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Third Party Abcp Restructuring Rbc Feb28[1]
1. RBC Dominion Securities Inc. INDUSTRY | COMMENT
Andre-Philippe Hardy, CFA (Analyst) FEBRUARY 27, 2008
(416) 842 4124; ap.hardy@rbccm.com
Dave Mun, CFA (Associate) RBC Canadian Financial Services Beacon
(416) 842-5638; dave.mun@rbccm.com Third-party ABCP restructuring has progressed, but
risks remain
Event
We have seen significant progress made in the restructuring of the third
party Canadian Asset Backed Commercial Paper market, and we
continue to believe that a resolution is the most likely outcome, but there
is still risk of a delay, or worse, failure. We believe that many players are
motivated to support a restructuring but the wider credit spreads get, and the
longer they stay wide, the more risk there is to a successful restructuring.
• This report focuses on the current restructuring plan and risks
associated with it. For a greater understanding of the past growth of the
third party Canadian ABCP market and why it ran into serious difficulties in
August 2007, we direct readers to our August 20, 2007, report on the topic.
• Credit spreads on North American investment grade debt have
widened significantly since early February (from about 110 basis points to
142 basis points), when the the Pan-Canadian Investors Committee for
Third-Party Structured Asset Backed Commercial Paper (The Committee)
last updated the public on its progress.
• We continue to believe that a restructuring remains the most likely
outcome and that a liquidation of the conduits would likely lead to losses
that are greater than the underlying asset quality would suggest given the
lack of liquidity in structured products.
• We do not believe that ABCP holders will receive securities that trade
close to par value initially, even if the restructuring gets completed as
planned. The value of the assets should be closer to par at maturity (about
seven years).
• The continued widening of credit spreads for investment grade debt has
negative implications for the initial valuation of the ABCP and it also
probably complicates the restructuring process as holders of credit
default swaps are probably owed very significant amounts from the ABCP
conduits, and may be less inclined to support a restructuring.
• Swap counterparties had agreed not to make margin calls under a
standstill agreement that expired February 22, 2008. There has been no
reported extension of the standstill; if the delay is due to swap
counterparties becoming less supportive of the restructuring and they ask
for margin to be posted, it could derail the restructuring. We do not know
the cause of the delay at this point.
• National Bank's $2.3 billion exposure to non-bank sponsored ABCP is
highest of the six Canadian banks, and National Bank is the smallest of
the six. From a stock price perspective, we believe that most market
participants are assuming a successful restructuring of the ABCP conduits.
We therefore believe there is little upside to National Bank's ($52/SP/A)
shares in the near term if the restructuring progresses, but there is downside
risk if a negative announcement comes.
Priced as of prior trading day's market close, EST (unless otherwise noted).
All values in CAD unless otherwise noted.
For Required Disclosures, please see Page 8.
2. February 27, 2008 RBC Canadian Financial Services Beacon
Floating rate notes could begin trading in the spring
• There is $33 billion in Canadian third-party asset-backed commercial paper that has been frozen since mid-August 2007
(i.e. holders of that paper have not been able to receive cash as their short term paper matured).
• The Committee has been working on a plan to convert the ABCP into floating rate notes (FRNs), thereby eliminating
the duration mismatch inherent in commercial paper and eliminating funding risk.
• The Committee intends on presenting its plan to ABCP investors in upcoming weeks and have a vote by 3-4 weeks
after that. If ABCP investors vote in support of the restructuring, they should receive floating rate notes by April 2008.
• The floating rate notes should start trading shortly after, on the assumption that a secondary market develops. Not all
ABCP holders will be willing to hold the converted paper as many need the liquidity, and will likely have no interest in
holding floating rate notes with a duration of five to eight years. This is likely to initially pressure valuations of floating rate
notes when they start trading (beyond the valuation impact of marking to market credit positions).
• It is not clear how actively traded the floating rate notes will be. The Committee hopes that by making the underlying
assets and risks more transparent, a secondary market will develop. In an effort to improve transparency, The Committee
expects to make available to investors all information that rating agencies currently have. Even with those efforts, it is not
clear how much or where dealer support would come from to create liquidity in the FRNs.
