In 2007, more than a year before the near-collapse of America’s mighty capital markets triggered the worst global economic crisis since the Great Depression, Canada experienced a stunning financial meltdown of its own.
In 2013, I wrote a book about Canada’s forgotten crisis with the help of Eric Ben-Artzi, an expert in quantitative financial modeling who worked for major Wall Street firms including Goldman Sachs and Deutsche Bank.
For now, the book remains an unpublished manuscript. Eric and I will be publishing selected chapters over the next few months. You can read more background information here.
Below, find the second chapter of the manuscript.
2 A Large Butterfly Flaps Its Wings In Paris
On August 9, 2007, BNP Paribas, France’s largest bank, froze three of its asset backed security funds.
Investors in the Parvest Dynamic ABS, BNP Paribas ABS Euribor, and BNP Paribas ABS Eonia funds would be unable to invest more money and, more frighteningly, unable to access the money they had already invested until further notice.
In a statement, the bank blamed “the complete evaporation of liquidity in the US securitization market” for its inability to publish what it deemed to be fair net asset values. Collectively, the funds shrank by more than 450 million euros from July 27 to August 7, an alarming decline in such a short period.
The banks’ head of asset management and services, Alain Papiasse, blamed the sudden deterioration in value on an investor exodus that was apparently gathering momentum. “For some of the securities there are just no prices,” Papiasse said flatly. “As there are no prices, we can’t calculate the value of the funds.”
Some 3,000 miles west of BNP Paribas’ Paris headquarters lies Baffin Island, the largest island in Canada and the fifth largest in the world. In 2007, the island’s population was only 11,000 and consisted mostly of Inuit Native Americans.
To be sure, the frigid domain in Canada’s Nunavut Territory is about as far removed from the world’s financial hubs as one could possibly imagine. Iqaluit, the island’s largest settlement and the territorial capital of Nanavut, is accessible mainly by plane or boat, has no traffic lights, and cancelled its public transportation bus service in January of 2004 due in part to a general lack of interest.
Near the top of Baffin Island, a little over 600 miles northwest of Iqaluit, lies the Mary River iron ore deposit. The Mary River deposit was discovered in 1962 as Murray Watts, then head of British Ungava Explorations Ltd., was flying over the site in a single engine Cessna. Watts was unable, in his lifetime, to secure funding to develop the site due to the extreme logistical challenges of undertaking such a project inside the Arctic Circle.
A few years before Watts’s death in 1982, an MBA candidate named Gordon McCreary was finishing his thesis on the feasibility of the transportation of iron ore from Mary River. In 1986, Baffinland Iron Mines Corporation, a small mining company co-founded by McCreary, gained control of the Mary River site.
Baffinland Iron went public in 2004 and subsequently raised enough money to survey Mary River. Studies confirmed the first deposit of four contained some 337 million tons of the purest iron ore anywhere. Mary River was found to be one of the largest undeveloped sites on the planet. Fortuitously, record high commodity prices, voracious demand for iron ore to fuel the development of the world’s emerging economies, and the fact that global warming had opened Arctic shipping lanes, made mining Mary River economically feasible for the first time in history.
With negotiations moving forward regarding the construction of a railway to transport the ore, everything was going largely according to plan for McCreary and Baffinland late in the summer of 2007. On August 9 of that year, 200 workers at the Mary River site (around half of them Inuit), went about their business, presumably with no notion of the shock waves reverberating through the financial system. Incredibly, the domino effect set in motion that day by BNP Paribas would soon imperil the well-being of those workers.
As their names imply, the three BNP funds invested primarily in asset-backed securities and collectively held around 35% of assets under management in securities linked to the U.S. subprime mortgage market which, at the time, was beginning to collapse.
In March of 2007, Moody’s Investors Service published a research note entitled “Challenging Times For The U.S. Subprime Mortgage Market,” in which the ratings agency warned that subprime loans originated in 2006 were experiencing delinquency rates and default rates well in excess of those exhibited by loans originated in previous years.
As opposed to prime and near-prime, subprime borrowers typically had low credit scores and unreliable income streams — in short, they were more likely to default than other applicants. Although more than three quarters of all mortgages were considered prime in 2007, the growth in securitized mortgages (i.e., mortgages that went into pools which secured mortgage-backed securities) was heavily dependent upon subprime borrowers. “Subprime and near-prime loans shot up from 9% of newly originated securitized mortgages in 2001 to 40% in 2006,” the Dallas Fed noted.
