Consolidate or evaporate
Wide-spread deleveraging was always expected, yet the ferocity of the unwind since mid-September has shocked many. It has not only shut down most primary markets, but also dramatically altered the global financial landscape, with nationalisation and consolidation the main themes, alongside the end of the era of light-touch regulation. Malini Menon reports.
Every crisis has a turning point. The Lehman Brothers bankruptcy filing on September 15th was arguably the watershed moment in the current one. After attempts to sell the broker as a whole failed, Lehman Brothers was left with little option but to file for bankruptcy. It opened a Pandora's Box of counterparty risk and recovery rate suppositions, and turned the too-big-to-fail assumption on its head.
Why was an assisted takeover handed out to Bear Stearns in March, while Lehman was left to fend for itself? The US authorities felt that the bankruptcy of Bear Stearns would have caused systemic risk, while that of Lehman would not. Yet the market disruption caused by Lehman's demise has prompted the authorities to look at a US$700bn bank bailout package, dubbed Troubled Asset Relief Programme (TARP). Though the initial proposal was rejected by the US Congress, the diluted second version eventually was approved on October 3rd.
"With the TARP solution being passed in the US Congress, at least a back stop bid has been created for troubled assets and that should help liquidity," said a senior FIG DCM banker.
Prior to the Lehman collapse, the Fed put Fannie Mae and Freddie Mac on conservatorship, undertaking to inject capital to keep them solvent. The expected cost is around US$100bn each, and the move effectively guarantees senior and subordinated bonds. These entities were seen as too big to fail.
Within a fortnight of the Lehman collapse the US authorities extended an US$85bn term liquidity line to AIG, at a penal rate of 8.5%, in exchange for 80% government ownership whilst the line is outstanding. AIG was seen as systemically important, but the Fed was reluctant to provide a full guarantee.
A commercial solution was hastily worked out by Merrill Lynch, before it too fell prey to market forces following Lehman's downfall and was acquired by Bank of America. That just left Morgan Stanley and Goldman Sachs as pure investment banks. The writing on the wall was clear: pure investment banking as a model will not work if access to the wholesale funding market is disrupted.
Before the full weight of the market fell upon them, the two opted for a dignified exit, converting themselves into commercial banks. It gave them immediate access to liquidity provided by the Fed and future access to cheaper source of funding, via bank deposits, when they open shop under their newly acquired status.
This, along with some capital infusions – from Mitsubishi UFJ for Morgan, and Warren Buffet for Goldman – calmed collective nerves. The changes in status, however, will put them under the Fed's oversight, which means more stringent regulation and a considerable scale-back on risky businesses.
On September 25, battered Washington Mutual was shut and its assets seized by the Federal Deposit Insurance Corp, following US$16.7bn of deposit outflows since September 15.
While selling the bulk of WaMu's assets to JPMorgan, the FDIC said the acquisition does not cover claims of Washington Mutual equity, senior debt and subordinated debt holders. It was Wachovia's turn next: an assisted takeover was proposed, with Citi set to acquire almost all of Wachovia Bank, using the negative goodwill to write down the problem loan book. FDIC were to take loan losses above a certain level in exchange for a hybrid note issue by Citi.
The fluid state of the current market was amply reflected on October 3rd, when Wells Fargo surprised the markets by announcing that it had signed a definitive agreement with Wachovia for the merger of the two companies - including all of Wachovia's banking operations in a whole company transaction requiring no financial assistance from the FDIC or any other government agency. Wells Fargo said it will buy Wachovia for about US$15.1bn in an all-share merger. The deal, if approved by the regulators, will see Wells Fargo acquiring all of Wachovia's preferred equity, indebtedness and banking deposits.
In Europe, which had seen IKB Industriebank, Northern Rock and Roskilde Bank seized by their respective authorities as the credit crisis deepened, the body count rose a further five in September. Government equity injections were administered to Fortis, Glitnir, Hypo Real Estate and Dexia to prop them up, while Bradford & Bingley was assumed by the UK Treasury. B&B’s retail deposits and branches were sold off to Spanish banking giant Santander, after the Treasury failed to find an outright buyer. Back in July, the Spanish bank had acquired Alliance & Leicester for £1.3bn in an all-share deal.