Restructuring plan would convert ABCP into longer-term notes
• The Committee plans to split the $33 billion of ABCP into three categories:
o Conduits that are made up of non-synthetic assets (i.e. traditional ABCP) will be separately restructured and
are likely, in our mind, to be highly rated and trade close to par (or at the very least provide investors with a security
that will likely be worth par if held to maturity). There is about $3 billion in assets that are likely to fit in this bucket.
o Conduits with ineligible assets (primarily investments backed by U.S. sub-prime mortgages) will see the
ineligible assets separately restructured. There is about $3 billion in ineligible assets, with seven of the twenty
trusts participating in the restructuring process holding such securities (the percentage of ineligible assets ranges
from 10% to 100%, depending on the trust). We expect significant pricing risk on this asset category given the
current trading values of assets backed by U.S. sub-prime mortgages.
o The remaining $26 billion in assets will be pooled into two master asset partnerships (MAPs).
The MAP1 will issue term notes and will self-fund potential margin calls if the value of the assets held
by the partnership deteriorates. MAP1 will include La Caisse de Dépôt et Placement du Québec, and
Desjardins Financial Group among others. Investors that will be invested in MAP1 would self-fund a
margin facility (in return for a commitment fee from the MAP), with $8 billion in committed margin
funding already approved. ABCP investors who wish to join MAP1 and have the credit capacity to do so
may join MAP1 and, as a result, would not “lose” the annual commitment fee payable for a third party
margin facility (which is being provided in MAP2).
• The Committee expects $15 billion of the $26 billion of assets to be included in MAP1, with
the rest in MAP2, based on interest expressed so far.
The MAP2 will issue senior notes, which JP Morgan believes will be AAA-rated, and subordinated
notes, which are unlikely to carry a rating. We believe that 80-85/20-15% is a reasonable estimate of the
breakdown between senior and subordinated notes. The MAP2 will have a third party funded margin
facility to protect against potential margin calls, which would cost about 160 basis points annually to
maintain. The cost would reduce the net yield on assets held in the MAP2.
• A senior/subordinated note structure is being created to ensure that the majority of the assets are
AAA-rated as the underlying ABCP assets are likely not AAA-rated on their own.
• The Committee has secured a margin facility of $14 billion, and we believe that most of it has
come from global banks, which were the primary counterparties on written credit default swaps, in
our view. Canadian banks would also be participants, except for TD Bank.
• Any advance to the margin facility becomes senior to the obligations of the MAPs.
2
3. February 27, 2008 RBC Canadian Financial Services Beacon
• A key component to a successful restructuring of the ABCP is the restructuring of trigger clauses in derivatives
agreements. The Committee hopes to make the margin requirement trigger points more remote1 and failure to do so could
derail the restructuring process, in our view.
o The third party ABCP conduits synthetically created credit exposures by writing credit default swaps since
they were not natural originators of assets. Most credit default swaps have provisions that require the
counterparty that is out-of-the-money (in this case, the ABCP conduits) to post margin based on the replacement
value of the derivatives, which can vary dramatically based on credit spreads.
o Since credit risk is arguably low, the key risk is funding potential calls for margin that are related to negative
marks to market. A negative mark-to-market on leveraged assets can quickly affect an equity holder, no matter
what the ultimate asset value may or may not be. Failure to post margin would lead to a conduit selling its assets to
meet that margin call, in our view, as swap counterparties have first claim on assets and have the right to unwind
transactions and liquidate assets to recover their mark to market gains.
o We believe that the ABCP conduits would have to post significant collateral today if the counterparties
demanded it2, but the amount has not been disclosed. Since the conduits probably do not have much cash, if any,
they would likely have to sell assets and crystallize potentially large losses.
o The level at which a price movement triggers margin posting is important in determining how much liquidity
the MAPs may need to access – the farther the trigger points, the lower the probability of the MAPs requiring to
post margin and the higher the rating of the securities, in our view. Triggers could also be changed to reflect
underlying credit ratings as opposed to market value, but we suspect the swap holders may not be inclined to support
such a change.