Of the $2.5 trillion in total mortgage loan origination volume in 2006, $1.9 trillion was pooled and packaged into mortgage-backed securities. Around one quarter of those securities were backed by subprime loans. Mortgage securities issued by private firms (also called “non agency MBS” to distinguish them from securities issued by the government-sponsored entities Fannie Mae and Freddie Mac) accounted for 57% of the mortgage-backed securities market in 2006. Of that 57%, nearly half were secured by loans to subprime borrowers.
To make matters worse, 92% of subprime mortgages originated in 2006 that were later securitized were adjustable rate, or “ARMs,” meaning borrowers could expect their monthly payments to rise after a set period. “The most problematic loans came with ‘starter’ rates, usually fixed for the first two or three years, that were written in the tail end of the lending boom. Unlike conventional adjustable mortgages — with payments that can fall if market rates go lower — monthly payments on these loans are destined to jump to substantially higher levels regardless of market rates,” NBC’s John Schoen said at the time, underscoring the extent to which this problem had made its way onto the radar screens of mainstream media outlets. “Unless lenders agree to modify the terms, many of these borrowers will likely default.”
Data collected by Credit Suisse as the crisis began to unfold showed that in April of 2007, the dollar value of mortgages resetting to higher rates was around $26 billion. In May and June, the figure rose to $38 billion. In both July and August it was $44 billion, and in September, mortgages totaling nearly $49 billion were scheduled to reset. The figure peaked at more than $50 billion in October. With so many ARMs on the verge of resetting to higher rates, investors feared borrowers would soon begin to default en masse.
According to a Wall Street Journal study, $1.5 trillion in high interest loans (read: high-risk mortgages to borrowers who had either questionable qualifications in terms of income and credit history or who simply could not afford what they were buying even with high salaries and decent credit) were made between 2004 and 2006 by some 2,500 financial institutions. Over the same period, the percentage of home loans comprised of high-rate mortgages rose from 16% to nearly 30%. All told, nearly 24% of all mortgages made between 2004 and 2006 were high-rate loans.
During boom times in the housing market, robust demand for mortgages caused existing lenders to expand their capacity and enticed new lenders into the market. The homeownership rate in the U.S. hit 69.2% in both the second and fourth quarters of 2004, a record high, and up from 63.8% ten years earlier. (The rate has declined since the height of the bubble and now sits at 65.1%).
The problem came when excess capacity in the market bumped up against waning demand. Mortgage rates in the U.S. began to creep higher starting in the summer of 2005 and the average sales price of new homes grew just 3% from 2005-2006 after rising an average of 8.65% per year since 2001. “As the lending market cools (e.g., when interest rates rise, home price increases abate, or the economy slows), competition among lenders for the reduced pool of borrowers heats up and lenders may lower credit standards (i.e., make riskier loans) in order to maintain origination volume. The riskier loans are more likely to become delinquent and default,” Moody’s said, commenting in March of 2007 on the prevailing market dynamics.
In order to court borrowers, lenders continually relaxed their standards, extending loans to buyers without requiring documentation of income and assets. In many cases, loans were made for the full amount of the purchase price, meaning buyers had no equity in their homes. Additionally, the structure of some loans set buyers up for dramatic increases in the amount of their payments by specifying that after a set period, the applicable interest rate would rise substantially. In many cases, these risk factors were “layered.” For example, Moody’s noted that “a borrower could get a low initial payment, without documenting their income or assets, and put no money down.”
Rising home prices and low interest rates provided a bit of downside protection against the risks associated with making subprime loans. “Subprime borrowers who encountered financial problems could either borrow against their equity to make house payments or sell their homes to settle their debts,” the Dallas Fed remarked, adding that depressed interest rates “helped lower the base rate to which adjustable mortgage rates were indexed, thereby limiting the increase when initial, teaser rates ended.” However, lenders failed to appreciate the extent to which these factors kept delinquency rates at bay, choosing instead to focus on the unemployment rate, which remained low even as the rate of home price appreciation began to slow and interest rates began to rise.
In the first quarter of 2007, the cracks began to show as the residential foreclosure rate rose to the highest level on record. On July 10, around four months after it warned on the market initially, Moody’s downgraded 399 bonds backed by subprime mortgages which together totaled some $5.2 billion. Meanwhile, Standard and Poor’s (S&P) suggested it was close to cutting ratings on more than $12 billion in mortgage-backed securities due to declining home prices and rising default rates. On July 12, Fitch Ratings placed 19 structured collateralized debt obligations on “Ratings Watch Negative” due to a significant deterioration in the underlying portfolios of residential mortgage-backed securities. Fitch said that as part of a revised rating methodology, it was raising the default probability it assumed on residential mortgage-backed securities issued since 2005 by a full 25%. That same day, S&P cut its ratings on 498 subprime mortgage-related bonds worth some $6.39 billion.
