Finance Committee on June 16th, 2008

[The Chair, Conservative, Rob Merrifield]

Thank you very much.

Your time has really gone.

Monsieur Crête, very quickly, I have only 30 seconds, and then I'm going to call this part done.

[Paul Crête, Bloc, Montmagny—L'Islet—Kamouraska—Rivière-du-Loup, QC]

Do you think that foreign banks should fall within your mandate and that you should monitor them?

[Julie Dickson]

When they take deposits here, yes, but if a car company, a grocery company, or a Coventree wants to deal with a foreign bank, I think they should be allowed to do so. Those foreign banks have regulators, and they are regulated for solvency.

[The Chair, Conservative, Rob Merrifield]

Thank you very much for your time, and for coming and presenting. We want to honour your time commitments as well, so we will suspend the meeting until we have the finance department come to the table.

Thank you very much, Ms. Dickson.

[The Chair, Conservative, Rob Merrifield]

I appreciate that we have the Department of Finance with us.

We have Mr. Tiff Macklem.

Thank you for coming in. Do you have a presentation for the committee? I appreciate that.

The floor is yours. Proceed, please.

[Tiff Macklem, Associate Deputy Minister and G7 Deputy for Canada, Department of Finance]

Thank you, Mr. Chairman and members of the committee. The Department of Finance and the Minister of Finance welcome these important hearings on Canada's asset-backed commercial paper--ABCP--market, specifically the non-bank sector of this market that was subject to the Montreal Accord and a court-supervised restructuring under the Companies' Creditors Arrangement Act.

I am pleased to have the opportunity to appear before this committee on behalf of the Department of Finance.

The restructuring of the non-bank-sponsored ABCP market under the Montreal Accord has been a market-led initiative with no public money or government guarantees. The restructuring provides a good example of how the private sector can sort out a market issue, and its success has been admired internationally. This, however, does not detract from the reality that the process has been long, complex, and very difficult for everybody involved.

Before I take your questions, I'd like to share with you the Department of Finance's perspective on the ABCP market and events leading up to the freezing of the non-bank sector market, including the global context in which this happened, some of the lessons learned, and the response of policy-makers.

The regulation of securities markets in Canada is the responsibility of provincial securities commissions. The regulatory framework specifies, among other things, the level of disclosure required of issuers and investment dealers selling securities to the public. In Canada, commercial paper, including ABCP, is sold under a short-term debt provincial securities regulations exemption. This exemption allows short-term debt maturing not more than one year from the date of issue and having an approved credit rating from an approved credit rating agency to be sold without the need for a prospectus.

In Canada, there are two distinct ABCP market segments: bank- sponsored conduits, representing about $80 billion Canadian of outstanding ABCP as of last August, and non-bank-sponsored conduits, which accounted for around $35 billion Canadian.

In all ABCP programs, there is an inherent mismatch between the term of the assets—normally several years—and the term of the ABCP—normally three months or less. ABCP conduits therefore require standing liquidity lines from financial institutions that can be accessed under conditions where the sale of new ABCP is difficult or impossible.

In most jurisdictions, ABCP programs are backed by “global style” liquidity lines that can be accessed under a wide variety of market circumstances, including a credit event. An unique feature of the Canadian market as it existed prior to August, was that most ABCP, including all conduits in the non-bank sector, were supported by “general market disruption” lines, which were only accessible to issuers when the inability to issue new ABCP relates to a general disruption in the Canadian ABCP market, rather than the deterioration of creditworthiness of the issuer or its assets. This left the Canadian ABCP market more exposed to risk, so that investors would be unwilling to roll their paper at maturity.

The Canadian marketplace, including investors and the rating agency, accepted “general market disruption” lines. This was not a decision made by regulators. The Superintendent of Financial Institutions has already addressed you on this issue.

