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September 2007

The credit crisis: How this happened

‘The credit crisis: How this happened’

by Canadian Business Senior Writer Jeff Sanford

Canadian Business, September 5, 2007


It was late July, and Adam Breslin, a partner at Penfund, an independent merchant bank based in Toronto, noticed fewer people than usual were on vacation. Financial types usually decamp from Bay Street’s sweaty canyons for the cool woods of Muskoka by then – not this year. For Breslin, bankers running hard to get deals done provided evidence of one thing: the peak in the Great Liquidity Event of the Century had arrived.

It was high time. John Bradlow, another partner at Penfund, expresses incredulity at the levels of leverage and excess that had developed in the credit markets. “It’s amazing. We’ve never seen anything like this. It’s looser than I’ve seen in either ’98 or ’88.” The evidence? Companies leveraged up to seven times EBITDA. Convenants on private equity deals that became ever lighter. The appearance of toggle bonds – which let a company pay interest by issuing more debt instead of parting with cash. The denouement had to be near.

Sure enough, it arrived two weeks after Breslin’s observation. The S&P/TSX composite dropped 500 points in a morning. In the States, Mad Money guru Jim Cramer descended into inanity on CNBC. And U.S. Federal Reserve chairman Ben Bernanke dropped more money on markets than Alan Greenspan did after 9/11.

The beginning of the end actually occurred late last year, when U.S. mortgage originators that had been writing so-called sub-prime loans began going under in large number. Then, in January here at home, Toronto-based Dominion Bond Rating Service announced it would tighten requirements for assigning ratings to controversial non-bank asset-backed commercial paper conduits, which often held sub-prime mortgages. But the big fun kicked off in July when a German bank, IKB, announced it wasn’t able to roll over the short-term paper in one such conduit. The sell-off of August 2007 began.

How did it get to this point? Over the past decade, a slew of mortgage loan originators with names like Homeside Lending and Plaza Home Mortgage wrote some US$100 billion to US$200 billion in subprime loans and packaged them (along with all kinds of credit-card debt, car loans and standard mortgages) into collateralized debt obligations, or CDOs. These structured products are bundles of loans from banks, sliced into various new securities that receive various credit ratings.

This isn’t bad, in itself. Securitization does have benefits in terms of risk diversification. But many CDOs came to be held in highly leveraged vehicles and, in some cases, offered investors access to high-yield return through the issuance of so-called asset-backed commercial paper (ABCP). One Canadian example, Coventree Inc. (TSX: COF), at one point offered $1,000 of long-term, high-yield debt exposure for just $100. By investing in these conduits, you could squeeze out an extra five to 10 basis points of return over similarly rated traditional commercial paper. So why not do it? For investors looking for income in a low-rate environment, it was a deal.

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About Penfund

Penfund is a leading provider of junior capital to middle market companies throughout North America. The firm is currently investing its most recently established fund, Penfund Capital Fund VII. Penfund manages funds sourced from pension funds, insurance companies, banks, family offices and high-net-worth individuals located in Canada, the United States, the Middle East, and Europe. Penfund has invested more than $3 billion in over 225 companies since its establishment. Assets under management are approximately $2.8 billion.

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