Speech by Jean-Guy Langelier before the Treasury Management Association of Canada

Wednesday, November 21, 2007

I'm pleased to be with you today to talk about the commercial paper crisis, though rest assured I would much rather be having a discussion with you about Management of treasury activities. But as you know, we are currently living through an unusual situation, the result of a new phenomenon affecting markets on a global scale.

I would also like to emphasize that what I have to say reflects my personal viewpoint. My remarks should in no way be construed as the official position of the Desjardins Group or the Montréal consortium. As well, my comments are based on my own observations of how this crisis has evolved, from the beginning to the present.

Following the terrorist attacks in September of 2001, the central banks, with the U.S. Federal Reserve in the lead, were compelled to lower key rates immediately. The attacks had such a negative impact on consumer confidence that the western economies could have quickly fallen into a deep recession. The tech bubble had already started to deflate. After the attacks, we were right to expect the worst.

The U.S. Federal Reserve, for its part, had to lower the rates at which it lent to commercial banks to just 1%. We had not seen rates this low since the Great Depression in the 30s. Western central banks' massive injection of liquidity had a beneficial impact in the short run, but proved to be more detrimental in the medium term. Portfolio managers must always keep a portion of their investment in fixed-income securities. Given that interest rates were extremely low, these managers had to turn to lower-quality securities. The hunt for higher returns was on.

We also saw that spreads on credits from all sources were narrowing. In Canada, not only did the spreads between provincial securities and federal government bonds shrink, but there was also a substantial, generalized decline of yields on corporate securities.

Unfortunately, as you know, the holders of bank securities or of portfolio fund companies require a return of more than 15% per year. This need for such high returns pushed the banks to engage in more complex activities like Collateralized Debt Obligations (CDO), Credit Default Swaps (CDS) and Leveraged Super Seniors (LSS). The quest for returns also pushed banks and portfolio managers to invest in securities, even though they would not be fully compensated for the risks they incurred.

As a result, with more liberal credit terms, structures and fund managers became more and more imaginative and creative. One of the methods they employed to increase the return on their portfolios was to aggressively use the effects of leveraging. In fact, despite the current environment, it's not unusual to see pension trustees taking advantage of this. Not only are they investing in securities with returns that are lower than what they should expect, but in order to compensate for the smaller returns, they are borrowing on the markets in order to invest and thereby benefit from a leveraging effect.

Furthermore, one of the direct results of narrowing corporate spreads was a boom in LBO activity. As business financing costs were very low, investment firms and pension funds capitalized on the situation. They bought up public companies and restructured their balance sheets. They also offloaded a substantial part of their purchases by issuing bonds on the capital market. These activities in turn pushed the stock markets to new heights.

During this time, U.S. banks approved loans to borrowers with solvency problems, the type of credit commonly known as "subprime". This new practice also stems from narrowing credit spreads. These not very creditworthy borrowers could handle their mortgage payments as long as interest rates remained very low benefiting at the same time from a fiscal deduction for their interest payment. But given that the loans were granted on a variable rate basis, debtors became very vulnerable to an interest rate increase.

In turn, this environment helped the U.S. real estate market reach unparalleled heights. Increasing the number of new owners put intense pressure on the pool of existing homes. Not only did home prices skyrocket, but the market's strength induced a greater number of real estate developers to build and thus help create a boom.

The low interest rates that prevailed for more than five years helped narrow credit spreads on corporate securities, drove stock markets up and encouraged real estate prices to rise.

About 18 months ago, once again in a concerted effort to stem potential overheated economies, the central banks were forced to revise their key rates upward. One of the first things the U.S. real estate market noticed was the trouble some borrowers were having in meeting their payments. They had heavy debt burdens, largely incurred on the basis of extremely low interest rates, and could not cope with the revised payments. This situation became widespread in the subprime market which, in turn, had a negative impact on the real estate market, when borrowers opted to hand over the keys rather than having to face their new obligations.

For their part, in recent years, subprime mortgages had been securitized. They were used as assets for new instruments that issued asset-backed commercial papers. Ingenious structures made it possible to recycle debt and convert it into securities that appeared to be very solid. What's more, the credit rating agencies regularly awarded them AAA ratings. The credit rating agencies could never have foreseen that the subprime market would deteriorate this dramatically due to the increase in defaults, triggering a cascade of rating cuts for asset backed papers.

The crisis affecting U.S. mortgage credit resulted in pressure on corporate credit. The latest LBO transactions, which had banked on a favourable financing terms, could not be finalized. An initial direct consequence of this was to bring the U.S. stock market down; after that, it took all of the stock markets into a negative spiral last summer. The central banks acted promptly, agreeing to broaden the pool of securities eligible for repurchase agreements (REPO). They thus injected much needed liquidity to contain the financial markets' fears.