The key trigger of the global turmoil was the rise in the default rate in U.S. subprime mortgages. This immediately affected structured assets that were backed by such mortgages. What is clear now is that in the rapidly growing U.S. subprime mortgage market, originators of loans had loosened their standards of lending considerably. This created a pool of questionable assets that found their way into structured finance products around the world through the process of securitization.

Investors' concern quickly spread to a broad range of complex products with potential exposure to subprime securities, owing to their complexity and to a general lack of transparency. This included structured securities rated highly by rating agencies. One example was the global market for ABCP.

Against this evolving global backdrop last summer, Canadian investors came to question the quality of the assets underlying Canadian ABCP. In mid-August, the non-bank market froze, as investors refused to roll their paper. Domestic banks, to their credit, supported their own ABCP programs, but for non-bank ABCP, liquidity providers did not provide funds for the most part. The failure of the non-bank conduits to meet their maturing commercial paper obligations raised the spectre of a fire sale of assets and significant losses of capital.

On August 16, a group representing major investors in non-bank-sponsored ABCP and the main international bank asset providers agreed to a standstill under the Montreal Accord. This accord laid the basis for a market-led restructuring of the non-bank ABCP market, with a view to preserving investors' money. The restructuring process, led by the Pan-Canadian Investors Committee under the leadership of Mr. Purdy Crawford, has been a market-led initiative.

Since the standstill began, the Department of Finance and the Bank of Canada have encouraged a market-led restructuring as a better course of action for investors, other participants, and capital markets than a fire sale of assets. We are not a member of the investors committee. However, we have monitored developments closely through an observer on the committee, and we have encouraged all parties to work constructively toward an orderly resolution. The Minister of Finance has issued statements supporting the restructuring process at key milestones.

On June 5, the Superior Court of Justice of Ontario approved the plan for restructuring asset-backed commercial paper, developed by the Pan-Canadian Investors Committee. This marks a decisive step in what has been a long and difficult process. Since last August, the Government of Canada has supported this market-led restructuring as a preferred course of action for investors and for the ongoing stability of the overall Canadian financial system. Small investors' interests have been accommodated in the final plan. Its successful resolution removes an overhang of uncertainty and should help restore greater stability in our money markets.

While the Montreal Accord is a good example of the market sorting out a market issue, there are clearly lessons to be learned for market participants and for policy-makers, both domestically and internationally. The Canadian market is already adjusting; investors are demanding greater transparency and disclosure from issuers and are stepping up their own due diligence. Since last August, all bank-sponsored ABCP programs have adopted global-style liquidity lines, and sponsors are making efforts to increase the transparency of the underlying assets of these programs. Financial institutions are also strengthening their risk management policies and practices.

Many of the lessons learned are global in nature, requiring a coordinated global response. In April, G-7 ministers and central bank governors endorsed a report of the Financial Stability Forum, which provides detailed recommendations to address the weaknesses that contributed to the global market turmoil and to enhance market and institutional resilience going forward. The Minister of Finance has indicated that Canada is fully committed to implementing these recommendations, which include specific timelines and priorities.

A number of these recommendations apply to the asset-backed commercial paper market. In particular, recommendations deal with the need for improved transparency in the securitization process, changes to the role and quality of the ratings process, and the appropriate use of ratings by investors and regulators.

The FSF has made a number of other relevant recommendations related to improving accounting and valuation processes for complex products and enhanced disclosure for financial firms. The Department of Finance, the Office of the Superintendent of Financial Institutions, the Bank of Canada, securities regulators, market participants, and credit rating agencies are all engaged in these issues, as are international standard setters.

For example, within its purview, securities regulators are reviewing the conditions under which commercial paper backed by structured credit products may be sold to Canadian investors. Prudential regulators, including ours, for their part must assess the appropriate capital treatment and risk management policies and practices respecting structured credit products.

The FSF also called on countries to review and strengthen their financial regulatory frameworks. In Canada, the priority is a common securities regulator with a more principles-based regulatory framework.

