The crisis in asset backed commercial paper

Aug. 23, 2007


The sub -prime mortgage market implosion in the US has affected the entire North American financial markets structure. The arcanely but logically named asset backed commercial paper market has been particularly badly affected with banks and other financial institutions in Canada as well as mining companies and one airline Transat A.T.Inc. with major holdings($154.5 million) of the damaged paper.Some of these companies have been   dumping their holdings and seeking the shelter of government paper. In the US the damage is more widespread with a number of mortgage companies and loan companies closing their doors because of the debacle.More than a 1000 employees of one company have lost their jobs.
The flight to quality government paper should come as no real surprise as I have pointed out before that government backed paper is almost always more secure an investment than private assets. One of the Canadian new chartered banks Dundee Bank of Canada (with whom I should say I have a small retirement account though most of it is invested in mutual funds and stocks that are mostly not directly affected although exposed to stock market fluctuations) has had to reassure its clientele that all will be well despite their exposure in their 2 billion dollar plus asset base of deposits to 400 million dollars of these ABCPs which are now unsaleable and may turn out to be junk bonds salvageable at heavily discounted prices, a useful approach by the way to solving the crisis without excessive moral hazard.

Dundee according to the Globe and Mail apparently will pass the damaged goods up to its parent company or to its holding company in order to clear it off the books of its own balance sheet. Whether this will completely reassure its clientele remains to be seen but its temporary embarassment reveals how widely the sub -prime mortgage market crisis has spread its impact.

The way this worked is that the "asset backed commercial paper is short term debt in the form of mortgages, car loans or credit cards that is packaged up and sold to investors"for rates of return that exceed those on government Treasury bills. Unfortunately, some of those sold in Canada were backed by the sub prime mortgage market in the US. When this was disclosed the major banks
which had previously guranteed these ABCPs put out by companies like Coventree Inc. withdrew their guarantee thereby causing the liquidity crisis by essentially freezing the market since no one will buy unguaranteed debt exposed to the sub prime disaster in current circumstances.(See Credit Crunch Dundee, NavCan latest liquidity victims by Derek DeCloet Globe and Mail ,p.B1, Aug.23, 2007)

The Globe and Mail article points out something else I have been arguing for many years. The issuance of regular and substantial amounts of government debt instruments plays an important role in the financial markets by guaranteeing a steady and stable supply of good quality secure government assets in which banks and other financial institutions can invest.

If governments cease issuing new debts by running only surplus budgets the supply of such debt dries up and financial actors are forced to go elsewhere to find assets to invest in. Inevitably they will stray into riskier and riskier assets that from time to time will border on Ponzi finance(named after the financial swindler from the 1920s who perfected pyramid schemes in the financial markets and eventually went to prison for his actions) and provoke precisely the crisis we are now in.

In the US four of the largest banks have borrowed at the discount window of the Fed doing precisely what the Fed wants showing that there is no danger of a liquidity crunch because the money is available at the window. Some large foreign banks have also taken advantage of the Fed offer.
The American markets for the moment appear to be calming down.


I wish Dundee and the other firms well in recovering from the hit. But I hope some lessons will be learned from this about the nature of risk and uncertainty and the negative consequences of obsessive fiscal conservatism and the sometime virtues of government debt.

Government debt is almost always an asset as well as a liability. In the complex world of financial markets it has an important role to play.