ABCP, Sub-Prime, Coventree

There has been some slight readjustment in the market lately at the intersection of the three titled subjects, and I’ve received some queries regarding how it all works.

So, for those who don’t wish to read Moody’s explanation of the market (hat tip: Financial Webring Forum) or the Federal Reserve’s Examiners’ Supervision Manual, here’s a stripped down version of how it all came together. Please note that I have no inside information whatsoever regarding the specifics of the holdings or clients of Coventree’s trusts; also note that I am recklessly making up the numbers with a view to showing how the system works, not with a view to calculating actual profits:

(i) A hedge-fund guy (HF) has $100 he needs to invest.

(ii) HF is offered some 6% 30-year sub-prime paper and decides that it’s a good investment.

(iii) HF buys $1,000 of this 6% paper and borrows $900 on margin at 7% to pay for it. At this point he has negative carry, which is a Bad Thing.

(iv) Coventree offers to lend him $900 at 5% for ten years against the assets, provided he over-collateralizes. HF borrows the $900 from the Coventree trust at 5% for a ten year term and uses these proceeds to repay his margin debt. The loan is secured by a pledge of the $1,000 worth of 30-year 6% sub-prime paper.

(v) Coventree then issues $900 of three-month paper to yield 4%. The buyer is … Investor Guy (IG), who needs a liquid investment but doesn’t want to buy T-Bills yielding 3%.

So at this point, everybody’s happy:

(a) The ultimate financer has $900 worth of three-month paper yielding 4%

(b) Coventree’s trust is borrowing $900 at 4% and lending $900 at 5%, for projected profit of $9 annually.

(c) HF is levering his $100 capital into a $1,000 investment which pays $60 interest annually and financing $900 at 5%, paying $45 annually. HF thus has a positive carry of $15 annually on an investment of $100 and has a chance at a capital gain … if the market goes his way, he can sell the sub-prime paper and collapse the loan.

Everybody’s happy. Coventree is confident they’ll be able to issue three month paper for the next ten years; HF is confident he’ll be able to take out 10-year loans for the next thirty years. The ratings agencies poke around inside Coventree and say, hey! There’s over-collaterallization here, and positive carry on the underlying investment. No problems. Until step six:

(vi) IG reads in the paper that sub-prime paper is worthless. All of it! Not only are all those deadbeats going to default on their mortgages, but the houses won’t be worth anything after foreclosure.

(vii) IG gets a note telling him that Coventree trusts have sub-prime paper in them – something like that disclosed by Coventree in their latest MD&A:

Management continues to believe in the high quality of those underlying assets. Coventree-sponsored conduits have limited exposure to U.S. subprime mortgages – less than 4% of the total assets in Coventree-sponsored conduits are backed by assets related to U.S. subprime mortgages. Those assets continue to perform within the range of initial expectations and, as such, continue to be rated AAA, and are not expected to be materially affected by the recent increase in delinquencies and losses in that asset class.

(viii) IG just wants a really safe Money Market investment. He doesn’t like headlines. He therefore does not buy any more Coventree-sponsored paper.

(ix) Coventree-sponsored trusts can no longer operate since they’re unable to repay the money market notes as they come due.

(x) The Montreal Proposal is made; notes will be issued to reflect the underlying trust asset; thus, there will be a conversion of the overnight paper into a ten-year note, secured by Coventree’s ten-year loan to HF.


In short: Coventree was doing a classic bank thing: borrowing short and lending long, making money on the term spread and the quality spread.

They ran into the other classic bank thing: a run.

Update, 2007-08-24 : Tom Graff has explained a variation on the theme

Update, 2007-08-24 : The issuers of the short term paper did anticipate that a run might happen and set themselves up with one of two defenses:(i) Extendible Notes … if the paper can’t be rolled, they can just extend the maturity by a period of time, which gives them some breathing space.

(ii) Back up Liquidity – in the example above, they’ve got $9 net interest income. They can enter into a contract with a bank, whereby they pay the bank $1 annually for an emergency borrowing facility. The trouble starts when the word “emergency” is defined, as noted by DBRS:

During the weeks of August 13 and August 20, 2007, DBRS noted that while many ABCP issuers continued market issuance activities in the normal course, a number of ABCP issuers were unable to roll their ABCP maturities. In these instances, backup liquidity facilities were drawn upon and while liquidity was advanced in several cases, in others they were not. In cases where liquidity was not advanced, investors may now be exposed to mark-to-market risk in the underlying assets.

In further comments,

During the last two weeks, DBRS noted, a number of issuers of asset backed debt, also known as ABCP, were unable to roll over – or find buyers for – debt as it matured.

The situation was made worse when the issuers couldn’t get cash under liquidity provisions set up as a sort of safety net in case of market disruptions.

[DBRS group managing director Huston] Loke said this is one area that DBRS is looking at, since its rating system hasn’t previously looked at the reliability of the liquidity agreements put in place between the issuers and their financial institutions.

He noted that some financial institutions provided liquidity when requested by ABCP issuers and others did not, even though the contracts were worded similarly.

“I think that’s something we would need to look at in terms of our revisions to criteria,” Loke said.

Update, 2007-08-24: Coventree uses the term “credit arbitrage” to describe its process; Fabrice Taylor made fun of this term:

Coventree earns fees and spread income from trusts that buy assets like mortgages, leases and other receivables that earn interest income. They then issue shorter-term debt to investors on which they pay interest, hopefully earning a spread. The company calls this spread revenue “credit arbitrage,” which is a misnomer because, by definition, arbitrage is supposed to be a risk-free profit.

Fabrice Taylor’s track record was not disclosed. According to the Moody’s primer linked above:

Credit arbitrage programs are bank-sponsored programs that invest in securities rated Aa3 or higher. The programs are similar to a cash flow CDO, but funded with short-term liabilities instead of term debt. They generally have no credit enhancement because the securities are highly-rated and the program administrator must sell the securities or provide credit enhancement if the assets are downgraded. The liquidity facility is sized at the face amount of ABCP outstanding and purchases assets at book value, implicitly protecting investors from market value risk. These programs exist largely because the initial BIS regulatory capital regulations for commercial banks do not distinguish between highly-rated and lower-rated securities. By funding off-balance sheet, banks obtain regulatory capital relief. The program also serves to diversify the bank’s sources of financing.

And according to Coventree:

Credit arbitrage transactions closely resemble derivative transactions which are designed to transfer risk from one highly sophisticated financial institution to another. Coventree’s revenues for credit arbitrage transactions consist of the spread between the return on the underlying investment and the conduit’s cost of funds.

One Response to “ABCP, Sub-Prime, Coventree”

  1. […] A lot of hedgies are going to get wiped out and the sooner the better; a few pension funds are going to play blame the manager; credit squeezes and the sudden conversion of Money Market instruments to term debt a la Coventree may give a recessionary cast to the economy; the US may well enter a recession, since a lot of their deficit-fuelled growth in the past few years has been housing-related and there ain’t gonna be much more of that; a few real companies will probably get weak enough that they get taken over at prices that don’t make long-term shareholders very happy (like just happened to Sachsen, mentioned here on August 20); and we might even see a spectacular flame-out if a big institution’s risk-controls are found wanting  … but I’m not so sure that the solidly investment-grade tranches of sub-prime debt are as bad as they’re made out to be. […]

Leave a Reply

You must be logged in to post a comment.