The Minister of Finance announced in February 2008 the establishment of an expert panel on securities regulation to advise on enhancing the content, structure, and enforcement of securities regulation in Canada. Under the chairmanship of the Honourable Tom Hockin, the panel is currently consulting across Canada with a broad range of market participants, including investors and their representative groups. The panel will deliver to the Minister of Finance and provincial and territorial ministers responsible for securities regulation a final report by the end of 2008. The minister applauds this committee's decision to hold hearings on these matters. There are a number of important issues that you could usefully explore.

With those words of introduction, let me open it up to your questions.

Thank you.

[The Chair, Conservative, Rob Merrifield]

Thank you.

Mr. McCallum.

[John McCallum, Liberal, Markham—Unionville, ON]

There was a bit of confusion about global-style liquidity versus general market disruption. You say near the beginning of your comments that Canada was virtually unique in having these general market disruption clauses. Then you say this was not a decision made by the regulators. I assume there were four reasons for this: (1) all parties wanted it that way; (2) the rating agency agreed, which perhaps was unique to Canada; (3) the investors liked it that way; and (4) OSFI permitted it. Is that a fair statement?

[Tiff Macklem]

The superintendent has been clear on OSFI's role. Her role is to protect depositors and to look at appropriate capital requirements. She's been through that, and all this is being looked at and revised. In the U.S., investors and rating agencies demanded global-style liquidity arrangements. This was not the situation in Canada.

[John McCallum, Liberal, Markham—Unionville, ON]

But OSFI now requires global-style liquidity. Is that not correct?

[Tiff Macklem]

What is happening is that the market players have all moved to global-style liquidity. As the superintendent explained, there were different capital requirements for global-style versus general market, a disruption-style liquidity, and those are all being reviewed. She explained that the bank-sponsored conduits with general market disruption liquidity came in and, to the benefit of investors, backed their conduits and provided liquidity. Although legally they were separate and were under no obligation to do so, they did. What that has brought to the fore for the superintendent is reputational risk and the fact that they're likely to do this in any event. So the capital charge needs to reflect this.

[John McCallum, Liberal, Markham—Unionville, ON]

That action has been taken recently. But if OSFI had decided earlier that it didn't want these general market disruption clauses, and one could have anticipated that banks would face this reputational risk, OSFI, at least in theory, could have made this new ruling many months ago. Then we would have had in Canada the global-style liquidity lines and not the made-in-Canada general market disruption clauses.

[Tiff Macklem]

As the superintendent indicated, her job is to protect depositors and figure out the appropriate capital charges. She is revising those.

[John McCallum, Liberal, Markham—Unionville, ON]

Okay. I think I now understand it.

This will be my last question. Weren't there a number of what one might call red flags that popped up along the way and that should have served as a warning to somebody earlier? The fact that Canada was unique with these general market disruption clauses, the fact that only one of the rating agencies would rate the asset under these conditions, the fact that at least one major bank wouldn't participate--weren't these somewhat unusual developments that perhaps should have been noticed and acted upon earlier?

I know it's difficult—hindsight is 20/20—but it does seem to me that these are fairly self-evident warning signs that appeared along the way.

[Tiff Macklem]

Let me put this into the global context and then come back to the specific issue.

I think it's fair to say that in the global context, if you go back a year or a year and a half ago, many people saw that the risk spreads were very low. They seemed unsustainably low and needed to widen. I think it was recognized that there was even a possibility that this wouldn't be an entirely smooth process. But I think it's fair to say that nobody foresaw the kind of global financial turbulence we have been going through in the last 10 months. Nobody foresaw the potential for contagion from subprime mortgages into a whole broad spectrum of complex products. Nobody foresaw the contagion effects this could have in the money markets at the core of the financial system.

This has certainly precipitated a great deal of reflection, a great deal of work on what needs to be done to prevent this type of crisis from happening again. The reality is that credit cycles are not new. They're not going to go away. So we also have to be prepared to manage these situations in the future.

