Credit crunch claims victim in Canada

The global credit crunch claimed a Canadian victim yesterday, as financing company Coventree Capital Group Inc. saw its stock plummet on news that investors have turned their backs on its $16-billion portfolio of loans.

In a move that speaks to the market's newfound aversion to risk, Toronto-based Coventree reported yesterday that "unfavourable conditions" in credit markets meant it could not find investors for $250-million of asset-backed loans that came due yesterday. The move knocked backed Coventree's stock price by 34 per cent.

Coventree's woes come on the heels of global debt market turmoil that has seen hedge funds blow up, France's largest bank, BNP Paribas, freeze withdrawals on three asset-backed funds and a government-based bailout of a German bank burned by mortgage investments.

Coventree, Canada's largest independent player in the $120-billion domestic asset-backed security market, ran into trouble after investors big and small woke up to the risks that come with making loans, after years of carefree lending.

"Our attitudes towards risk are not always rational. Risk aversion is something we learned in the jungle, it's not always based on science," said Alan White, a finance professor at the University of Toronto's Rotman School of Management.

Prof. White compared what's happening now to the Russian debt crisis of 1998.

"You get these situations, where fund managers who are happy to hold Russian bonds one day are suddenly unwilling to hold that paper, at any price, the next day," Prof. White said. "I hate to use the word irrational, but there is an element of that kind of behaviour at play. People are scared."

Coventree is a classic go-between, caught in a market that has turned on its products. Founded in 1998, it buys and packages a variety of long-term debt from other companies, and resells the loans as what's known as commercial paper to investors such as money market mutual funds. Commercial paper is short-term debt, due in under a year, that companies can issue without having to register with regulators.

Retailers, for example, sell Coventree the credit card loans they extend to customers. Auto makers pass on car loans. Banks hand over residential mortgages, which can include the U.S. subprime mortgages that have spooked markets.

Coventree bundles up $16-billion of this debt with flashy names: Rocket Trust, Comet Trust and Apollo Trust are among the nine trusts it sells. Coventree trusts are sold to institutions looking for low-risk, short-term debt that pays slightly higher interest rates than Government of Canada bonds.

As recently as a month ago, Coventree could attract investors by offering a premium of just eight basis points to government debt. (There are 100 basis points in a percentage point.)

Then the bottom fell out of the American subprime mortgage market, as investors woke up to the fact that many of these home loans will never be repaid. Lenders around the world turned off the taps, sending credit markets reeling. Coventree doesn't tell investors exactly what is in each of these baskets of loans. When markets turned ugly, that lack of transparency undermined confidence.

By last Friday, the premium on Coventree commercial paper had ballooned to between 40 and 60 basis points. Yesterday, there were simply no buyers.

"You may be looking at the next leg of a deeper debt crisis, as problems in subprime mortgages give way to problems with liquidity in the asset-backed market," said one Canadian fund manager who invests in Coventree's trusts.

"In Coventree's view, problems that initially seemed isolated to a few U.S. subprime mortgage lenders have led to broader concerns related to debt capital markets generally," Coventree said in a press release. The company added that "with the involvement of key industry participants, this market disruption can be addressed."

Those "key industry participants" include the big banks, which Coventree has tapped for $700-million of loans to fund all but one of its nine trusts.

The banks signed agreements to provide this liquidity, though according to documents related to the trusts, the banks can sidestep the obligations to provide loans if there is "any diminution of the creditworthiness of the Trust or any deterioration in the performance of the assets of the trust."

In addition to the bank funding, existing investors who held $250-million of securities that came due yesterday are being forced by Coventree to continue holding the commercial paper. The company has the right to do this for up to one year.

Coventree itself has no legal obligation to backstop the trusts if the banks don't come through, but has said in filings that it may do so to protect its reputation and ability to do business in the future. "If Coventree were to support its conduits in such circumstances, the cost of such support could require the expenditure of significant amounts of capital and significantly reduce Coventree's profitability," the company stated.

Trading in Coventree shares was halted briefly yesterday on the Toronto Stock Exchange, before the company explained what was happening to its trusts.

DBRS Ltd., which awards seven of Coventree's trusts the highest possible rating for commercial paper, said that, in its opinion, Canadian asset-backed commercial paper conduits "continue to perform in a manner that is consistent with the ratings that were originally assigned."