In recent years, Desjardins Group, for its part, had tabled a strategy with its Board of directors for reducing its dependence on short term capital. Not only had it decided that extending its funding maturity was crucial, but that it was also imperative to diversify its sources. It was thus agreed to set up a liquid borrowing yield curve mainly in Euro, a market with much greater depth than the Canadian market. The structure of commissions in Europe, twinned with the narrowing of spreads on currency derivatives, allowed Desjardins Group to create this curve at highly advantageous costs.

In parallel, two years ago, we also invested our energy in diversifying our sources of funding. That is when we closed our first mortgage securitization issues through the Canada Mortgage and Housing Corporation. This new avenue allowed us not only to borrow over the medium term, but do so at excellent conditions. The price for these asset sales was set based on the Government of Canada's credit rating, not on the rating of the financial institution. With this program, in recent months, we have been able to continue to maintain our supply at highly competitive terms.

The industry is going through substantial transformation, while disintermediation is growing. Depositors put less and less value on traditional deposits, forcing financial institutions to sell assets rather than borrow on wholesale markets.

I would like now to address the issue of the assets underlying the ABCP markets. Much has been said and written about these famous ABCPs.

If we look at the current situation, in my view, despite the representations of few participants, the crisis we have, and are still experiencing in Canada on the ABCP markets was, for the vast majority of investors, not foreseeable, given that to date we are still unaware of the agreements binding Coventree and the other agents to the banks, to secure adequate liquidity.

In light of the work that has been done, I can confirm that the assets underlying the non-bank ABCPs are generally of good quality. In fact, the problem we're experiencing today is in no way related to the intrinsic value of the assets purchased by securitization vehicles. In essence, there are two major classes of assets.

In the first category are traditional assets. These may consist of lines of credit, mortgage loans, CDOs and securitizations. In the second group are the so-called non-traditional ones. These are complex derivative products, which themselves are based on other derivative products to which a leveraging effect has been added. Incidentally, more than 2/3 of the underlying assets fall into this category.

You are all aware that whether in Europe or the United States, it has been possible for several years to trade credit derivatives that bear corporations as reference entities. For example, a financial institution could decide to make a loan to a company and then, by means of derivative products, immunize itself with respect to the credit risk of the same company.

In both the United States and Europe there are pools of products derived from the credit on Investment Grade firms, on the CDX in the U.S. and ITRAXX in Europe. As far as the U.S. is concerned, the reference pool is made up of 125 corporations, each of which has an identical weight. One part of the derivative products that interests us refers to a percentage of these pools. In many cases, for us to be called on to absorb the losses, the number of bankruptcies among all of these companies would have to reach 25%, something that is highly unlikely.

Since the risk of seeing so many companies go bankrupt was miniscule, the income that these trusts received, in the context of extremely low interest rates, was very weak. In order to boost their income, the trusts managed to structure their transactions in a way that would add a leveraging effect. For every dollar deposit, they often had ten dollars of assets in place. The risk of default remained just as tiny, but the trusts could still calculate them at market value daily basis.

In effect, since these are transactions of derivative products, they are generally governed by Credit Support Annexes, which anticipate margin calls. The credit crisis we went through this summer, and which we're still dealing with, pushed the rate spreads to extremely high levels. The depressed market caused the market value of these structures to "plummet", setting off margin calls on the trusts.

The possibility of this happening is something that the trusts had foreseen. They had negotiated liquidity agreements to hedge themselves in the event of a liquidity shortage. In order to obtain that assurance, they had duly paid their insurance premiums over the years. As unbelievable as it may seem, on the day that what we can now describe as a worldwide crisis occurrence, those who were contractually bound to provide liquidity refused to do so. Essentially, they declared that the environment was not exceptional and as a result, they were not obliged to provide the liquidity for which they had been collecting premiums over the years.

Many among those involved were quick to blame the rating agencies for the fiasco in Canada. In effect, the rating agency - and under the circumstances, it would have been much better if more than one had been involved - was perhaps not as responsible for the current situation as some have suggested.

There is no doubt that the rating agencies had access to all of the documentation and we must presume that they were satisfied with the contracts that would oblige the major Canadian and foreign banks to provide liquidity if ever there were a margin call and the trusts were unable to issue new securities in the market. But before assigning the blame to the rating agencies, there is good reason to ask about the precise terms of these contracts - information that, as investors, believe it or not, we still do not have access to.

The reluctance of the banks to provide us this information should push us to press the issue more forcefully. Bear in mind that 35 billion dollars in liquidities were frozen overnight, and months later, we still do not have access to the documentation that would enable us to determine where the fault should lie.

• Should it be with investors, who may have bought instruments without enough knowledge about the underlying assets?
• With rating agencies, who have been too liberal?
• With overly complex structures?
• Or was it just simply a breach of contract by the insurer with respect to the trusts?

Having said that, let me emphasize that given the state of the crisis, even if it is true that the interests of various stakeholders differ, it is in all of our interests to find the best possible solution. Disorderly liquidation of the assets underlying the various securitization instruments would not be good for any of the participants.

