The asset-backed commercial paper crisis has finally come to a resolution this month with the restructured paper’s liquidation and many institutional investors, including some large pension funds, getting their money back. But the decade-long journey to that result has been anything but smooth, so what are the lessons for institutional investors?
While they’re a complex financial instrument, the investments in question carried the highest commercial paper rating — R1 — from Toronto-based credit agency DBRS, says Paul Halpern, a professor emeritus at the University of Toronto’s Rotman School of Business and co-author of a new book, Back From the Brink: Lessons From the Canadian Asset-back Commercial Paper Crisis, that discusses the lessons learned from the restructuring. “If we view asset-backed commercial papers as an envelope and then the envelope has a lot of little pieces under it which generate cash. Then comes more complex stuff, which was basically insurance policies written against corporations, so they would insure corporations and get money for it. It’s a complex financial instrument. That was the big chunk of what went into that envelope and a very small part was these mortgages from the U.S. That’s the envelope. You buy the envelope . . . and you get money,” he says.
“Every 30-45 days, it rolls over, which means investors replace their existing paper with new paper . . .,” he adds.
In 2007, Coventree Inc., the manufacturer of the paper, put out a memo indicating there was a small exposure to subprime mortgages, says Halpern. DBRS then issued a notice stating it was reviewing its rating. “Investors panicked and tried to roll the paper but couldn’t find buyers,” says Halpern. “Liquidity arrangements, the first line of defence in this situation, weren’t necessarily met, leaving the trusts to find money to cover the maturing paper.”
Many large investors, including the Caisse de dépôt et placement du Québec and the Public Sector Pension Investment Board, had invested in the paper. Both pension funds declined to comment, but the federal government pension fund’s media team wrote in an email to Benefits Canada that it’s “satisfied with how it ultimately unfolded for investors.”
Of the $32 billion of asset-backed commercial paper outstanding, Caisse was the biggest holder, with $16 billion. Henri-Paul Rousseau, its president and chief executive officer at the time, participated in restructuring the outstanding paper, along with a number of other executives, according to Halpern. “It started with Caisse, PSP, Desjardins, National Bank. . . . These people were deep into asset-backed commercial paper. They had to find a restructuring. The existing paper was replaced with new notes. The restructuring, which took 18 months, was a negotiation between the dealers in ABCP and the investors.”
While the restructuring took place in January 2009, the restructured notes didn’t expire until 2017. As of today, the main notes have been paid in full, plus accrued interest, says Halpern, noting some of the riskier notes remain outstanding.
So what are the big lessons took take away from the asset-backed commercial paper crisis?
The biggest lesson for institutional investors is the importance of spreading risk management across an entire portfolio, says Caroline Cakebread, editor of Canadian Investment Review and co-author of the book. “What happened for the Caisse — and they certainly weren’t on their own — they were using what they felt was really sound risk-management practices. They’re a big leader but they were very siloed. As pension funds become bigger and bigger, they have to be really careful to make sure they don’t get too siloed and that they are looking at these things holistically.”
Even among investors that did their due diligence around the investments, it was still really difficult because there wasn’t a lot of information available, says Halpern. “The Caisse is a good example — good in that it shows a lot of the problems — of risk management. They had a risk management system that really didn’t work. They literally didn’t know how much risk they had in total. . ..”
Institutional investors also need to ensure engagement and awareness by their governance boards about risk, says Cakebread, noting many trustees would be unable to describe in simple what an asset-backed commercial paper is, let alone many other products their pension plans are trading in. “I think it would be interesting for more companies and more large investment organizations and financial institutions to have bigger risk committees,” she adds.
And perhaps the most basic lesson is to avoid investing in anything an investor doesn’t understand. “I know that sounds really simple, but ABCP was so complex,” says Cakebread. “And the fact that there was Canadian-style liquidity and these issues were rampant, I think, goes to show that it was probably a bit too complex.”