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ABCP and Pintos: It was buyer beware

awillis@globeandmail.com

Market regulators are setting pulses racing on Bay Street by pushing the idea of $100-million-plus fines against each of the Canadian and foreign investment banks that sold asset-backed commercial paper to institutional clients in the summer of 2007.

Even without these eye-popping sanctions, these banks should fight back. The banks that traded ABCP in the days that preceded the credit crisis should challenge the Ontario Securities Commission and other securities watchdogs. There's a strong case to be made that the dealers did nothing wrong in early August, 2007, when the credit crunch began.

Regulators are deep into an investigation of what happened just before the country's $32-billion third-party ABCP market froze, leaving holders of this supposedly low-risk paper with high-priced losses. According to sources caught up in the probe, market watchdogs are focused on what happened between mid-July, when the firm that created much of the ABCP, Coventree, began to detail just what assets were wrapped in these securities, and mid-August, when the ABCP market seized up.

Back on July 14, 2007, Coventree circulated a report to dealers that detailed just how much of its ABCP was backed by U.S. subprime mortgages, among other assets. It was one of these PowerPoint specials, with subprime exposure shown in all sorts of pie charts. The now-infamous housing loans were only beginning to show their toxic tendencies.

In a classic misjudgment of market perception, Coventree executives later said that they expected dealers and investors would be thrilled to hear that subprime mortgages were, at most, 7 per cent of total ABCP assets, and that this exposure was falling.

Instead, some folks in the fixed-income crowd saw Coventree's pie charts and got indigestion: They decided even a tiny slice of subprime was unappetizing. What happened next has the regulators' full attention.

Regulators are going to allege that the banks, realizing that the ABCP they held in their own portfolios was dangerously tainted, decided to dump the junk on unwitting clients in the days that led up to the market's collapse. Bankers could end up being accused of ripping the faces off clients, to quote a favourite phrase from bond trading desks.

There's an expectation the regulators are pushing for hefty fines to punish this behaviour. There is talk that institutions that bought ABCP, and lost money, might somehow be made whole. Retail holders of ABCP - with less than $1-million of the paper - have already been paid back 100 cents on the dollar as part of a rescue plan put in place by lawyer Purdy Crawford and his team.

This is a sweeping probe, with many of the domestic bank-owned firms and global banks targeted, along with former Coventree executives. With the arrival of the regulators, the ABCP blame game begins in earnest.

Investment banks should take a stand, in part because only hindsight proved subprime mortgages and the other credit derivatives packed into ABCP could be harmful to an investor's health. When the summer of '07 began, this triple-A-rated paper seemed no more nasty than cigarettes looked to Second World War soldiers.

Dealers selling ABCP in early August didn't have insider information, as Coventree's pie charts were not a major, material revelation. Anyone willing to poke around the securitization world knew what went into this paper.

Think of it this way: If I'm buying a used Ford Pinto from an auto dealer, I assume the salesman knows more about the car than I do. So I cut the price I'm willing to pay for the clunker, to reflect the fact that the seller has more information. I might demand a warranty. If the Pinto breaks down or blows up, well, I knew what I was buying.

Some of those same tensions exist in the relationship between an institutional investor and an investment dealer. For the regulators to nail the banks, they will have to prove that bond desks knew, in the early days of August, 2007, that the $32-billion ABCP market was likely to blow up. That will be a difficult case to make.

If the problem here is that investors were sold a flawed product - and ABCP was flawed - the mistake lies as much with regulators (and credit rating agencies) as it does with investment dealers.

To settle this case by paying a fine, even without an admission of guilt, is tantamount to a bank saying it put its own interests ahead of its clients, and bagging them with a toxic security that the dealer was no longer willing to own. That is not a settlement to be taken lightly.

Hedge funds outperform

It was a stock picker's market in June, with equities going sideways over the course of the month, and Canadian hedge funds were able to outperform benchmarks.

Scotia Capital's hedge fund index showed that domestic money managers were up 1.64 per cent in June on an equal-weighted basis. That's well above the flat performance of the S&P/TSX composite - it was 0.05 per cent - and the 0.02-per-cent rise in the S&P 500. The investment dealer said that in a month marked by "indecisive" markets, "Canadian hedge funds posted correspondingly mixed results on the month with out- and underperformance dispersed across strategies."

See Andrew Willis's Streetwise Blog at ReportonBusiness.com

© 2007 The Globe and Mail. All rights reserved.

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