In the current crisis, people seem to be suggesting that there is a bit of a divide between Toronto and Montréal, something that in my opinion does not exist. The differences lie in the role that each played: investor, agent, swap counterparty or liquidity supplier. The major Canadian banks helped maintain liquidity for their securitization vehicles, while some major Canadian and international banks did not contribute the expected liquidity for non-bank securitization vehicles.

Moving forward, it is highly likely that both investors, provincial and federal regulators will turn a critical eye on the launch of new securitization products.

Furthermore, they will insist on greater transparency and insure that liquidity clauses are comparable with European and American liquidity clauses, so that margin calls cannot jeopardize a vehicle's survival. The Bank of Canada, for its part, has been highly active and has shown its openness to quelling pressures on credit markets and thus ensuring that the Canadian capital market was not overly hurt by the waning global crisis.

So, what should we learn from all of this?

The current economic environment

As you know, the first "jolts" could be felt in the month of July when we could see pressures mounting on the CDX and ITRAXX indexes. In Canada, the crisis peaked around the middle of August. During one session, the CDX, which last spring traded at about 30 basis points peaked at more than 100 points to close at 80. In September, market conditions seemed to make a partial comeback. In fact, after the sudden collapse in markets everywhere in the West, in many cases a drop of more than 10%, we witnessed a rebound of the stock market indexes as a whole. At the end of September and beginning of October, we actually saw the market hit new heights.

For their part, the credit spreads began to come down gradually. In fact, from the peak of 100 points, they came back into the neighborhood of between 40 and 50 points. We were more confident about the future. It seems as though the markets had underestimated the losses that would be posted by brokers and more generally, by large financial institutions throughout the Western world.

Whether it was Merrill Lynch, Barclays, or large Canadian or foreign banks, every institution was hit, in one way or another by these bad loans, which were a major factor in the crisis. Not only did these leading institutions have to post losses, they had also seriously damaged the sources of recurring revenue that the complex structures of derivative products and accounts had given them.

The reaction to these poor results, magnified by rumors surrounding certain financial institutions, was a "somersault" in the stock markets. More than once, we witnessed feverish activity, where indexes might drop 2% in a single session, but then close unchanged, or simply drop 2% and close there.

For my part, I remain convinced that despite the peaks that we are experiencing on credit spreads, or that we have experienced so far, we will, one day, see the return of a more stable environment. That said, there are certainly some lessons to be drawn from this and I will talk about those shortly. Now coming back to the ABCP, it is clear in my opinion that although a complete resolution of the various trusts has not yet been announced, major progress has been made. The involvement of JP Morgan as a financial advisor is a good addition toward the resolution of the situation in a positive direction.

As you know, the pan-Canadian investor committee, in conjunction with various stakeholders, should announce the conclusions of their efforts to restructure ABCPs on December 14, 2007.

My colleagues and I are actively involved in the restructuring of the securitization trusts. I am pleased to confirm today that we are finalizing the restructuring of Skeena, a 2 billion dollars trust where all the investors, large or small, the banks, and financial agents have all made compromises to come to an agreement.

There will be new securities issued, with terms that this time will be compatible with the underlying asset. These securities will have an excellent credit rating and there will be no potential for a margin call.

This is an eloquent demonstration of how, if we all work together honestly to resolve the ABCP crisis, we can emerge without any of the parties suffering significant losses.

Incidentally, as you all know, the Montréal proposal which, in general, is aimed at converting short-term commercial papers into variable rate term bonds, already has the support of over 80% of investors. This means that a large majority of these investors are participating and/or staying very up to date on the ins and outs of the consortium's work.

I said earlier that there were lessons to be drawn from this situation.
For my part, I believe it is our duty to learn from this experience.

First and foremost, it is imperative that to the extent possible, the terms of the funding should be compatible with those of the assets. Over the last decade, there have been serious abuses in which too great a proportion of assets were financed with a short term loan and eventually, synthetic products have to be used to offset the spreads. We owe it to ourselves to fully understand the risks inherent in the assets underlying these products. The days of the simple swap of interest rates are over in financial markets, and indirectly, the products have become much more complex.

Second, I recommend that promoters remain accountable, one way or another, for the loans and or structure that they promote. Too many financial engineering are structured with a view to rapid resale. The financial agents, once their commissions have been secured, simply walk away from the deal and wash their hands. It would be interesting if, instead, each sponsor not only had to be a solid financial firm, but also be subject to be regulated by a competent regulatory authority. I don't think I need to point out that greed is not the best advisor.

Third, it would be highly preferable from now on that more than a rating agency be asked to rate a security in order to have a second opinion.

Thank you for giving me this opportunity to express my views on this important subject and hopefully to shed some light into this unique situation which as I said earlier, is still unfolding and I hope we will be able to explore the outcome of this crisis in greater depth sometime soon.