Inside Scoop on ABCP Debacle. June 8, Daryl Ching

Transcription

1 CIFPs 7 th Annual National Conference Inside Scoop on ABCP Debacle June 8, 2009 Daryl Ching

2 Transaction Diagram Traditional Securitization A securitization transactions involves multiple parties that all have their own distinct roles (1) Sale of a pool of assets to a Special Purpose Vehicle (SPV) (2) A major financial institution provides liquidity (3) Protection provided by hedging through a swap counterparty, credit enhancement and subordinate notes (4) SPV issues highly rated notes to ABCP investors to fund the assets (5) Originator receives cash upfront for the sale of their assets and remits collections to the SPV on an ongoing basis Liquidity Provider (3) Swap Counterparty Originator (1) (2) SPV (3) (4) (5) Credit Enhancement/ Subnotes Investors 2

3 Rating Agency s Role The first step in the securitization process is for the rating agency to assess the potential originator based on general guidelines highlighted below The intention is to ensure the originator has solid underwriting practices and the ability to collect on its receivables General guidelines Minimum of three years of monthly performance history Minimum equity Stable loss and delinquency performance in the portfolio Documented underwriting guidelines for originations Documented credit and collections policies Minimum size of portfolio for securitizable assets Diversified portfolio Strong management team Originator Investment Bank CP Holders Assures proper funding Assures proper payment of CP 3

4 Credit Enhancement Rating agencies demands at three years of monthly data for analysis ratings criteria for each asset class based on the desired structured finance rating, which is achieved by calculating an expected loss and requiring a multiple credit enhancement coverage Internal enhancements: Reserve consisting of additional assets (overcollateralization) Excess spread Cash collateral Third party (external) enhancements Third party purchase of defaulted obligations Letters of credit Subordinate Notes Credit enhancement must cover a multiple of expected losses Performance triggers add protection to the transaction 4

5 Stress Testing Process Traditional securitization structuring involves sizing enough credit enhancement to meet rating agency stress tests to achieve an investment grade rating Rating agencies have methodologies for stress testing that differ across asset classes After three years of monthly data is gathered from the originator, the first step is to assess the expected value of key metrics based on past performance and the business plan Certain metrics are then stressed such as losses, delinquencies, payment rate, etc. The transaction structure must provide enough credit protection to withstand the stresses that have been selected Achieving a AAA rating means ensuring with 99.9% confidence that the cash flow from the assets is sufficient to cover investor principal, interest and the various fees to other counterparties Unlike the corporate credit market, it is difficult to determine a mark-to-market value on traditional assets, such as a pool of auto loans Deterioration in portfolio performance, which leads to a decrease in loss multiple coverage by credit enhancement can lead to do a downgrade of the transaction 5

6 Prime Mortgage Example Theoretically, any transaction can be structured to a AAA level, provided there is sufficient credit enhancement Below is an example of a prime mortgage transaction (1) Loss Protection is provided by excess spread of 2% (yield minus cost of funds) (2) First loss of 3% is absorbed by originator by means of overcollateralization or excess receivables (3) Another line of defense comes from the 2% cash reserve (4) Not including excess spread, originator must incur 5% net losses in order for investors to experience a loss Swap Counterparty Mortgage Co. SPV (97% Funding) Cash Reserve (2%) Excess Spread 2% (5) 97% of the assets are funded Investors 6

7 Subprime Mortgage Example With increased risk in the portfolio, there is a requirement for greater credit enhancement Below is an example of a subprime mortgage transaction (1) Loss protection is provided by excess spread of 7% (yield minus cost of funds) (2) First loss of 10% is absorbed by originator by means of overcollateralization or excess receivables (3) Another line of defense comes from the 5% cash reserve (4) Subordinate Notes provide further protection to the ABCP (5) Not including excess spread, there is 30% credit enhancement to the AAA tranche (6) 90% of the assets are funded, with 75% funded at the AAA level Excess Spread 7% AAA Note 75% AA Note 5% A Note 5% BBB Note 5% O/C 10% Cash Reserve 5% 100% 7

