Social risk key to losses in asset-backed commercial paper

Special Guest Blog by Eugene Ellmen, Executive Director of the Social Investment Organization

The news that Quebec’s giant Caisse de depot lost 25% of its value partly due to the collapse in the asset-backed commercial paper market (ABCP) has left people shaking their heads. Top people in government, banking and investment are now asking the obvious question: “How could they not have seen the risk in this?”

As the murky world of ABCP has come to light, it’s becoming increasingly apparent that two issues were key to this massive market failure. First, the exact nature of the underlying assets were never made public; and second, the unique social risks presented by these assets were never disclosed nor understood by the market.

This lack of transparency was caused by disclosure exemptions representing massive regulatory failure; a regulatory failure that cost investors billions of dollars in assets.

The non-bank ABCP market was worth an estimated $35 billion before it collapsed in August 2007, weighed down by concerns over the sub-prime mortgage industry in the US. Non-bank ABCP contained bundles of loans and mortgages that were not backed by the assets of Canada’s banks, unlike bank-owned ABCP. While the U.S. sub-prime mortgage market only represented a small fraction of the total ABCP market, the market uncertainty over sub-prime mortgages cast a pall over the market, destroying their value. After months of negotiations between investors and brokers, a restructuring agreement was completed just this past January, restoring some assets to investors.

While the Caisse de depot was probably the most high-profile investor in ABCP, it was certainly not alone in this market. Major corporations, mutual funds, pension funds and more than 1,000 individuals were caught in this market collapse.

How could such a thing have happened? In hindsight, it has become apparent that issuers of ABCP failed to disclose the underlying assets contained in the ABCP bundles. This lack of disclosure created a market fog, encouraging buyers to treat them as secure, highly-rated instruments.

The lack of financial disclosure was bad enough, but there was a compounding problem of a lack of social disclosure. As many observers have made clear, unethical lending practices were the norm by many of the sub-prime mortgage companies in the U.S. These mortgage companies used high-pressure sales tactics to place low-income borrowers into sub-prime mortgages, only to see these mortgages skyrocket in penalties and interest rates in the future. These penalties and interest rates combined to create such a burden in communities across the U.S. that large numbers of homeowners walked away from their mortgages, creating a cascade effect that collapsed the sub-prime mortgage market, along with real estate values and other credit
markets.

This represented a unique social risk. In fact Innovest Strategic Value Advisors identified weaknesses in the credit markets based on an environmental, social and governance (ESG) analysis as far back as 2006. The ESG analysis conducted by Innovest in a review of bank credit markets found that rising home ownership combined with lower real wages was putting the sub-prime mortgage markets at grave risk.

Yet this risk was not disclosed either in the mortgage-backed securities that were sold directly in the U.S. market, nor as part of the bundle of asset-backed commercial paper in Canada.

The main reason why issuers of ABCP and other structured finance products could escape such disclosure is that they are considered to be part of the exempt market by securities regulators. In other words, securities commissions treat structured finance products more as a debt product (that doesn’t need disclosure requirements) than a security, which is subject to prospectus provisions and continuous disclosure requirements.

The Canadian Securities Administrators – the umbrella organization for securities commissions in Canada – has just completed a consultation on this issue. There are wide ranging calls for more disclosure and tightening of the exempt market. It’s clear that issuers of non-bank ABCP need to be considered reporting issuers, subject to prospectus requirements and continuous disclosure obligations.

But more than that, the non-bank ABCP market, and securities generally need to be subject to environmental, social and governance disclosure obligations that will bring to light the unique non-financial risks that they pose.

The ABCP debacle shows the need for massive regulatory reform, so that the market can better understand social and environmental risks, integrate them into their investment decisions, and price them into securities offered for sale.

For more information, http://www.socialinvestment.ca/.