DCM 2007: May you live in interesting times
Lacking liquidity and confidence in equal measure, the European financials market has floundered since late July and has been severely stress tested since. The run on Northern Rock notwithstanding, broad consensus is that the fundamentals for the banking system remain sound and banks are, by and large, well capitalised. But it will be a while before they can overcome the period of pain. Malini Menon reports.
Even though the European FIG primary market has seen step-by-step reopening - starting with Deutsche Bank's 10-year fixed-rate senior deal through the dual-tranche 10-year LT2 from BNP Paribas to the recent five-tranche, multi-currency, step-up and non-step Tier 1 transactions from RBS - it will be a while for the market fully to regain its composure.
Recent issues in the investment-grade credit market clearly demonstrate it has undergone a dramatic repricing from the bullish levels seen at the beginning of this year. The balance of power now clearly lies with investors, who can now no longer complain about flat credit curves and the lack of diversification of sector spreads.
Over the summer, spread widening across the financial capital structure ranged from 120bp in Tier 1 to 26bp in senior paper issued by banks, according to figures from UBS. Within that range, LT2 spreads have been the major underperformer, moving out an average of 60bp.
Current spreads, which are four to five times wider than the levels seen in June, reflect several facts. The absence of bank investors and money-market funds in the financial credit arena as a result of turbulence in the money markets means that asset managers and pension funds now constitute the bulk of demand. As a consequence, the floating-rate note market has dried up and most of the supply has been in longer-dated (five to 10-year) fixed-rate paper. This is not the historical investor base for senior bank credit as return constraints are generally higher for this type of account.
Wider spreads have made the senior bank sector an attractive investment. Besides, as opposed to banks, asset managers and pension funds do not benefit from a favourable Cooke-weighting treatment (minimum capital requirement on a risk-weighted basis) while buying banking paper, which drives spreads wider. This reduced investor base has led to a shift in the pricing power from borrowers to investors, with a widening effect on new issue conditions.
Moreover, the current uncertainty about how the sub-prime crisis could affect banking results constitutes a negative credit environment that justifies wider spreads, according to market participants. "At current spreads, we believe that most of the risks to the banking system are priced into the market," says Joseph A. Biernat, director of research at European Credit Management.
This pricing environment has not prevented financial borrowers from tapping the market, which is now open for prime accounts (Double A or strong Single A rated main financial institutions), both in senior and subordinated formats. For second-tier financial institutions, it is a case-by-case situation. "Before the year-end, we anticipate a normalisation of this situation, with investors increasingly open to taking on paper from the rest of the European financial institutions. Spreads will, however, remain wider than the pre-crisis levels," says Demetrio Salorio, deputy-head of debt capital markets at SG CIB.
It is not only the investor base and spreads but also the method of price discovery that have undergone change as the illiquid secondary market has failed to throw up relative value comparables. Bankers are now, in turn, directed towards CDS levels to build upon relative value discussions.
"In volatile times, credit indices and their associated derivative contracts might be the only way to hedge global credit exposures on asset portfolios, as there is no other final demand to buy protection on specific names," says Salorio. "In the current crisis, we have seen a huge increase in the volume of the iTraxx (Main and Crossover) contracts reflecting this point. Thus, the iTraxx constituted a fair proxy by showing the overall credit market mood while volatility was at its peak. However, as the emphasis moved from credit concerns to liquidity concerns, we saw the iTraxx trading down while the cash market was widening. This was mainly due to the fact that derivatives over the iTraxx are unfunded instruments. This might also be one of the explanations as to why new issue premiums are currently coming at a substantial premium to CDS," he explains.
More crunch time ahead
The median real global credit growth, which peaked at 14% in 2006 (its highest since the eve of the 1997 Asian crisis), is expected to slow to around 9% this year, according to Fitch Ratings.
"Credit crunches are a regular feature of the economic cycle. For those who are exposed to the withdrawal of credit, the consequences are severe, and can be traumatic. But for investors in bond and equity markets, the peak of the credit cycle is a significantly positive milestone," says Max King, investment strategist at Investec Asset Management. “Bond markets respond favourably to the prospect of lower interest rates as the inflation threat recedes and equity markets soon follow, even though, typically, earnings growth comes under pressure,” he adds.