In a clear sign that desperate times call for desperate measures, competition rules were brushed aside to pave the way for Lloyds TSB to acquire struggling HBOS (pending shareholder and regulatory approval).
Survival of the fittest
Investors struggled to keep pace with these rapid changes and their implications. The Lehman collapse left a web of counterparty risk linkages, but they also had to determine which swaps needed to be torn up, and what re-hedging needed to be done. It also exposed senior bondholders to massive losses for the first time during this credit crisis.
"If a regulated entity like Lehman Brothers is pushed back to the wall, with senior debtholders losing anywhere between 15 cents and 20 cents to the dollar, it tells you an awful lot as to what those debt investors would demand going forward," said an asset manager.
Bankers agreed: "We expect banks to face increased difficulties in raising term funding, as we see further deterioration in the average credit quality of financial institutions, coupled with growing supply pressures, which will increase not only the cost of financing but also execution risk," said Siddharth Prasad, co-head of EMEA FIG CM&F at Merrill Lynch.
The WaMu situation exacerbated the problems. FDIC said the US$1.9bn JPMorgan Chase acquisition of WaMu's branch network does not cover the claims of Washington Mutual equity, senior debt and subordinated debt holders.
It introduced a new, and possibly specifically US element to the problem, the effects of which will reverberate around the world; other jurisdictions may also incorporate regulations to protect against this eventuality.
"The implication of this move is huge,” said Prasad. “This is the first time ever that a deposit taking bank's senior bondholders have been hung out to dry. The markets will remain shut for a while, as investors will take their time to recalibrate risks.”
Analyst estimates ranged from a 50% recovery rate for WaMu senior unsecured bonds down to nothing. WaMu's senior bonds at the holdco level were trading at 4%–14% and at 7%–17% at the bank level on September 26th in the cash market. Meanwhile, Lehman Brothers senior bonds were trading at 13%–14%.
This is a concern not only given the €258bn of term debt maturing between now and year-end for European banks, but also with the broader need to term out liability profiles.
Upcoming maturities pose a problem for financial institutions. The term markets would command an extravagant spread, while the money markets are heading into a deeper freeze. Banks, brokers and other financial institutions have US$660bn in bond debt maturing over the next year, according to JPMorgan. The total debt of Asian investment-grade financials maturing between now and year-end is €7.579bn-equivalent, according to a Thomson Reuters estimate.
When some form of stability and confidence returns to the market, a defensive instrument – perhaps a short-dated senior trade from a "safe" issuer – would be the first to get off the mark, said many market participants.
Bankers expect substantial tiering between the haves and the have nots, and expect banks with the highest leverage and highest loan-to-deposit ratios to further underperform.
"We are now entering the final and worst phase for financials," said a FIG DCM banker. "The weak ones are being shaken out, while the strong ones – those with a broad funding base and broader business model – will survive. Next, we could see more mergers in Europe, but then I would expect spreads for financials to stay stable at wider levels."
"If we go back to basics it is clear that the crisis started because banks had in their balance sheets assets which were overvalued," said Demetrio Salorio, global co-head of debt capital markets at SG CIB, adding that an orderly deleveraging is what it takes to bring stability to the market.
Concerted state intervention is the best crisis management tool, as evidenced by the Irish government's move to provide state guarantees to deposit holders, senior and dated LT2 bondholders (both existing and new) of its top six domestic banks until September 28, 2010.
Meanwhile, countries are looking at tightening regulations and increasing depositor protection. The European Commission has proposed changes relating to the management of large exposures, the supervision of cross-border banking groups, hybrid capital, liquidity risk management and risk management for securitised products.
As the assets that have gone into the pools covering WaMu's covered bonds are deemed safe, participants hope that secured financing in the form of a such a product might help create a mechanism whereby banks would come back into the market.
"Right now, banks have the legacy issues across jurisdictions to be dealt with. Then, they could look forward and develop platforms and programmes that work for increasing ongoing lending for various asset classes, which can keep economies moving forward," said one source.
Until such time, market participants have to grapple with a dead primary market, a malfunctioning money market, flight to quality, fickle, volatile market backdrop and ever-widening spreads.
(Disclaimer: In this constantly mutating world of financials, parts of the report face the risk of being dated when it comes out. All facts accurate as on October 3.)