Sex, lies, and transparency

What is more intriguing, and arguably more important than assigning blame for the troubled Canadian non-bank sponsored asset-backed commercial paper debacle, (see “Doing it all,” Canadian Lawyer, November/December 2009), is discovering the reasons why the unresolved problems relating to the so-called “toxic” assets in securitized debt instruments continue to threaten the nascent recovery.


I have found a remarkable similarity between the behaviours of the folks who brought us the troubled (toxic) assets and of the people who practise unsafe sex. There may be deep-seated propensities which promote similar problematic behaviour in more than one sphere of human activity.

Consider the following: those who fall into either category are bent on achieving instant gratification; suffer from irrational exuberance; do not fully understand the underlying mechanisms affecting their behaviours; fail to employ appropriate risk management; and are prone to sweet-talk others into acting against their best interests.

In both cases, a lot of people get screwed, with disastrous consequences.

Of the three letters that are bandied about when unfortunate consequences ensue, only SIV requires elaboration. Structured investment vehicles, similar to conduits, are special-purpose vehicles that purchase long-term fixed income securities, which are usually funded by issuing short-term debt in the nature of commercial paper.

The financial consequences when markets for such paper fail amount to the equivalent of taking a long walk off a short pier. It is such investments — including the Canadian non-bank sponsored ABCP — that continue to represent a danger to the economy, and will do so until they are effectively dealt with.

A must-read is the largely ignored “The continuing risk of troubled assets,” the Aug. 11, 2009 report of the Congressional Oversight Panel chaired by Elizabeth Warren, a professor at Harvard Law School. The panel was established to oversee the efficacy of the Troubled Asset Relief Program (TARP) approved by Congress in October 2008.

The facts represent an empirical and data-driven update on the state of the troubled assets, and of the reluctance of financial institutions to make their dealings in them transparent.

Before reading the report, I was starting to believe the worst of the economic downturn was over. My optimism was fuelled by a continuing stream of pronouncements from pundits in the business press, central bank heads, prominent economists, and CEOs of major corporations.

Below are some of the facts contained in the report relating to the unaddressed problem of the troubled assets that are still on the banks’ books or soon to be returned.

There are numerous references to problems created by the lack of transparency resulting from the withholding of information by the banks or as a result of the complexity of the forms used to package the troubled assets.

The first can be dealt with by mandating disclosure. The second can be overcome using existing technology that permits the recording, in a straightforward spreadsheet format, of the information hidden in the documentation, which is essential to making an informed investment decision by anyone contemplating the purchase of such assets.

An excellent description of this technology (XBRL) is contained in “A radically transparent plan to remake the market,” an article by Daniel Roth in the March 2009 Wired. Without the newer technology, obtaining the information is slow and cumbersome, and the results disappointing.

The title of the report gives a pretty good idea of what it concludes (at pp. 62-3):


“Troubled assets were at the heart of the crisis that gathered steam during the last several years and erupted in 2008. . . . One continuing uncertainty is whether the troubled assets that remain on bank balance sheets can again become the trigger for instability” [my emphasis].

It continues: “In publicly-available data reviewed by the panel, the 19 tress-tested [bank holding companies] have reported: $657.5 billion in Level 3 [poorest quality] assets. . . . [and] $8.9 trillion in credit default sub-investment grade exposure.”

The above figures should be read along with the following statement found in the report: “Based on information submitted by the BHCs, bank supervisors predict that this change [that the assets be marked to market] alone could result in approximately $900 billion in [troubled] assets being brought back onto the balance sheets of these institutions [beginning in 2010].”

A sanguine view of the future prospects for the troubled assets is that they are not as toxic as has been assumed and will benefit from an improving economy. This view was articulated in an Aug. 13 article on, “TARP remains troubled” by John Osbon, founder and chief investment officer of Osbon Capital Management, who also felt “[the] worst was over.”

A less optimistic scenario is based on the assumption that the assets are truly toxic. As the report makes clear, there is insufficient transparency to permit an accurate assessment of the nature or quality of the assets bundled and securitized.

As it is now a less daunting task, one wonders why the financial institutions involved continue to be so reluctant to make full disclosure. Revealing upwards of 200 pages of largely unanalyzed data with respect to assets backing commercial paper makes them more opaque than transparent.