Hedge fund manager Steve Eisman wanted to know why it had taken the agencies so long to make the move: “The news has been out on subprime now for many, many months. The delinquencies have been a disaster for many, many months. The ratings have been called into question for many, many months,” Eisman said, on an S&P conference call. “I’d like to know why you’re making this move today instead of many months ago.”
Bill Gross, founder and co-CIO of PIMCO, and the man known around the investment world as “The Bond King” had an answer. The ratings agencies, Gross explained, were simply duped by the “six inch hooker heels” donned by the collateral backing the bonds.
As Bloomberg noted at the time, the trade in mortgage bonds and CDOs was thin, meaning ratings were particularly important for investors in terms of valuing their portfolios, as computer models take ratings and past performance into account when valuing underlying collateral. Investors can also look to the market and derive best guesses for their holdings based on the prices fetched for similar securities. By August of 2007, the market for securities backed by subprime loans had dried up entirely, leaving firms like BNP with no reference points to look to when pricing the assets that constituted their ABS funds. This, in turn, made it impossible to calculate the value of the funds.
At the time, BNP noted that because there simply was no market whatsoever for a number of the securities held by the funds, if investors were allowed to cash out, the firm might be forced to liquidate some assets at what would amount to firesale prices, a move the bank said would jeopardize the interests of the funds’ owners. Paradoxically, BNP claimed to be protecting investors’ interests by refusing to give them their money back. Whether or not this was truly an example of benign paternalism on the part of the bank is debatable, but whatever the case, one thing was clear: The market for anything related to the U.S. mortgage market was drying up — fast.
Just two days before BNP’s announcement, WestLB Asset Management (a joint venture between Düsseldorf-based WestLB and Bank of New York Mellon) suspended redemptions in the WestLB Mellon Compass Fund: ABS, which at the time had around $295 million in assets. As of March 2007, the fund was 80% invested in mortgage-backed securities. By the end of July, market conditions had deteriorated to the point that determining the fund’s net asset value was well nigh impossible. There’s “rising uncertainty among investors,” said Uwe Fuiten, the firm’s head of investment management.
Fuiten was quick to distance WestLB Mellon from the most toxic segment of the U.S. housing market. “We are not at all invested in U.S. subprime,” he said. Nevertheless, the Financial Times noted that as of June 2007, the fund had 22.2% of its assets invested in collateralized debt obligations (CDOs) backed by “high-yield bonds or leveraged loans [and] a further 7.2% [of its cash] invested in CDOs of unspecified structured credit instruments.”
In a similar move, Germany-based BHF-Bank’s investment fund company, Frankfurt Trust, froze redemptions in the $221 million FT ABS-Plus Fund on August 3, after investors pulled out 20% of their cash in the space of a week. The fund was exposed to the U.S. subprime market and clients apparently weren’t interested in sticking around to see how things played out. “The situation for the asset-backed securities and CDOs market has gotten much worse in the last few days because of the U.S. real estate crisis,” the company said.
A little over a week before the ABS WestLB Mellon Compass Fund was frozen, another Düsseldorf-based firm was struggling to cope with the evaporation of liquidity in the market for securities backed by mortgage assets. It was the end of July and IKB Deutsche Industriebank — a German small business lender that is now nearly a century old — found itself in a rather precarious position: A conduit sponsored by the bank was on the verge of collapsing.
In 2002, IKB set up a special purpose vehicle called Rhineland Funding Capital in an effort to diversify away from the traditional business of lending to small- and mid-sized German companies. Rhineland’s business model was simple: It sold short-term debt to investors and used the proceeds to fund the purchase of relatively high-yielding bonds. As long as the interest rate Rhineland paid on the short-term debt it sold (called “commercial paper”) was less than the return it realized on the bonds it purchased, the IKB affiliate made money.
As the Wall Street Journal noted at the time, Rhineland’s operation was far-flung — at least in terms of who bought the commercial paper it sold. Unlikely investors included the city of Oakland, California, and a Minneapolis school district. What those investors likely did not know, was that Rhineland was using the money it raised to invest in complex securities, some of which were tied to subprime mortgages. “This adventurous portfolio building was the outcome of a carefully planned strategy,” IKB’s head of structured finance Dirk Röthig told Risk magazine in 2004. By July of 2007, Rhineland had accumulated some 14 billion euros in assets, even as the stock market value of parent IKB was just 2.6 billion euros.
