It is now clear that the asset-backed commercial paper business was a scheme to fund highly risky loans with short-term borrowings without the full disclosure of the nature of the investment risk. Investors were led to believe that the ABCP instruments had a high probability of modest gains compared to government treasury bills and a low probability of loss. Unfortunately, the low probability failure option was grossly underplayed by those with an interest in earning huge fees.

Some banks and credit unions have already fully compensated clients for their ABCP investments, others have not. Two thousand small investors in the $32 billion ABCP market were not included in the original restructuring negotiations. These retail investors, who make up roughly 1 per cent of the face value of the conduits, or about $330 million, are needed to go along with the restructuring plan, which will convert the original short-term commercial paper into longer-term securities. Under the restructuring plan, small investors would have to agree with the large investors not to sue the institutions that sold them the commercial paper.

Before the ABCP market seized up, investors thought that they had purchased liquid, secure commercial paper offering slightly better returns compared with government bonds or treasury bills. And despite a mishmash of underlying assets, the commercial paper also was typically rated AAA by a recognized bond rating firm.

Selling the commercial paper product also paid off well for the companies and banks that originally issued them, since they received handsome fees. The issuing companies also paid a fee to the rating agency to have their notes certified. And, of course, the instruments were popular with the brokerage houses and investment advisers that sold them to retail, institutional and commercial investors.

These dodgy products were packaged with a AAA rating and were sold to individual investors with the expectation that they would be as liquid as treasury bills or bank CDs, but ended up being frozen and illiquid. However, the effective result has been a financial fiasco for the unlucky investors who were not bailed out by the sponsoring institutions.

Individual investors have every right to be outraged at those who created these securities, at the firm which rated them as "riskless" and at the investment professionals who sold the notes to unsophisticated investors.

Indeed, what began as an attempt to avoid a fire sale of these securities for the large investors has turned out to be a potential disaster for some retail investors.

The restructuring plan that was worked out by the large holders of the investment securities is now being presented to the 2,000 small individual investors for their approval. The Crawford Committee's restructuring proposal would replace the ABCP short-term notes with long-term bonds backed by the same questionable securities that backed the original paper.

The question is whether small investors should be treated the same as the large investors, who have negotiated the restructuring scheme. The individual investors hold a relatively small proportion of the total $32 billion pie and treating this group separately should not greatly affect the whole plan as negotiated by Purdy Crawford and the large investors.

There are other ample reasons for the individual investor to be treated differently. Retail investors were sold the ABCP notes as being as good as cash, or nearly so. Small investors lacked the sophisticated analysis that the large investors should have had, which would have allowed them to avoid these risky investments.

Some have suggested that the large investors, in some cases pension funds, are really just representing individuals and that they should be treated equally. But the pension funds are advised by skilled investment professionals and if they make mistakes, then the pensioners and prospective pensioners should hold their advisers responsible. For all these reasons it would make sense for the individual investors to be treated in a much different manner than the large sophisticated investors.

The individual investors are being told that the frozen securities they currently hold are worth only 20 to 30 cents on the dollar. But if they hold the bonds to maturity, five or more years, the investors will get all or almost all of their original investment back. What nonsense!

If an investment is worth 20 cents now, what annual rate of return would be required to make it worth one dollar in five years? A 10 per cent annual return would make a 20 cent investment worth about 33 cents in five years.

What is needed is for those responsible, those who packaged the ABCP notes, those who rated the paper as AAA, and those who sold the paper to individual investors, all to take responsibility for their greed, their lack of transparency and their mistakes. And along with these one should also include the regulators who allowed these questionable securities to be sold to individual investors.

Let all of them step up to the plate and take the individual investors out of the debacle that seems to be looming.

Finally, what new regulations are needed to prevent this kind of disaster from happening again? In the United States, the Secretary of the Treasury has proposed a host of new regulations and new set of regulators. In Canada, we do not even know who is the responsible party for regulation – the federal government or the individual province.

What is clear is that a consistent national set of regulations is required for Canada's so-called "shadow banking sector." The federal Finance Minister has stated that he is in favour of creating a national securities regulator. Thus he should take this opportunity to set forth rules and create a regulator for the portion of the financial sector that does not at present fall under federal jurisdiction. The federal government can do this by imposing rules on all securities that trade across provincial borders. Considering the present mess, it should also have the support of the provinces, none of whom seem eager to enter into the regulation of these complex instruments.

In closing, what is really required is a careful study of the present complex set of financial circumstances surrounding the ABCP market and the current regulatory deficit. Some of the components that will need to be examined for more complete regulation include the appropriate level of transparency for such financial instruments, the appropriate capital requirements for the shadow banking sector, the supervision and auditing requirements for this sector, as well as a careful look at conflicts of interest between rating agencies and their customers.

Doug Peters is the former chief economist of the Toronto-Dominion Bank and was secretary of state (finance) from 1993 to 1997. Arthur Donner, a Toronto economic consultant, began his career as an economist at the Federal Reserve Bank of New York.
 

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