Equity Strategy September 7, 2007:

The ongoing revelations of credit problems in specific products issued by the Canadian financial services sector are starting to have wide spread impact. The Asset Backed Commercial Paper (ABCP) market has come to a complete halt as investors realize there is no secondary market for these instruments.

There are many lessons that can be learned from this turmoil, but the main one is know what you own. It is a simple idea and one that seems to have been over looked by a great many investors over the past few years. The best way not to be surprised by an investment is to understand how it works and what events will affect the price.

The ABCP is as good an example as any, the instrument is based on the idea that short term corporate borrowing could be secured by a long term instrument if it was packaged in such a way as to allow the creation of a number of short term maturities that would continuously roll over, backed by the assets pledged.

Corporate Paper has been actively traded in Canada for decades; originally Corporate Paper was just that a short term bill (promise to pay) issued by a corporation with a term of less than a year as a method of funding short term cash requirements. These instruments are issued in the same manner as a Government Treasury Bill, issued at a discount to maturity (PAR Value) value. The yield on the Corporate Paper would be dependent on the credit worthiness of the issuing corporation the higher the credit rating the lower the risk and the lower the yield and vise versa.

So investors knew what they were buying because the name of the issuer was right on the paper, with Asset Backed Corporate Paper investors are not privy to the ownership of the assets pledged so have no way of measuring the risk and are forced to blindly assume that the credit rating agency knows how to accurately measure that critical component of the investment decision. Uncertainty develops because those assets used as collateral are not clearly identified this lack of transparency leads to uncertainty.

This uncertainty is what started the credit market sell off as investors realized that some of their investments could not be properly priced due to the lack of transparency and lack of liquidity. Once investors started to question the value of a big portion of the short term corporate market virtually all trading stopped and new issues could not be sold to cover the maturing paper.

The freeze up in the short term market lead to questions regarding other asset backed issues the so called Collateralized Debt Obligations (CDO’s). The answers the questions were not pretty, many of the assets backing these debt obligations were sub prime mortgages where default rates were starting to escalate creating the potential for default on the CDO.

The surprising thing to me is just how widely held the obligations are, many hedge funds, pension funds and mutual funds appear to have substantial exposure to these investments. This has become a global problem which has forced the central banks to pump billions dollars in cash into the financial system as fear mounted that the system would stop functioning.

The fall out from the Collateralized Debt Obligation, Asset Backed Corporate Paper and sub-prime mortgages has only just started, there are close to $300 billion of mortgages coming up for renewal over the next few months. These mortgages in many cases were issued with low “teaser” rates that will now be reset to market rates likely 3-5% higher than the teaser rate, the increased interest costs will be more than many borrowers can afford forcing them to default on their mortgages. These defaults will impact on a global basis and continue to create turmoil in the financial markets.

The financial services industry is going to be under a cloud of uncertainty for many months to come as the full impact of the loose lending standards and the massive creation of debt obligations based on those lending criteria hits the market.

As the credit markets continue to get hit over the next several months revenue in the financial services sector world wide will decline. The creation of massive amounts of credit and the creation of massive amounts of new debt obligations has in turn created a massive amount of fees for the financial service industry that is going to change dramatically over the next year. The leveraged buyout business will slow dramatically now that investors and institutions have an increased aversion to risk, these deals will not be nearly as easy to complete.

The earnings growth in all segments of the financial services sector will slow as the volume of new business slows and the reality of loans and investment losses starts to mount. Investors should avoid banks, insurance companies and fund companies going forward as the potential upside in these sectors is limited over the next 12 – 18 months.