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Caisse commercial paper accord prevents anarchy in derivatives

On the surface, Deutsche Bank's actions last week made no sense. One day, the German bank is helping to create a crisis in the commercial paper market by refusing to backstop certain issues of this short-term debt as it comes due. The next day, last Thursday, Deutsche Bank steps forward as a player in the asset-backed commercial paper bailout package unveiled by the Caisse de dépôt et placement du Québec. What looks like a flip-flop is actually a sign of a credit crunch bailout that was complex, and extremely alarming. Credit the Caisse and National Bank with leading a rescue plan that not only thawed a frozen commercial paper market, but also prevented a meltdown in derivative markets that could have been ugly. Here's what was going on at Deutsche Bank, and a number of other big players, when the market dried up for about $40-billion in paper issued by non-bank financial companies such as Coventree. These banks refused to provide loans to backstop the commercial paper because they believed they weren't required to do so. Under their agreements with issuers such as Coventree, this emergency liquidity only came into play if credit markets shut down completely. That never happened, as lots of other commercial paper programs were going strong last week. (Two rating agencies, Standard & Poor's and Moody's, turned up their noses at Coventree's commercial paper in part because it lacked strong liquidity guarantees. Dominion Bond Rating Service awarded its highest rating.) However, the portfolios of debt underlying the commercial paper programs were neck-deep in derivatives created by Deutsche Bank and rivals. These collections of mortgages, credit card debt and auto loans were packaged with credit protection and other derivatives guaranteed by global banks. If companies such as Coventree started to default on commercial paper, and they were on the verge of doing so last Thursday, the worst-case scenario would have been a liquidation of billions of dollars in debt, creating a nightmare for derivative markets. The banks would have taken enormous short-term losses, as they were forced to put a price on derivatives contracts for debt that suddenly had no buyers. There would have been a furious fight over who owed what on broken derivative contracts. Shock waves would have rolled through credit markets that were already shaky. That's why a long list of banks signed on to what folks are calling the Montreal proposal, a plan to convert about $40-billion of short-term commercial paper into long-term floating rate notes. Along with National Bank and Deutsche Bank, the supporters are ABN Amro, Barclays, Desjardins, HSBC, Merrill Lynch and UBS. All of these banks likely sold derivatives that underlie Canadian commercial paper. They are taking their lumps by extending the life of those derivatives. Thank goodness they are doing so, as the alternative was anarchy in Canadian debt and derivatives.