8 Auto Lease Credit Risks With lease transactions, residual risk needs to be modeled, which is the risk that vehicles that are sold at the end of a term will recover a market value less than the depreciated book value (1) In Canada, most leases are open ended residual is guaranteed by customer (2) For closed ended lease portfolios, detailed analysis required for potential resale of each vehicle stresses for AAA include: A. Recovery value of 50-60% with a 3-5 month lag B. Credit losses increase 4-6 times C. Reduction in Automotive Lease Guide ( ALG ) values of vehicles of 22.5% to 30% D. Turn-in rate of 90% (3) Measures need to be taken so that timing of credit enhancement will cover funding shortfalls 8

9 Personal Lines of Credit Like credit card receivables, personal lines of credit are unique in their short-term nature (1) Due to short-term nature of assets, a revolving structure is the most common (2) Co-ownership structure with minimum seller s interest (3) No underlying collateral (4) Shorter expected payout period in amortization (5) AAA stress tests include: A % reduction in yield B % reduction in payment rate C. 4 to 5 times increase in worst case charge-offs 9

10 CDOs A CDO is simply a re-packaging vehicle that issues liabilities and equity to purchase assets: very similar to a mutual fund Financial institutions sell CDOs to reduce capital requirements, hedge risk or enhance financial flexibility Investors buy CDOs seeking a yield on an investment greater than the cost of their funding source, otherwise known as spread arbitrage The most common CDO sold in Canada is the Leveraged Super Senior (LSS) Running Premium Payments Financial Institution Contingent payments on default Collateral on margin calls Investor 10

11 Corporate CDOs Corporate CDOs are backed by a pool of credit default swaps with exposures to various corporate names and then tranched to create a capital structure Reference Obligation 1 Reference Obligation 2 AAA (85%) Super Senior Reference Portfolio of CDS s AAA (5%) Senior AA (3%) Mezzanine BBB (4%) Junior Mezzanine Reference Obligation 100 Not Rated (3%) Equity 11

12 Leveraged Super Seniors Leverage is applied to corporate CDOs to boost the spread margin calls will be made in the event of mark to market deterioration Reference Obligation 1 Reference Obligation 2 Financial Institution $1 billion Pays 10 bps = $1 million Reference Portfolio of CDS s Investor $100 million Receives 100 bps Reference Obligation

13 Canadian Securitization Market With over $120 billion outstanding as of August 2007, Asset Backed Commercial Paper (ABCP) has been the largest component of the non-government short term debt market Canadian Non-Government S-T Debt Market Canadian Short-Term Debt Market C$BN ABCP Bankers Acceptances Corporates T-Bills & Agencies 39.0% ABCP 30.6% '97 '98 '99 '00 '01 '02 '03 '04 '05 '06 Aug '07 BA's 14.9% Corp CP 15.5% Small margin above risk-free return Prospectus exemption AAA-rating Trusting investors during benign credit cycle * Based on DBRS Canadian Securitization Servicer Report as at August

14 CDO Explosion Growth in ABCP was fueled by Collateralized Debt Obligations (CDOs), as they had doubled in 2 ½ years and became the largest single asset class in ABCP in Growth of Asset Classes All other Asset Classes Residential Mortgages CDOs '03 '04 '05 '06 Aug '07 * Based on DBRS Canadian Securitization Servicer Report as at August

15 Mark-to-Market Triggers Although the credit quality of the underlying portfolio remains strong, LSS CDOs require the ability for the investor to make margin calls during a liquidity crunch, this is not possible Most transactions had mark-to-market triggers set at 5-10% deterioration in the portfolio, which was considered stressful when considering the assets are solely investment grade CDS LSS CDOs were created under the assumption that diversification provided uncorrelated returns In a severe credit crunch, correlation across all industries becomes 1 When the ability to issue new ABCP is taken away, LSS CDO transactions simply do not work Without the triggers, most LSS CDOs required 30-40% defaults for investors to experience a loss in interest or principal at the AAA-level 15

