The Black Box

Topics: Subprime mortgage crisis, Moral hazard, Financial crisis Pages: 3 (732 words) Published: October 21, 2008
Major problems:

1- The transparency issues:

Canadian investors kept buying the commercial paper without any concerns, caring only about the high returns received. Therefore, on a “don’t ask, don’t tell” basis, banks did not feel obligated to disclose further details about the risks and nature of the ABCP or the assets underlying it

Considering that the banks earn a transaction fee from selling securities, it may have been more profitable for them to hide the risks from investors and increase sales

The bank’s failure to advise clients about the nature and risks of these investments is a result of the moral hazard problem; this raises questions about the transparency of these transactions and conflict of interest between the bank as both a profit-seeker and dealer of ABCP

This lack of transparency eventually played a large part in causing a credit crisis for the ABCP trusts

Without explicitly knowing, Canadian investors had been exposed to the subprime mortgage crisis in the U.S. through ABCPs; this caused a sudden loss of confidence and contraction of the ABCP market due to decreased demand coupled with excessive supply

With no investors buying the paper, issuers were left unable to raise the necessary funds for the two-thirds of $33 billion ABCP currently maturing

If the investors had known accurately about the underlying assets of the commercial paper, they would have been able to weigh the risks of the U.S. subprime crisis on Canadian markets appropriately (Exhibit 1)

2 - The regulatory issues:

The ABCPs had built in a variety of insurances against disaster, including emergency liquidity support agreements for trusts by banks in the case of liquidity problems

However, the conditions of these agreements, drafted by OSFI, favour the creditors by the general wording of the conditions in which a bailout was necessary: a “general market disruption”

Two of the world’s biggest rating agencies (Standard &...
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