The real problem with the business model was that because Rhineland borrowed money for short periods and invested it in long-term assets, it relied on the sale of additional debt to repay investors whose notes were maturing. If new investors could not be found, the only way to raise cash was to sell assets.
It goes without saying that in such a scenario, it helps to have assets that people actually want. With liquidity drying up in the market for CDOs, Rhineland quickly found itself in trouble, and on July 27, it became clear that no one was willing to buy its commercial paper or the assets on its book. With no way to repay investors, the IKB conduit was facing default. Ultimately, IKB was bailed out by the German state-owned lender KfW just seven days after assuring investors that nothing was wrong. “Nobody anticipated that the market for commercial paper would develop in such a way,” an IKB spokesman told the Journal.
Clearly, the market was in a rather fragile state at the beginning of August 2007. Against this backdrop, it was hardly surprising that BNP’s announcement triggered a small worldwide panic.
The Dow Jones Industrial average fell 387 points that day and the Chicago Board Options Exchange’s volatility index, (known by market participants as ‘the fear gauge’), hit a four-year high. Shares of JPMorgan and Citigroup both lost 5% representing what, at that time, was the most dramatic one-day decline the two names had suffered in nearly five years.
At a news conference that day, President Bush attempted to reassure the public by stating that according to what he had been told, the system had plenty of liquidity. The actions of the Federal Reserve told a different story. Overnight lending rates had jumped 25 basis points from the day before, a sign banks were becoming more cautious. To remedy the situation, the Fed injected $24 billion into the market – the same market Bush claimed needed no liquidity. One strategist quoted by the New York Times that day was quite clear in his assessment: “There is certainly a liquidity crisis in the financial system.”
Meanwhile, across the Atlantic, the interbank lending market was seizing up. The euro overnight deposit rate jumped 0.3% after the BNP announcement, suggesting banks were beginning to have a more difficult time finding funds as fears of an imminent collapse led to a sudden and generalized unwillingness to lend. Alarmed, the European Central Bank (ECB) injected 94.5 billion euros into the banking system, an unprecedented sum at that time. The ECB also promised to answer all calls by banks for liquidity and, in an effort to avoid exacerbating an already fragile situation, kept its comments sparse noting only that its actions were designed to “assure orderly conditions in the euro money market.” This, of course, suggested that conditions were quickly becoming disorderly.
In a testament to the scope of the panic BNP’s announcement set in motion, central banks in Japan and Australia also injected billions in liquidity to ensure money markets functioned normally. The Bank of Korea and Bank of Canada each issued statements expressing their willingness to pump money into the system at a moment’s notice should conditions deteriorate further.
Recognizing the gravity of the situation, Larry Elliott, economics editor for the British newspaper The Guardian, noted that “August 9, 2007 has all the resonance of August 4, 1914.” Elliott’s foreshadowing was particularly apt. August 4, 1914, not only marked the beginning of World War 1, but also the day the Treasury invoked the Aldrich-Vreeland Act which allowed US banks to pledge assets other than government bonds for cash in order to head-off a potential liquidity crisis in the US banking system.
Less than 24 hours after BNP roiled the markets, Toronto-based Coventree began to feel the heat.
The company’s business model revolved around the issuance of asset-backed commercial paper, a kind of short-term debt instrument. For weeks, a Coventree executive by the name of Judie Dalton had been doing her best to reassure the market about the assets that backed the paper. The reality was that only 4% of the $16 billion or so in commercial paper sold by Coventree-sponsored conduits was tied to the U.S. subprime market. However, investors’ lack of visibility into the asset pools and the generally complex nature of the transactions that stood behind some of the debt, made it difficult for the company to allay fears at a time when a looming subprime meltdown was the talk of the financial universe.
Coventree was the largest third-party issuer of asset-backed commercial paper in Canada, accounting for nearly half of the $32 billion market. First issued in Canada in 2000, third-party asset-backed commercial paper was not sponsored by a bank (hence the term “third-party”). In a nutshell, the paper was simply short-term debt that gave investors the opportunity to earn slightly more interest than they would were they to buy short-term government bonds instead.