16 US Subprime Debacle There are two key causes of the debacle 1) Too many degrees of separation between the originator of the mortgage and the risk taker and 2) Greed Traditional Model Today s Reality Borrower Collections Servicer Borrower Mortgages Bank Deposits Customers Mortgages Broker Mortgages Banker Sale of a pool of mortgages Approval of ratings Aggregator Securitization of mortgages Rating Agency CDO Manager Issuance of CDOs Approval of ratings Investor 16

17 Canada vs. Other Jurisdictions Although Canadian ABCP has its similarities with other jurisdictions, there are also remarkable differences General Market Disruption Liquidity GMD style liquidity is not prevalent in any other established securitization market. Extendible Notes With No Liquidity In Canada, extendible commercial paper has no way to assure investors of timely repayment. Other markets require this assurance. Single Rating Agency In most global markets, ABCP carries two ratings. Third Party Conduit Sponsors Third party sponsors had a much greater presence in Canada relative to other markets. ABCP is generally a bank dominated market elsewhere. 17

18 Timeline Dominion Bond Rating Service (DBRS) had publicly expressed their concern about the growth in the CDO market in November 2006 and changed the criteria in January 2007, which essentially halted the CDO market January DBRS issued a letter, changing the criteria for CDO transactions, requiring global style liquidity. This letter essentially shut down the CDO market, as market participants scrambled to find a solution. Spring Increasing concern from investors about US subprime mortgages due to increased headlines November 06 January Spring 07 November As the outstanding amount of CDOs grew beyond $30 billion, DBRS made an announcement that it will form an additional committee to approve CDO transactions. As a result, CDOs were subject to greater scrutiny and deals were taking longer to get approved. 18

19 Timeline On August 13, several Canadian conduits gave notice to banks of a market disruption or the inability to roll commercial paper an unprecedented event in the Canadian market for an industry that has been in existence for over 20 years August 13 Several non-bank institutions announce their inability to roll commercial paper, calling for a market disruption. August Seventeen non-bank sponsored conduits could not repay maturing ABCP that week. August 24 DBRS announces that they will review ratings criteria for Canadian ABCP. July August August July 14 Coventree reveals its subprime exposure to a handful of investors who made inquiries. August 15 Big 5 banks confirm they continue to be able to roll their own commercial paper. August 16 Origination of Montreal Accord August 21 & 22 BMO, CIBC and TD reaffirm support of their bank-sponsored ABCP programs by announcing they will convert existing backstop liquidity facilities form GMD to Global Style 19

20 The Montreal Accord On August 16 an announcement was made by a consortium representing banks, asset providers and major investors to help establish normal operations in the Canadian Third Party ABCP market This committee is led by Purdy Crawford Objectives of the Restructure Prevent a fire sale of the assets in a distressed credit environment where recoveries are expected to be low To address the lack of liquidity create long-term notes to match the maturity of the assets to prevent a mismatch in terms Provide structural enhancements to bring the majority of the new notes back up to an investment grade rating Protect various parties who have cooperated from potential law suits through a legal release Develop an active secondary market and attract buyers to purchase notes Maximize possibility of investors recovering par at maturity Improve transparency by providing more information on the assets than previously disclosed 20

21 Timeline As the Montreal Accord continues its restructuring process, some efforts have been made to facilitate a secondary market for frozen ABCP Perimeter Financial created a platform for trading September 12 DBRS announced that it will no longer assign its highest rating to ABCP with GMD liquidity October 15 Purdy Crawford s restructure committee announces another extension of the standstill period for an additional 60 days to December 14 October 16 DBRS announces that 27 trusts comply with the new Global Liquidity Standards. Conduit sponsors include Deutsche Bank, BNS, BMO, TD, CIBC, NBF, and HSBC November 6 Apsley Trust gets downgraded from R-1 (high) to R-4 September October November October 24 Aastra Technologies launched a lawsuit against HSBC for advising them to buy ABCP November 14 Perimeter Financial sets up a platform to take private bids on ABCP 21

