The Law: Boiling Point

But the non-bank ABCP also came with considerable risks, as the current debacle demonstrates. And those involved in making the non-bank ABCP investments now face some difficult questions about precisely which assets backed this paper and the nature and extent of the bank guarantees supporting these assets—not to mention who was responsible for making inquiries about the nature of these assets, the risks they entailed and the limited guarantee that stood behind them.

Most pension fund investments in non-bank ABCP were made by professional money managers with mandates that include money market instruments. Pension fund administrators may well have created these mandates, believing that short-term money market investments were the “safe” component of their asset allocation.

Now pension fund administrators will be asking what inquiries their managers made before they decided to invest in non-bank ABCP. Did they know the nature of the instruments in the non-bank ABCP trusts? Did they know that the trusts were exposed to U.S. subprime mortgages, or to other debt or derivative instruments with considerable risk? Did they know the durations of the investments held in the trusts?

Investment managers will refer to the high ratings given to the non-bank ABCP by independent rating agencies. Apart from the questions these ratings raise about the agencies themselves, money managers must still answer the question: was it prudent to rely only on the agency’s rating, if no further inquiry was made into the assets held in the ABCP trusts and if the risks being assumed by these managers, on behalf of their pension fund clients, were largely unknown?

Canada’s own non-bank ABCP crisis illustrates some important aspects of the new world of pension fund investing. The range of investments for pension funds was once limited to bonds, equities with established dividend records, real estate and foreign assets. Today, the financial instruments available to and used by pension funds are much more complex, and risks of gain and loss are defined and allocated between different types and classes of investors in much more complicated ways than before hedge funds, credit default swaps and collateralized debt obligations came into existence. This complexity requires a new degree of care and diligence, with different skills required to assess the risk and opportunity implicit in the new assets.

The non-bank ABCP crisis is a warning of what can go wrong with new and complex financial innovations. But more importantly, it underlines the need to understand the material characteristics and risks of potential pension fund investments— as well as the dangers of not undertaking this due diligence. Murray Gold is a partner with Koskie Minsky LLP in Toronto. mgold@kmlaw.ca

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