Generally, asset-backed commercial paper was issued through so-called “conduits” or “trusts.” Either a bank or some other entity (like Coventree) sponsored or administered the conduits, although, as it turned out, the sponsors did not have a legal obligation to make payments to investors in the event something went wrong and the conduits were unable to meet their obligations. Conduits contracted with dealers including such well-known banks as CIBC, Deutsche Bank, and National Bank to sell the commercial paper to investors. In many cases, the same banks provided the assets from which the conduits generated their profits.
The paper was backed either by cash-flow-generating pools of assets such as credit card receivables, mortgages, and auto loans (this was a “traditional” securitization) or by exposure to securities via credit default swaps (these were known as “credit arbitrage transactions”). In credit arbitrage transactions, the issuing conduit profited (in theory) by pocketing the difference between the fees it collected for assuming credit risk and the interest rate paid to investors on the commercial paper. Credit arbitrage transactions were also called “structured finance transactions” and came to be a major driver of growth in the asset-backed commercial paper market in 2006 and 2007.
To summarize: Sponsors like Coventree issued short-term debt (commercial paper) backed either by income-generating assets or by various structured finance deals. The paper typically matured in 30-60 days (the average maturity for Coventree’s paper was 30 days) setting up an inherent mismatch between the long-term nature of the underlying assets and the short-term nature of the commercial paper. Investors had to be paid back continually (every 30-90 days) but the loans that ultimately backed the paper might not be paid back for quite some time. As such, the trusts simply paid investors whose paper was maturing by issuing new paper — the debt had to be rolled.
As late as July of 2007, Coventree was able to issue commercial paper by offering to pay a premium of just 0.08% over the yield on comparable Canadian government bonds. That changed on August 10. After BNP’s announcement, investors began demanding between 0.4% and 0.6% above Canadian government debt; that is 5 to 7 times as much as they had asked for just one month earlier.
By August 13, bids for Coventree’s paper had dried up altogether – there were no buyers at all. Coventree’s head of capital markets, David Allan, couldn’t believe his eyes. “The market was turning a corner into chaos,” he would later tell The Globe and Mail.
On Thursday, August 16, Gordon McCreary had just finished 18 holes at Rattlesnake Point Golf Club just outside Mississauga Ontario. It was a decent round: McCreary shot an 84. The man who 27 years earlier had written his thesis on the viability of transporting iron ore from the remote Mary River deposit, was seeing his vision come to life as it appeared his company would finally get the chance to develop the remote site. To top it off, his daughter was getting married in two days. Things were going well.
Then, McCreary learned that the consortium of market participants which met in Montreal that day to sort out the mess caused by the inability of Coventree and other third-party sponsors to roll their debt, had agreed to convert all of the outstanding third-party asset-backed commercial paper to floating rate notes with maturities that matched those of the assets held by the trusts. For McCreary, this was a disastrous turn of events.
Around a month earlier, Baffinland Iron had begun buying asset-backed commercial paper from Coventree. Over the course of several transactions, McCreary and Baffinland Iron managed to tie-up $43.8 million of the company’s total $45.6 million in cash and investments in debt instruments issued by Coventree-sponsored trusts. Around $34 million of the total amount Baffinland Iron invested was due between August 13 and August 16 with another $10 million due two weeks later on August 30. Under the terms of the new deal negotiated in Montreal, this money would be unavailable to Baffinland Iron for the foreseeable future. What were supposed to be short-term investments had just been forcibly converted into long-term notes.
Upon hearing the news, McCreary ripped the inside handle off his BMW Z3. “We have 200 people to keep alive,” McCreary would later say in an interview. That money “was our lifeline to getting critical materials to the north.”
Less than 24 hours later, Baffinland Iron Mines disclosed the extent of its exposure to short-term debt issued by Coventree. After revealing that more than 95% of the company’s cash and investments were trapped in liquidity limbo, Baffinland sounded alarmingly uncertain as to whether it would have enough cash to fund operations. The company said it would be ok “provided the market disruption [was] resolved in a timely manner” and investors were told that Baffinland was “working diligently on a short-term solution.”
That solution would have to come sooner rather than later. Baffinland planned to spend between $10 and $20 million over the next month and a half and critical supplies including around 18 million liters of diesel fuel needed to be shipped to the Arctic circle before shipping lanes froze over.
Fortunately for the 200 workers at the Mary River deposit, Bank of Nova Scotia extended Baffinland Iron a $21 million emergency credit line.
It was a bit of poetic justice. It was Bank of Nova Scotia who advised the company to buy the commercial paper in the first place.
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