22 Timeline After arduous negotiations, the Investor Committee released a 385-page restructure plan in March for the investors to vote on due to their inability to extend the Standstill Agreement, the Committee filed under the CCAA December 6 Two privates investors launch lawsuits against Canaccord for selling ABCP, who in turns sues Scotia for providing advice on ABCP. January 9 DBRS closes European offices and lays off about 110 people. February 4 Standstill agreement extended to February 22. Committee announced reaching an agreement in principle with four of the Big 5 to provide money for the margin facility. March 17 An application to the Ontario Superior Court of Justice is granted to the consortium for a restructuring plan under the provisions of the Companies' Creditors Arrangement Act (CCAA). December January February March January 21 CICA issues special alert calling for clear disclosure of ABCP and providing supplements to financial statements. Brian Hunter creates a Facebook page to bring retail investors together to one forum. Retail investors speak up in the media and make it clear they will vote no to the restructure unless they receive all their principle back. 22

23 Timeline After a 96% majority approval of the plan and approval from Ontario Superior Court, the decision was appealed by corporate investors It took another five months for the appeal to be denied by the Supreme Court of Canada and for the restructure to move forward April 9 Canaccord announces relief plan to provide 100% of principle + interest to 1,400 of their retail investors. Credential Securities follows suit shortly after. May 16 Campbell defers his decision on the ABCP restructuring to May 30th in order to hear further submissions. June 5 Ontario Superior Court approves the plan with a carve-out for fraud June 18 ABCP corporate noteholders seek leave to appeal Campbell's decision on the grounds that the restructuring plan, in many cases, does not allow noteholders to sue ABCP dealers for fraud. August 18 The Ontario Court of Appeals back the restructuring plan. Several corporations announce their intentions to escalate decision to the Supreme Court of Canada April May June Aug / Sep April 25 Ninety-six per cent of shareholders endorse the restructuring plan. A final sanction hearing will be heard by Ontario Superior Court Justice Colin Campbell June The Ontario Court of Appeals hears the appeal of Campbell's decision. September 19 Supreme Court of Canada denies the appeal and backs the restructuring plan. 23

24 Margin Funding Facility and Spread-Loss Triggers 84% of existing Leveraged Super Senior (LSS) transactions subject to mark-to-market triggers have breached and would enter a fire sale the new spread-loss triggers prevent a fire sale and are in fact 139% away as of March 2008 Distance to Triggers - Before and after Restructuring 15 $B 10 5 Post Restructure Pre-Restructure 0 Triggered 10-20% 30-40% 139% Estimated Distance to Trigger Source: JP Morgan In addition to the spread-loss triggers a number of institutions involved with ABCP have contributed to a $17 billion margin facility to be drawn in the event of margin call. 24

25 Hindsight on CDOs Rating agency models are too dependent on quantitative assumptions common sense needs to be applied to structured finance models Rating agencies rely on historical data to predict future trends Going back as far as 1994, 5-year investment grade corporate credit spreads have not passed 260 bps Highest annual BBB credit default rate since 1981 is 1%, occurring in 2002 No quantitative model has predicted the current events to date Real estate market collapse in the US Collapse of large global financial institutions Global liquidity crunch Correlation among all industries and geographies is much higher than we think Counterparty risk must be assessed much more carefully Source: DBRS 25

26 Blame Game Since the market disruption, there has been finger pointing at numerous parties it is not easy to attribute responsibility to one key party Investor Diligence? US Subprime Market? Regulators? Rating Agency Methods? Market Disruption Disclosure by Sponsors? Liquidity Banks? GMD Liquidity? Dealers? 26

27 Lessons Learned How did so many smart people get it so wrong? What did we get wrong? Liquidity Correlation, counterparty risk History does not always predict the future How did we get it so wrong? Greed chasing yield Automation - Over reliance on quants with designations and templates Complacency - Due diligence by generalists we need specialists What fundamental systemic issues need to fixed? Some products are never meant to be rated AAA Risk Management too insignificant a role in most institutions Risk Management outsourced Budgeting process: Unrealistic targets set by shareholders & BOD Past compensation structures encourage quick short-term profits, thus encouraging riskier transactions 27

28 Questions? Daryl Ching 28