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October 2007

Money Markets No Safe Haven? What's Going On?

By: Brian White & Tony Corona

Over the summer, we have been seeing investors look for a safe haven from the volatile markets of late. Usually money market type funds are the investment of choice when investors want something ‘risk free.’ Now, in the era of the sub-prime dilemma, money market funds are considered risky! What is going on?

To understand what has happened with money market funds, we need to look at the panic in the market which is being caused by global financial market volatility which has been driven by the U.S. sub-prime mortgage crisis. Sub-prime mortgages are issued to home buyers with poor credit histories. They can be issued in a variety of exotic structures and often with variable interest rates (sometimes low introductory rates). When the rates adjust upwards, foreclosures increase.

After years of lax lending standards stemming from a previously robust housing market, mortgage defaults are rising. The fear of increasing defaults has caused turmoil in U.S. debt markets. The effects of this trouble (changing risk tolerances and increased volatility) have spread to securities and markets that are not directly related to sub-prime lending (the Canadian ABCP market) and have created a liquidity crunch.

Liquidity Crisis

This liquidity crisis has affected the Commercial Paper market. Commercial Paper is a form of debt obligation issued with short-term maturities. Asset-Backed Commercial Paper (ABCP) is created when issuers securitize (or re-package) various types of debt and sell the package to investors. The types of underlying debt can include trade receivables, credit card debt, car loans, and mortgages. The Canadian market includes approximately $75 billion of ABCP issued by banks and another $40 billion issued by non-bank ‘third party’ issuers.

The recent liquidity crisis in the ABCP market affected third-party issuers who experienced difficulty in finding buyers for some of their maturing paper. The largest third-party issuer in Canada is Coventree Capital, which has issued approximately $16 billion of third-party ABCP and has been the subject of much scrutiny. When ABCP matures and issuers cannot find buyers, they call upon their ‘liquidity providers’ – parties that agree to be the lenders of last resort to ensure the paper is rolled over. However, in the recent crisis, liquidity providers of third-party paper have largely refused to provide the liquidity subject to legalities that allow them to avoid this obligation.

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