o We believe that an agreement in principle had been reached to restructure trigger agreements with swap
counterparties, but credit spreads have been rapidly widening (Exhibit 1). The continued widening of credit
spreads for investment grade debt probably complicates the restructuring process as holders of credit default swaps
are probably owed very significant amounts from the ABCP conduits, and may be less inclined to support a
restructuring that significantly reduces their potential gain.
o A lack of support from swap counterparties would have significant negative implications for the
restructuring, in our view. The standstill agreement under which they agreed not to ask ABCP conduits for margin
expired on February 22, 2008, and there has been no public release from The Committee since then.
o The Committee is also encouraging better disclosure on the nature of the loss triggers and hopes to make them
dependent on both credit spreads and actual loss experience rather than just mark to market.
• The duration of the assets will be extended. The ABCP held by investors had short duration (30-90 days), but the duration
of the floating rate notes will be in line with the duration of the underlying assets (about seven years on average). The
Committee could not realistically salvage both value and liquidity at the same time, in our view.
• The approval process to restructure the ABCP into FRNs will require two thirds approval in each ABCP trust (and in
some cases, series of trusts). Approval will be based on value of holdings (not the number of holders). A trust or series of
trusts will not be eligible to participate in the restructuring if less than two thirds of holdings vote in favour of the
restructuring. We believe that at least four players, which collectively own over 60% of the assets, are likely to be positively
predisposed in favour of the restructuring.
• The Committee expects that “upon completion of the restructuring, participating parties will receive comprehensive
releases and all outstanding market disruption liquidity facilities will be canceled.”
o We believe that this feature is probably the Committee’s biggest “asset” in negotiating with swap counterparties. We
believe that many of the swap holders were also the providers of liquidity facilities, which, as we all recall, refused to
provide liquidity to conduits when the market froze in August, arguing that there was no general market disruption3.
1
According to DBRS, 92% of triggers in the trusts being restructured were mark-to-market triggers, which are based on the market price of
protection on the referenced CDO tranche. 2% were loss only triggers based only on accumulated default losses experienced by the referenced
portfolio, and 7% were spread and loss triggers based on both credit risk and market value. To make margin requirements more remote, the
triggers are being restructured to become more remote spread loss triggers.
2
The swap counterparties had agreed not to make margin calls while the restructuring process evolves under a standstill agreement that expired on
February 22, 2008.
3
4. February 27, 2008 RBC Canadian Financial Services Beacon
The issue of market disruption was never vetted by a court (i.e. there was not enough time in August for the
ABCP administrators and the liquidity providers to go to court to determine whether there indeed was
market disruption or not). We therefore believe that the presumed threat of legal action by ABCP holders,
which if successful could lead to the liquidity providers owning all of the assets, could be enough to
motivate the swap buyers to restructure their collateral agreements (i.e. they may be willing to accept lower
collateral but avoid the possibility of owning all these assets outright).
o We also believe that the presumed releases from potential legal actions is also why some players that were involved in
the third party ABCP market in some capacity (as distributors for example) are interested in supporting the
restructuring, partly by providing a margin facility to the trusts.
Restructured assets unlikely to trade at par initially
We believe that the aggregate assets are likely to trade at a discount to par value. We believe the discount could be 10-25%
initially, including the ineligible assets. Some of that discount to par should come back in over time based on the information we have
(The Committee and DBRS have been adamant that the trusts ran into funding difficulties, not credit issues). However, CDO
transactions make up about three quarters of the assets of third party ABCP and structured finance assets have seen meaningful pricing
pressure no matter how good their credit ratings have been. As a result, the current market value of the assets held in ABCP is almost
certainly less than par.
o The $3 billion of conduits that are made up of non-synthetic assets (i.e. traditional ABCP) are likely, in our mind, to
be highly rated and trade close to par.
o The $3 billion in conduits that are primarily backed by U.S. sub-prime mortgages could trade at a 20-80% discount to
par, depending on the rating of the underlying securities and year of vintage.
o The $26 billion in conduits that is made up of synthetic assets is likely to trade at a discount to par, which we believe
could be 10-20%.
o There has been significant spread widening for debt securities in general, and this has been particularly true for
structured finance assets. We believe that the credit default swaps in the ABCP would have primarily referenced
super senior tranches of collateralized debt obligations and synthetic assets such as CDOs, which are in theory high
quality assets but their spreads have not been spared by the current market malaise.
