution.

"The CDS Contagion" is an excerpt from a paper prepared by Sam and Aaron for the Canadian Institute Conference that was held on March 4 and 5, 2009.


1. GE Canada Equipment Financing G.P. v. ING Insurance Company of Canada (2008), 57 C.C.L.I. (4th) 230 (Ont. S.C.J.)

2. Statutory Condition 6(7) of O. Reg. 777/93 passed under the Insurance Act, R.S.O. 1990, c. I.8 provides that "There shall be no abandonment of the automobile to the insurer without the insurer's consent. If the insurer exercises the option to replace the automobile or pays the actual cash value of the automobile, the salvage, if any, shall vest in the insurer".

3. Personal Property Security Act, R.S.O. 1990, c. P.10 at ss. 4(1)(c).

4. GE Canada Equipment Financing G.P.

5. ING Insurance Company of Canada (2008), 39 C.B.R. (5th) 315 at par. 22.

6. Supra note iii at ss. 9(1). vi Supra note i at par. 54.

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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