The asset-backed commercial paper (ABCP) debacle: who is to blame? According to the National Post , it’s everybody and nobody. I find myself in unusual agreement. While I don’t wish to see likely criminals let off the hook, a better approach out of this mess is to change the rules of the game.
Last August, the Canadian market for non-bank ABCP was frozen after several large institutional investors in these financial instruments suddenly found themselves abandoned by buyers-of-last-resort (foreign banks) at the trading table. Seeking a private sector solution, these investors set up the Pan-Canadian Committee (also known as the Montreal Accord) to hammer out a deal under which the market would reactivate.
This problem is complex: complex in its players (a heterogeneous lot), in its playing field (the technostructure of postmodern finance) and in the very instrument under scrutiny (the handiwork of financial engineers). Brought together, a system has emerged characterized not by risk but by fundamental uncertainty. Unknown unknowns lurk on the horizon.
In a complex problem like this, it is a real challenge to assign ultimate responsibility. Who is responsible? The issuers of the ABCP, the brokers, the debt-rating agencies, the regulators, the investors themselves? One obvious suspect would be the original issuer of the ABCP. Charge them with fraudulent misrepresentation! However, there has to be proof that there was intent to defraud the buyer. The issuer can easily plead that the investor just didn’t understand the risks associated with the instrument. The ABCP broker can make the same case or plead that he too was ignorant of the risks.
It’s the structure of the market that is rotten. Here we have rules of the game biased toward the principle of buyer beware (where the buyer is wholly responsible for understandng the risks underlying the product) than by the principle of duty of care (where the seller has the duty to inform the buyer of the product risks). The information asymmetry is tilted towards whoever has the better understanding of the product, and this ultimately is the originator.
Investors are social animals. We rely on our trust (or confidence) in others when transacting. When trust falters, markets can collapse. Collective action, either competitive or cooperative, fails. Moral hazard created by the system can lead the system to system failure.
Take for example the reported Alberta farmer who has $350,000 in retirement savings invested in ABCP; securities which currently can not be traded and will perhaps be written down. Are we to judge this investor stupid? He did, after all, put all his eggs into one basket of questionable reliability. Or was he misled by his investment advisor to think that the non-bank ABCP was as safe as a GIC?
Trust needs to be restored to restore the market. There are several processes underway, the outcomes of which may indicate how the game will be restarted.
The Montreal Accord has been working since August to hammer out deal which will face a vote by both institutional and retail investors on April 25. As a private sector-led initiative, it seeks to restructure the terms of these instruments, giving them longer terms to maturity, as well as setting conditions on their tradability. The asset values may also be marked down. The thing about the Montreal Accord is that it only seeks to get investors back to the trading table. Under the terms of the deal, players’ score sheets are being re-valued and the rules of the game are being slightly altered. However, the fundamental structure of the game is left intact, leaving open the possibility that this debacle could return under some altered guise.
On Thursday, April 10, the House of Commons Finance Committee will be conducting hearings on the ABCP issue. Witnesses will be called, including Purdy Crawford, the lead negotiator in the Montreal Accord. On Friday, April 11, finance ministers and central bankers of the G-7 nations will meet in Washington to address the global credit market situation. Perhaps out of these two meetings we will hear calls to reform the credit market structure, including stronger regulations aimed at forcing greater transparency not only of market players but also of the financial instruments they trade. It may reduce informational asymmetries, which is arguably the steam on which capital markets run, but the danger of having another crisis in trust will be dampened.
- The Big Banks’ Big Secret (April 30th, 2012)
- Stock Market Swindles Galore (April 2nd, 2012)
- The Caisse and the mysterious life of market makers (March 9th, 2009)
- The Meaning(lessness) of Money — Why “Quantitative Easing” Won’t Do What People Think it Will Do (March 3rd, 2009)
- Laughing All the Way to the err…Bank (February 14th, 2009)