Retail Owners Were Sold Very High Risk Savings Vehicles as If They Were Safe as T-Bills
In 2007, Canada's total money market was $360 billion, of which 37% was risk free government treasury bills (T-bills). The Asset Backed Commercial Paper (ABCP) component of the money market was 32% or $115 billion. ABCP had two types: Bank ABCP and Non Bank ABCP. Bank ABCP was sponsored by banks in the form of trusts manufactured and distributed by the banks or their wholly owned investment banks. $35 billion of Non Bank ABCP, on the other hand, was in the form of trusts manufactured by relatively unknown non bank financial corporations. ABCP had historically been very safe as it comprised pools of various low risk credit securities, like investment grade mortgages, auto loans, and credit card receivables.
However, the Non Bank ABCP market froze in August 2007, when Canadian investors were no longer willing to buy this ABCP, due to their increased awareness of its potential for loss. The Non Bank ABCP under CCAA proceedings owned $3 billion of US subprime mortgages that were defaulting and $7 billion of traditional low risk credit securities. Another $22 billion was invested in a derivative called, credit default swaps (CDS), where bank counterparties paid premiums in exchange for the trusts agreeing to pay for marked to market losses on reference credit portfolios. The bank CDS sellers had the right to make margin calls for more cash to be added to the trusts to cover their losses and if these were not made the banks could seize the collateral of quality assets in the trust. $4 billion of the Non Bank ABCP was sold to the retail market, $18 billion to various government pension funds and agencies and $10 billion to corporations. During the financial crisis, $25 billion of the underlying assets became worthless. The bank counter-parties agreed to restructure the typical 90 day term Non Bank ABCP into structured credit vehicles that would run-off the underlying credit securities over 9 years. Over this period, the jump in credit spreads dissipated and the market value of the credit default swaps increased significantly.
Retail owners of less than $1 million got 100% cash settlements from the Canadian investment bank distributors in early 2009, while owners of over $1 million generally received non-recourse loans for 75% of their investment. Institutional owners accepted the long term structured credit securities, that would pay out recoveries over 9 years. The bank owned investment banks quietly settled with their retail customers, while independent investment dealer, Canaccord, and the credit union industry's investment dealer Credential, entered the largest retail investor settlement in history of $177 million after a vigorous high profile fight from its customers that had a majority of the votes to stop the court-administered restructuring of the Non Bank ABCP. There were $139 million of regulatory settlements with the Canadian investment dealers: $75 M National Bank; $29 M Scotiabank; $22 M CIBC; $6 M HSBC; $3 M Canaccord; $3 M Laurentian, $1 M Deutsche Bank and $0.2 M Credential.
Dominion Bond Rating Services (DBRS) bears significant responsibility for giving false top credit ratings on the ABCP that did not meet the international standard for liquidity agreements that paid investors in full in the event of the trusts going into default. Standard & Poor's Canada reported that the Non Bank ABCP was below investment grade in 2002. In 2002, Moody's also concluded that it was unable to assign investment grade ratings to any Canadian Non Bank ABCP because repayment to ABCP investors was not assured under the Canadian liquidity lines. On September 12, 2007, DBRS announced it was moving to the international standard for liquidity agreements, and no new synthetic Non Bank ABCP was sold after this date. DBRS did not receive any regulatory actions for its negligence, and misrepresentation of the Non Bank ABCP's safety. There was no disclosure on exposure to US subprime mortgages, or the degree of leverage within the CDS's owned.
The Federal Office of the Superintendent of Financial Institutions (OSFI) Regulation B-5 permitted the banks to sign the "Made-in-Canada" defective liquidity agreements for the Non Bank ABCP. The banks did not need to assign capital for their obligations under the Canadian standard liquidity agreements, because these liquidity agreements were of no use and would almost never lead to banks making payments to the ABCP owners. Standard & Poor's wrote a critical research report on the impact of Regulation B-5 called, "Leap of Faith," in August 2002.
The provincial securities commissions continue to exempt the Non Bank ABCP from being sold by a registered dealer and by prospectus, if it has an approved credit rating from an approved credit rating organization as defined in National Instrument 45-106. The provincial securities commissions were enablers of DBRS being the only credit rating organization providing top credit ratings for the Non Bank ABCP. The provincial securities commissions could have forced the Non Bank ABCP sponsors to prepare prospectuses for their commercial paper when both Standard & Poor's and Moody's reported that the Non Bank ABCP was below investment grade in 2002.
The bank counterparties to the credit default swaps are the same banks who signed the defective Canadian liquidity agreements in most of the problem trusts. These banks put themselves into the powerful position of being able to make a call for cash to pay for marked to market losses under their swap, knowing that they would walk from their liquidity agreements and gain access to the trust's collateral of top rated assets held in trust. Deutsche Bank had about 59% of the $22 billion face amount in 135 synthetic asset providers’ contracts. Behind Deutsche Bank was Merrill Lynch at 11%, HSBC Bank at 7%, CIBC at 7%, and UBS at 6%.
Deutsche Bank's $1 M regulatory settlement in Canada for selling unsuitable Non Bank ABCP to its customers was the only regulatory consequence in Canada despite the alleged fraud in selling leveraged CDS's at the same time it entered liquidity agreements purporting to guaranty the losses of the Non Bank ABCP investors. There was no economic rationale for entering these two contracts at the same time, and Deutsche Bank only did so knowing that it could walk away from the Canadian liquidity agreements. The US SEC entered a US$55 million settlement against Deutsche Bank as a US issuer failing to disclose that it had $12 billion of marked to market losses on its leveraged CDS contracts with the Canadian Non Bank ABCP counterparties. This is another case where US regulators act while Canadian regulators listen to prominent legal counsel, like now deceased Purdy Crawford, who said Deutsche Bank did nothing wrong.
Only Coventree, one of the 7 non bank financial institutions, manufacturing 34% of the Non Bank ABCP, received securities regulatory sanctions. It paid a settlement of just $2 million, despite being responsible for manufacturing $11 billion of Non Bank ABCP, with deficient disclosure on US subprime mortgages, leverage within the CDS's, simultaneous bank provision of CDS's and liquidity agreements and the demise of its ability to continue manufacturing Non Bank ABCP owning leveraged CDS's.
There were substantial risk premium dollars within the Non Bank ABCP structures to cover the liquidity, default and leverage risks. However, the Non Bank ABCP sponsors, bank credit default swap counterparties and liquidity agreement signatories, investment bank distributors and DBRS took most of the risk premium for themselves in fees and profits, while the owners of the Non Bank ABCP only got 5 to 10 basis points of extra yield over risk-free T-Bills.