Dealers are developing bespoke structures to arrange secured funding for liquidity-constrained peripheral banks, with some in advanced talks with real-money investors – fund managers, hedge funds, insurance firms, etc – looking to step in and provide financing to these institutions.
“Investors are more engaged in conversations about taking on secured peripheral bank risk, provided the haircuts are right,” said a European head of credit trading at a major house. “The trades aren’t widespread yet, but investors’ attitudes have changed compared to six months ago, with people starting to look at more illiquid assets. If spreads continue to tighten, we’d expect to see more activity.”
Estimates vary, but major dealers are thought to have extended as much as €40bn of liquidity to peripheral European banks through secured financing of assets ranging from covered bonds to RMBS, CMBS and loan portfolios.
But the reluctance to take on more peripheral exposure has led some houses to encourage cash-rich real-money investors to step in to these transactions. Dealers directly intermediating back-to-back repo transactions has its downsides, though, as the repo still sits on the balance sheet of the dealer, which also retains exposure to the peripheral bank.
As a result, some dealers are establishing off-balance sheet special-purpose entities, which issue notes to investors secured on peripheral bank assets. The dealer acts as arranger for an upfront fee. The SPE would be over-collateralised by assets with appropriate haircuts, while the transaction might be around three years in maturity.
The structure would look to pass on as much risk as possible to the end investor, although one senior European banker conceded his institution may have to retain some risk by acting as swap counterparty to the SPE. “The concept is very similar to a covered bond – the main difference is that the collateral is not prime real estate,” the banker said.
Some dealers have questioned whether peripheral banks will agree to the punitive funding rates on their more illiquid assets that investors will likely demand. However, for institutions looking to lock-in longer term funding on illiquid assets, the senior European banker argued the structure makes sense.
“The funding would definitely be punitive, but they don’t have much choice – they’re locked out of the market,” he said. “They can’t sell the assets because they don’t have the capital to take the losses, so they need to carry on funding and see the market recover. By locking in funding for two to three years they at least get some peace of mind.”
Some market participants are sceptical about dealers intermediating trades, though –whether on- or off-balance sheet – and take a different philosophy to improving peripheral banks’ funding situation.
“Back-to-back repo trades only succeed in tranching a dealer’s funding risk, not its credit risk exposure,” said Oldrich Masek, head of EMEA securitisation at JP Morgan in London. “We’re not in the intermediation game as we’re not balance sheet constrained. The amount of business we do is driven by client relationships and risk management.”
“Repo is a good tool in these types of markets, but it’s not meant to be a permanent part of the capital structure of these institutions. We’re using these facilities as bridges for clients, while helping to open up capital markets for them.”
Risks
Most dealers claim their attempts to syndicate funding risk are driven by balance sheet constraints. However, the sizeable exposure they have already built up to peripheral European banks through repos is also likely to be a consideration.
While all dealers stoutly defend their risk management processes, the correlation between counterparty and collateral is, nonetheless, an unwelcome by-product of these transactions. It’s also unavoidable: Spanish banks, for instance, predominantly own Spanish assets and will look to post them as collateral in repos.
“I think a lot of dealers have taken down significant wrong-way risk on their books,” said the head of credit trading. “Every dealer has its own haircut requirements, and some are more stringent than others. Haircuts are an art not a science, though – there’s no magic number where you’re safe.”
Dealers can mitigate wrong-way risk by overlaying hedges with credit default swaps or other instruments and setting appropriate haircuts and collateral triggers. The liquidity of the assets being pledged is also a crucial consideration. Dealers indicated the majority of liquid assets have already been cherry-picked for repos, meaning that it will be the more illiquid assets that peripheral banks look to fund in the future.
“It is important to look at the liquidity of the underlying assets. If there is a Spanish banking crisis, how much will asset values fall and how many other dealers are in the same position as you?” said the senior European banker. “I think banks have been providing funding over the last year and are now at the edge of their comfort zone.”
Another avenue for peripheral banks – selling illiquid assets – remains unpopular due to the capital hit banks would take on positions trading well below par. Dealers predict these sales may pick up in the coming months as spreads recover. In the meantime, though, repo trades have become a vital funding tool.
Christopher Whittall