With respect to this specific market, as the superintendent indicated, this is not a new market. It's been around for some time. It had been working successfully. With respect to the issues around global or general market-style liquidity, this was known in the market. As the superintendent indicated, the bulk of the investors in this market were highly sophisticated and very big investors. These were contracts issued in the private sector between relatively sophisticated players, by and large.

In terms of the regulatory oversight of this, as I indicated, securities regulation is in the domain of the provincial securities commissions. This was issued in the exempt market because it was a short-term instrument with an accredited credit rating. The scope of the exempt market is something the provincial securities commissions are looking at.

[The Chair, Conservative, Rob Merrifield]

Thank you very much.

We'll now move to Mr. Crête.

[Paul Crête, Bloc, Montmagny—L'Islet—Kamouraska—Rivière-du-Loup, QC]

Mr. Macklem, perhaps I am not understanding you clearly. You give me the impression that all of this happened by coincidence and through market forces, when we know very well that people borrowed thinking they could make easy profits. Banks fell into the trap of easy profits and acted as if they did not need to examine the content of the financial products, because it was not their responsibility.

Rating agencies issued securities. I witnessed a horrible situation: an agency gave a positive rating to this type of three-day loan, and after three days, the person who had bought the asset with the bank's approval lost $20 million out of the $25 million paid for the asset.

Do you think, as a result of the soul-searching which is happening today concerning the impacts of securitization, that various stages of the process will be tightened? I am not saying that this type of investment vehicle should be banned, but that there should be a significant tightening of the control mechanisms.

Do you acknowledge that this crisis has resulted from a laissez-faire attitude at many levels?

[Tiff Macklem]

Financial markets now offer many new products. Securitization is playing a much more significant role in financial markets. It is important not to lose sight of the advantages of diversification of risks and access to capital by companies. However, we must draw important lessons from this experience.

Regarding the credit rating agencies, a significant number of complex products did not yield the expected results for several reasons. When the agencies reviewed high risk mortgage loans and mortgages in general, they thought that diversification would minimize risks, but they did not anticipate that housing prices in the United States would fall to the extent that they did. As a result, diversification did not work as well as expected.

If you have a rating that's triple-A for a traditional single-name corporate, it has turned out that the behaviour of a triple-A complex product in situations of a lot of stress has tended to be different from a single-name corporate A. One of the recommendations of the Financial Stability Forum along with the IOSCO body is that rating agencies differentiate the ratings between structured and traditional products to provide investors with more information about the fact that their behaviour may be different even if their probabilities of default are the same.

[Paul Crête, Bloc, Montmagny—L'Islet—Kamouraska—Rivière-du-Loup, QC]

Do you know of a country which managed to control the value of its securities during that period and which as a consequence avoided the current crisis?

[Tiff Macklem]

Could you be more specific?

[Paul Crête, Bloc, Montmagny—L'Islet—Kamouraska—Rivière-du-Loup, QC]

Among developed countries, was there one country which did better than everyone else because it had a system which threw up warning signs in time or which prevented its markets from sinking into this quagmire? Did the United States, England, Japan, any European country or other countries manage to avoid the crisis?

[Tiff Macklem]

Each country had to deal with its own set of problems. The United States are really at the root of the problem. This is especially because standards

for credit assessment and underwriting of mortgages clearly became lax on the back of a very long and sustained expansion. This was exacerbated by the fact that interest rates were low. There was a search for yields. Investors were looking for products, and issuers were only too willing to provide them.

I give you this as an example. In different countries I think there have been different areas where the focus for improvement needs to be....

Canada stands apart because it does not have a common securities regulator.

[Paul Crête, Bloc, Montmagny—L'Islet—Kamouraska—Rivière-du-Loup, QC]

Do other countries have a common securities regulator?

[Tiff Macklem]

Yes, that is the case for each of the other developed countries.

[Paul Crête, Bloc, Montmagny—L'Islet—Kamouraska—Rivière-du-Loup, QC]

But they could not avoid the crisis either.