Viewed in the larger context of the U.S. experience, Canada’s mini-meltdown, described in “Doing it all,” could be an example for either outcome. The “ABCP crisis in Canada: the implications for the regulation of financial markets,” a research paper prepared by John Chant, professor emeritus of economics at Simon Fraser University, for the expert panel on securities regulation is instructive. As stated in the executive summary:


“The assets held by third-party conduits were divided between traditional assets (29 per cent) and synthetic, or derivative, assets (71 per cent). Of the derivative assets, $17.4 billion (59 per cent of total assets) were Leveraged Super Senior Swaps through which the conduits provided protection for others against credit losses.”

The discovery of this asset mix was something of a surprise. Court documents disclose that the lawyers acting for those supporting the application to restructure the individual ABCPs, based on the Montreal Accord arrived at by the Pan-Canadian Investors Committee, did not believe that there were any synthetic assets involved.

It also may have come as a surprise to holders of the notes that, as Chant recorded, “the sponsor was bound to exercise the same care as it would if acting on its own.”

Considering this undertaking, purchasers would not have expected that $17.4 billion of their money was being spent to insure “bad loans of international banks” as Diane A. Urquhart said in her March speech “The Canadian asset backed commercial paper crisis, the cause and cure,” to the Canadian Centre for Ethics and Corporate Policy.

Unfortunately, the market for the restructured Canadian non-bank ABCP appears to be less than robust. Although some holders, of the “highest quality notes” have sold them at a 50-per-cent discount, (the original ABCP notes were divided into 157 different classes), the conclusion of a Globe and Mail Nov. 25 article, “Long-thawed ABCP market simmering to a boil,” is consistent with my concern:


“Still, the notes are enormously complicated, requiring those interested in buying them to wade through hundreds of pages of documents to understand the underlying assets that determines the value of the notes. That remains a turnoff for some who have considered buying” [my emphasis].

With luck and an improving economy, the holders of the notes eventually hope to recoup a significant portion of their investments, at least if they hold them to maturity. Because such a large part of the original underlying assets were in the form of highly leveraged credit default swaps, any significant downward movement in the economy would lead to a situation which came close to scuppering the accord when it was saved by the governments of Canada, Quebec, Alberta, and Ontario. They came up with $4.5 billion in additional funds to support the swaps and convince the counterparties (a number of European banks), whose poor quality loans were “insured” by the swaps, to hold off on taking further action.

This part of the story is well-covered by Lou Brzezinski, who leads the commercial litigation group at Toronto’s Blaney McMurtry LLP, in “Canada’s ABCP crisis — the aftermath,” published in the February 2009 Commercial Litigation Update.

Prior to restructuring, the affected conduits in the case discussed in “Doing it all,” represented 27 per cent of the $117-billion Canadian ABCP market, the remainder being made up of bank-sponsored ones.

Positive experience with the Canadian bank-sponsored ABCP shows that the use of securitized debt instruments is not inherently inappropriate. It is their misuse that is dangerous.

A few voices have acknowledged the danger posed by the troubled assets. In a Nov. 29 New York Times article “Get ready for half a recovery,” Gretchen Morgenson refers to chief U.S. economist at High Frequency Economics Ian Shepherdson’s warning that “bad assets on personal and institutional balance sheets” represent a “ball and chain” limiting recovery.

Maybe the $8.9 trillion in credit default sub-investment grade exposure has scared the pants off almost everyone?

As Floyd Norris wrote in “Keeping derivatives in the dark” in the New York Times on Nov. 26: “Opaque markets breed insider profits and abuse of investors. Sunshine can bring competition and lower costs even if regulators do little beyond letting the sunlight shine”  [my emphasis].

Would anyone have invested in a Canadian non-bank sponsored ABCP if shown a list of assets containing 59 per cent leveraged super senior swaps insuring risky loans of a number of European banks, where the return would be only marginally higher than treasuries, even if a rating agency gave it an AAA?

Morley Gorsky practised law in Ottawa, and taught law at Queen’s University and the University of Western Ontario. He is presently an arbitrator/mediator and can be reached at [email protected].

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