ASSET BACKED COMMERCIAL PAPER – BUYER BEWARE!
Many companies have “tons of cash” on their books. But how safe is that cash? Not as safe as many people thought.
From the Financial Post (Canada):
Transat put a large amount of its surplus money into short-term investments known as asset-backed commercial paper (ABCP). Suddenly it has no access to 45% of its $340-million cash due to last week's meltdown in the non-bank ABCP market. It's unclear when Transat will be able to get its cash back - or how much it could lose.
follow investment policies that have them sock away the rest in liquid, dependable investments that, preferably, beat the overnight rate. They depend on their bankers to find investments that fit those criteria.
For that reason, Transat's banker, National Bank of Canada, and Dominion Bond Rating Service Ltd., which gave R1-High ratings to 90% of Transat's ABCP, have a lot to answer for. So, too, do other banks that steered their clients into non-bank ABCP.
Other victims so far include:
Cameco Corp., which said nearly 40% of its cash is in ABCP’s. It has C$13 million invested in asset-backed commercial paper held in two trusts. Both matured on August 17, 2007, but neither counterparty has paid Cameco.
Russel Metals Inc. says Coventree Inc. failed to repay $11 million when asset-backed commercial paper held by Russel came due on Thursday. About 5% of its cash on hand.
The Greater Toronto Airports Authority which has approximately 25% of its cash in ABCP’s.
Baffin-land Iron Mines Corp., which has all but $2.1-million of its $46-million in cash tied up in non-bank ABCP.
This has been major news this week in Canada, and no bank has been spared.
From reportonbusiness.com:
HSBC Bank Canada has become the second bank to say it was telling clients to buy non-bank commercial paper based on the ratings it had received from DBRS Ltd.
"Like other financial institutions and intermediaries, HSBC Bank Canada and our subsidiaries have supplied bank and non-bank ABCP [asset-backed commercial paper] to customers based on ratings," spokeswoman Sharon Wilks said yesterday.
While some financial institutions are buying back the troubled paper from mutual funds and retail investors, corporate clients are largely being left to fend for themselves, people in the industry said.
"Nobody's having luck getting their money back," said the chairman of one Canadian firm that holds non-bank ABCP.
So how are people reacting to this news? As expected. From Bloomberg:
Outstanding U.S. commercial paper fell 4.23 percent, the biggest weekly drop in almost seven years, as investors fled asset-backed debt and opted for the safety of Treasuries. Commercial paper outstanding has fallen by $181.3 billion in two weeks. The most recent decline is the biggest by percentage since at least November 2000, according to data compiled by Bloomberg.
Bloomberg:
U.S. money market funds run by Bank of America Corp., Credit Suisse Group, Fidelity Investments and Morgan Stanley held more than $6 billion of CDOs with subprime debt in June, according to fund managers and filings with the U.S. Securities and Exchange Commission. Money market funds with total assets of $300 billion have invested in subprime debt this year.
So what will be the result? Again from Bloomberg:
Commercial paper backed by assets led the fall as buyers fled debt linked to subprime mortgages. Outstanding paper may slump by a total $300 billion, representing the entire amount of such debt backed by home loans, said Tony Crescenzi, chief bond market strategist at Miller Tabak & Co.
``The shrinkage of the commercial paper market will force companies to obtain money elsewhere,'' Crescenzi, who is based in New York, said in e-mailed comments today. ``Some will be unable to obtain funding and will shut or scale back their operations.''
More than half of the $1.1 trillion in outstanding asset- backed paper comes due in the next 90 days, according to the Federal Reserve. Unless they find new buyers, hundreds of hedge funds and home-loan companies will be forced to sell $75 billion of debt, according to Zurich-based UBS AG, Europe's largest bank.
``The commercial paper market, in terms of the asset-backed commercial paper market, is basically history,'' Bill Gross, manager of the world's biggest bond fund at Newport Beach, California-based Pacific Investment Management Co., said in an interview today.
The Fed apparently realizes the seriousness of all of this and the huge amount of leverage in this paper. A freezing up of this paper and the inability to roll it over would cause massive bankruptcies. Thus, we received this announcement from the FED on Friday:
``In response to specific inquiries, the Federal Reserve Bank of New York has affirmed its policy to consider accepting as collateral investment quality asset-backed commercial paper'' for discount-window loans, Andrew Williams, a spokesman for the bank in New York, said in an interview.
This type of action is not new, but it is unusual. The Fed intervened in the market in a similar fashion in 1970 following the collapse of Penn Central and its default on Commercial Paper. As recounted in James Grant’s book, “Money of the Mind: Borrowing and Lending in America:”
In the week ended July 1, 1970, the volume of “non-bank” commercial paper outstanding – promissory notes issued by businesses – fell by $2.25 billion; in the next two weeks, it declined by another $714 million. Thus, in short order, one vital segment of the commercial paper market had shrunk by almost 10 percent. (sound familiar? – Mac) Commercial-paper investors now conceived a rapt, belated interest in the creditworthiness of the companies in which they invested only the best companies would do; second-tier issuers were obliged to pay a premium, and all corporate issuers were forced to pay significantly more to borrow than the Treasury paid.
The Treasury was not a party to the quick resolution of this crisis, but the Federal Reserve System intervened decisively. It encouraged banks to lend to corporations as it lent liberally to banks. It suspended the interest-rate ceilings above which banks had not been able to bid for new deposits. Harking back to the makeshifts of the 1930’s, it prepared what it subsequently described as “standby procedures to make credit available to worthy borrowers facing unusual liquidity requirements that could not be met by obtaining funds from other sources.” If this meant that the inflation was a lesser evil than a domestic financial crisis, so be it: “…the System recognized that it might have to let the money supply and bank credit temporarily grow faster than desirable over the longer run in order to maintain financial-market stability.”
History doesn’t repeat, but it does rhyme, and sometimes quite closely! Note that Penn Central Commercial Paper had “the highest credit rating possible” as rated by the National Credit Office (a forerunner to Standard & Poor’s, Moody’s and Fitch).
We need to realize how important this market is to the stability of the entire financial framework in the US. While the failures to pay have been primarily with Coventree and non-bank asset backed paper, the big numbers lie with the Investment Banks in the US. Most US Banks and Investment Banks that are Prime Brokers use Asset Backed Commercial Paper to finance their Prime Brokerage units. Citibank in a conference call this week pointed out the extreme leverage in the system. For example, in the first quarter of 2006, Lehman issued 183 pieces of Commercial Paper totaling US$833 Billion. That is in comparison to Lehman’s Total Assets of US$504 Billion. That is Commercial Paper issued in the first quarter of 2006 was 1.65 times the total assets that Lehman possesses. While other banks aren’t so egregious, many are still highly leveraged, with Merrill having a ratio of 0.89, Goldman having a ratio of 0.72, and Morgan Stanley having a ratio of 0.44. This compares to relatively unleveraged banks such as the Royal Bank of Canada which a ratio of only 0.08.
Thus, the Fed had no choice given the huge leverage in the system that along with the huge buyers strike has resulted in much higher yields being demanded as risk has been repriced. A collapse of one of the Investment Banks and an inability to service their hedge funds and others via their prime brokerage services would have been disastrous. This corresponds with a rumor that was relayed to me earlier this week: “JP Morgan and Citibank is out there aggressively telling the market that Lehman and Bear Stearns are pulling credit lines to hedge funds, conduits, and SIVs.” . In a way, the Fed is totally acknowledging the seriousness of the situation at hand. Below is a chart of 30-day A1/P1 Commercial Paper yields:
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