The CDX.NA.IG index4 has seen spreads almost double in the last two months alone, widening to 142 bps
from 78 bps at the end of December, or from 30 bps a year ago. (Exhibit 1)
Approximately $18 billion of the $26 billion refer to levered super senior swaps 5. The swaps would refer
to senior tranches of debt structures so the spread movements would be less than for the index as a whole.
o The high leverage in certain structures (mostly those backed by super senior tranches of investment grade
debt) magnifies the impact of wider credit spreads and is likely to create mark to market losses for the ABCP
conduits even though credit problems on the underlying assets are not an issue at this time. We believe that
leverage was probably around 5 times equity as an average, with variation on both the upside and downside
depending on the individual conduit.
We quote DBRS on how rising debt spreads may lead to losses for ABCP holders: “Consider an LSS
transaction referencing the ten-year CDX IG9 Index, with a 30% to 60% tranche, levered ten times.
Assume that the funded amount is $100 million and the MTM trigger is set at 50% of the funded amount,
or 5% of the total swap notional of $1 billion. If the trigger is breached, assume that the size of the
collateral call would be a predetermined amount known as the variation margin, set in this example at 2%
of the notional amount. For this hypothetical transaction, assume that when the index spread went over 110
3
Backup liquidity providers were only required to post liquidity in the event of “general market disruption” but the exact definition of such
disruption was not clear, although the circumstances under which liquidity could be drawn were widely viewed to be sufficiently remote by the
banks and regulators that banks structuring and selling CDOs to ABCP conduits were willing to provide GMD-style liquidity backstop facilities to
the conduits.
4
A tradable credit derivative index – North American Investment Grade Index is composed of 125 entities distributed among six sub-indices.
5
A levered super senior swap transaction occurs when credit protection is provided on a partially collateralized tranche that loses money only when
a trigger or attachment point that is AAA rated (or higher) is reached. The collateral held is smaller than the exposure under the swap, so a margin
call may rapidly increase the collateral the credit protection seller is required to post.
4
5. February 27, 2008 RBC Canadian Financial Services Beacon
basis points in mid-January, 2008, the tranche experienced a mark-to-market of negative 5.2%. The MTM
trigger is therefore breached by 0.2% of the total notional amount. If this were to occur, the credit
protection seller (i.e., the Conduit) would therefore be required to post $20 million of eligible collateral
within three to ten business days. Failure to do so would result in the transaction unwinding.”
DBRS wrote this note when investment grade spreads were 110 basis points; they are currently 142 basis
points.
o The Committee and DBRS claim that the assets, while opaque and leveraged, ultimately refer to high quality assets
(for eligible assets). If true, this would lead to most of the securities being worth par value as the notes matured if
the trusts have the capacity to hold assets to maturity.
Exhibit 1: North American Investment Grade CDS index spreads have widened significantly in 2008
Source: Markit.
Risks remain until the restructuring is done
Risks to the restructuring process will remain in place until a deal is done. Progress has been made, but issues could arise that
would derail the process. The following quote is from The Committee “The implementation of the restructuring… will be subject to a
number of conditions, including execution of definitive legal documentation, satisfactory due diligence, receipt of internal approvals
by dealer bank asset providers and participating Schedule I banks and receipt of the requisite approvals of holders of ABCP. A variety
of consents and other approvals will be necessary or desirable in connection with the restructuring, including certain governmental,
regulatory and court approvals.”