Though central banks' recent actions have succeeded in unfreezing money markets, allowing the absorption of maturing asset-backed commercial paper without major hiccups, neither money nor broader credit markets have so far returned to the to the conditions prevailing before the crisis.
Term lending in the interbank market is still sluggish, but market participants observe that the odds of the crisis worsening have diminished and there are grounds for firmer conditions ahead. One key for both the money and credit markets will be a reduction in the backlog of the approximate US$350bn of leveraged financing waiting to be syndicated to the general market by underwriting banks, notes Biernat.
While previous credit crunches resulted from tight monetary policy, modern ones are caused by psychological shocks to market confidence leading to a flight to quality. "The problem is that central banks were designed to handle bank runs, not market confidence crises," says Christopher Mahoney, vice chairman at Moody's Investors Service.
"The challenge is to ensure not just liquidity but fluidity throughout the system, ensuring that systemically important non-bank financial institutions obtain vital funding.”
Unlike the ECB and the Fed, the Bank of England initially adopted a hands-off approach, refraining from injecting liquidity in the money markets until September 14, an approach that culminated in the Northern Rock fiasco - Britain's first bank run in more than a century.
"Repricing and reallocation of risk has to happen as banks look for new homes for some of their assets. While central banks should not act in a manner to help or to reward banks that have taken excessive risks in the past, they have to help the markets stay orderly as the asset transfer takes place, or else risk economic damage," says Andrew Sutherland, head of credit at Standard Life Investments.
"Central banks are currently torn between maintaining relatively high base rates to contain inflation risks and limiting the economic fallout from the US sub-prime lending crisis. These conflicting pressures are likely to weigh on investor sentiment," says James Carrick, investment strategist at Legal & General Investment Management.
"The major risk is not that the credit crisis spreads into the real economy, but that it doesn’t," says Investec's King, presenting a contrarian view. "If central banks cut rates too far, too fast or pump too much liquidity into the monetary system, the current storm might blow over, but will be followed by a bigger one in a year or two. Bond markets, not economists or market commentators, will be the best judges of whether monetary policy is appropriate."
"If bond yields stay down, then attractive equity valuations in both absolute terms and relative to bonds combined with continuing robust earnings growth offer the prospect of very good equity returns over the next 18 months. An economic slow-down is likely to represent a much-needed rebalancing of the global market, with Asian and emerging economies relatively unaffected, the mirror image of the crisis 10 years ago. This is a time for investors to be brave, not to lose their nerve," says Investec's King.
Where to from here?
In the medium term, the market needs to address the broad question of whether the 50bp cut in Fed fund rates on September 18, only perpetuates the notion that it is merely bailing out excessive risk-takers, according to one bank strategist.
For investment-grade credit, it is expected that the initial sharp move tighter based largely on Street short-covering will now slow down. Market participants argue that there will be continued apprehension for a while as a result of the possible quantity of supply. There will also be concern about how much re-pricing would take place, but the market is sure to find a new clearing level. Already, new issue premiums are beginning to decline, according to some bankers. The bid for secondary product has been lacking, but a period of stability in the market would likely entice buyers of risk back and halt redemption flows. For now though, accounts are concentrating on mopping up the cheap primary supply.
Pressures on banks' profitability are expected to increase as demand growth slows down, consumer credit quality deteriorates and liquidity remains tight as uncertainties remain. "The strength of franchise, robustness of risk management and adequacy of liquidity contingency plans of many financial institutions are likely to be tested," says Roger Lister, chief credit officer of US financial institutions at DBRS.
"In Europe, we expect the recent market disruption will encourage money-market fund managers to exercise more prudence when choosing securities," says Francoise Nichols, associate director at S&P.
"We expect market and official pressure to require greater transparency from financial actors, to introduce larger liquidity buffers into the system and to consider ways to introduce automatic stabilisers to counter some of the pro-cyclicality inherent in an increasingly market price-sensitive accounting system," adds Moody's Mahoney.