We believe that an agreement in principle had been reached to restructure trigger agreements with swap counterparties, but
credit spreads have been rapidly widening, which could lead to problems. The continued widening of credit spreads for
investment grade debt probably complicates the restructuring process as holders of credit default swaps are probably owed very
significant amounts from the ABCP conduits, and may be less inclined to support a restructuring. The standstill agreement under
which they agreed not to ask ABCP conduits for margin expired on February 22, 2008, and there has been no public release from The
Committee since then.
We continue to believe that a liquidation of the conduits would likely lead to losses that are greater than the underlying asset
quality would suggest given the lack of liquidity in structured products. As such, we believe that a restructuring remains the most
likely outcome.
5
6. February 27, 2008 RBC Canadian Financial Services Beacon
National Bank is most affected by the restructuring
National Bank’s $2.3 billion exposure to non-bank sponsored ABCP is highest of the six Canadian banks, and National Bank is
the smallest of the six. The bank’s management remains optimistic that the bank's 25% writedown in Q4/07 was sufficient and the
restructuring of the ABCP under the Montreal Accord will be successful. Management recently reiterated its view that, for its
provision to be inadequate, a severe US recession or a disorderly liquidation of the ABCP assets would be needed.
We are more cautious on the near term adequacy of the provision as the rapid widening of credit spreads could cause an
increase in provisions in our view (i.e. the credit markets are increasingly pricing in a severe US recession in our view, which is one
of the 2 risks identified by management to its provision).
• The bank's Q4/07 provision of $575 million related to the holdings of non-bank sponsored asset backed commercial
paper represented 25% of ABCP holdings, a high figure compared to the writedowns taken by others. Other
writedowns were as follows: Scotiabank (we believe 20%), CIBC (17%), Bank of Montreal (15%), Caisse de Depot (15%),
Industrial Alliance (15%), HSBC Bank Canada (14%), ATB Financial (10%) and Desjardins (8%). (Exhibit 3) The
underlying asset mix of the conduits that National Bank is invested in appears consistent with the asset mix for the broad
non-bank sponsored ABCP market, so the discrepancies in valuations should not ultimately be that large.
• If the provisions taken by National Bank prove to be conservative, the bank will benefit from recoveries in upcoming
years. Given the asset mix underlying the ABCP, we think that there is a good chance that the bank will recover some of that
charge over time but there could be pressure on the provision in early days if investment grade spreads continue to widen.
• If National Bank were to have to increase its provision, we believe that it could increase its provision by a similar
amount as in Q4/07 (i.e. $575 million) and still have a Tier 1 capital ratio of over 8.5%.
• From a stock price perspective, we believe that most market participants are assuming a successful restructuring of
the ABCP conduits. We therefore believe there is little upside to National Bank’s shares in the near term if the restructuring
progresses, but there downside risk if a negative announcement comes.
6
7. February 27, 2008 RBC Canadian Financial Services Beacon
Exhibit 2: Disclosed Canadian financial institutions holdings of ABCP subject to restructuring under the Montreal Accord
Caisse de Dépôt $ millions As at December 31, 2007
Gross or par value of holdings 12,600 Fair value is net of $1,900mm writedown (15%), of which $469mm relates to US subprime
Fair value of holdings 10,700 mortgages with face value of $782mm. Remaining provision for assets on which it expects to
recover full value over time. Spreads widened since December, risk of worsening if recession.
National Bank
Gross or par value of holdings 2,294 As at October 31, 2007
Fair value of holdings 1,719 Net of $575mm writedown (25%)
Total liquidity facilities - NA provided $56mm of $554mm authorized loans to clients holding ABCP
Desjardins As at September 30, 2007
Gross or par value of holdings 1,939 Excludes $809mm held in certain guaranteed-capital savings products.
Fair value of holdings 1,779 Net of $160mm writedown (8.3%). Comprised of $181mm investment,
$541mm collateral assumed from clients, $1,210mm bought from funds/clients.
ATB Financial
Gross or par value of holdings 1,000 As at December 31, 2007
Fair value of holdings 900 Net of $108mm writedown (10%).
CIBC
Gross or par value of holdings 358 As at October 31, 2007
Fair value of holdings 297 Net of $61mm writedown (17%)
Total liquidity facilities - $1.6 billion liquidity facilities are for conduits that CIBC sponsored but third-parties had
structured, or conduits structured and sponsored by third parties. Two-thirds of that $1.6
billion are general market disruption facilities as opposed to global liquidity facilities.
Bank of Montreal
Gross or par value of holdings 360 As at October 31, 2007
Fair value of holdings 306 Net of $54mm writedown (15%)
Total liquidity facilities -
HSBC Bank Canada
Gross or par value of holdings 327 As at December 31, 2007
Fair value of holdings 280 Net of $47mm writedown (14%).
Scotiabank
Gross or par value of holdings 207 As at October 31, 2007
Fair value of holdings 187 Net of $20mm writedown (20% on certain holdings).
Total liquidity facilities 370
Source: Company reports, RBC Capital Markets Research
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8. February 27, 2008 RBC Canadian Financial Services Beacon
Required Disclosures
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Top Pick/Outperform, Sector Perform and Underperform most closely correspond to Buy, Hold/Neutral and Sell, respectively, the
meanings are not the same because our ratings are determined on a relative basis (as described above).
Distribution of Ratings/IB Services
RBC Capital Markets
Investment Banking
Serv./Past 12 Mos.
Rating Count Percent Count Percent
BUY[TP/O] 498 44.79 208 41.77
HOLD[SP] 526 47.30 149 28.33
SELL[U] 88 7.91 15 17.05
Rating and Price Target History for: National Bank of Canada as of 02-26-2008 (in CAD)
03/21/05 05/04/05 07/25/05 08/26/05 12/09/05 02/07/06 03/07/06 05/26/06 09/01/06 11/21/06 01/22/07
SP:56.25 OP:58.25 OP:60.5 OP:64 OP:65 OP:71 SP:66 OP:68 OP:67 OP:72 D:NR:NA
72
64
56
48
40
32
Q1 Q2 Q3 Q1 Q2 Q3 Q1 Q2 Q3
2006 2007 2008
04/30/07 08/01/07 08/31/07 11/13/07 12/11/07 01/24/08
I:UP:65 UP:64 UP:60 UP:59 SP:59 SP:55
Legend:
TP: Top Pick; O: Outperform; SP: Sector Perform; U: Underperform; I: Initiation of Research Coverage; D: Discontinuation of Research Coverage; NR: Not Rated;
NA: Not Available; RL: Recommended List - RL: On: Refers to date a security was placed on a recommended list, while RL Off: Refers to date a security was
removed from a recommended list.
Created by BlueMatrix
References to a Recommended List in the recommendation history chart may include one or more recommended lists or model
portfolios maintained by a member company of RBC Capital Markets or one of its affiliates. RBC Dain Rauscher Inc. Recommended
8
9. February 27, 2008 RBC Canadian Financial Services Beacon
Lists include a former list called the Western Region Focus List (1), a former list called Model Utility Portfolio (2), and the Prime
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abbreviation 'RL On' means the date a security was placed on a Recommended List. The abbreviation 'RL Off' means the date a
security was removed from a Recommended List.
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The analyst(s) responsible for preparing this research report received compensation that is based upon various factors, including total
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A member company of RBC Capital Markets or one of its affiliates received compensation for investment banking services
from National Bank of Canada in the past 12 months.
RBC Dominion Securities Inc. makes a market in the securities of National Bank of Canada and may act as principal with
regard to sales or purchases of this security.
Royal Bank of Canada, together with its affiliates, beneficially owns 1 percent or more of a class of common equity securities
of National Bank of Canada.
A member company of RBC Capital Markets or one of its affiliates received compensation for products or services other than
investment banking services from National Bank of Canada during the past 12 months. During this time, a member company of
RBC Capital Markets or one of its affiliates provided non-investment banking securities-related services to National Bank of
Canada.
A member company of RBC Capital Markets or one of its affiliates received compensation for products or services other than
investment banking services from National Bank of Canada during the past 12 months. During this time, a member company of
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