Putting the system together again
After a turbulent six months of discontent among covered bond participants, a consensus on the future of market making has yet to be reached. Various regulatory bodies have attempted to resolve this impasse but it seems the market is tentatively finding its own solution through the re-pricing of debt in the primary market. Mike Winfield reports.
Following a meeting held in mid-May a number of market participants put forward proposals to offer a screen-based trading platform for covered bonds. "Many traders say that the old market making obligations can no longer be supported in current market conditions and that it will be to everyone's advantage to improve market transparency," said Richard Kemmish, chairman of the market related issues working group at the ECBC, which arranged the meeting. "However others say that the old rules have served the market well and can continue with only minor modifications."
As a result BGC Partners, Bloomberg, EuroMTS, Eurex, ICAP and TradeWeb have presented their proposals, some of which embrace electronic price quotation based on requesting prices from competing trading firms – or a system of auto-executable prices. There remains, however, the caveat as expressed by Ralf Grossmann, head of covered bond origination at SG CIB: "It is difficult for any system to be completely infallible, especially considering the gyrations of the market seen since last summer, and in that respect flexibility will be required of whatever platform(s) it is decided to adopt as part of the medium term objective of the ECBC group."
This development is the latest attempt to find a sustainable solution to the breakdown in secondary market liquidity following the advent of the credit crunch last summer, accompanied by heightened volatility in the world's stock markets. The resultant change in the credit perception of the world's major banks created major dislocations in the Libor curve, the prime reference point used in the pricing and trading of covered bonds. The ensuing pace of the changing Libor valuations proved too much for banks participating on MTS, the dominant inter-dealer market making system, resulting in the abandonment of electronic trading. Despite efforts by MTS to restore liquidity in the following months, the unwillingness of the banks to take on additional risk through dealing with their competitors has remained central to the ongoing debate over how to restore liquidity in the covered bond market.
Prior to the events of last summer the prices of covered bonds, as well as those of many European agency issuers, were provided by banks who displayed live tradeable prices over the MTS electronic platform to each other. Against a background of relatively stable swap spreads, both these markets were widely regarded as quasi-rate products, with small price fluctuations largely determined by supply and demand. Pricing new issues was, therefore, relatively straight forward for frequent issuers, with good investor demand requiring only small concessions to their secondary trading levels. The interest rate swap market, through the Libor curve, provided the main reference point for comparing issues, although cash Bunds (or in some cases OATs) were often used in conjunction with futures contracts to hedge bond positions.
When volatility increased it became imperative to be hedged against something mirroring the underlying exposure. As intraday volatility became extreme, the electronic transmission of prices became a liability for the banks involved, as suitable hedges couldn't be set before the underlying market moved. "In addition to this the widening of bid/offer spreads in the government and swaps markets made the trading of covered bonds more problematic. This reached a point where it became cheaper to sell new positions than to hedge them, and the effect of relatively small tickets was to create large spread movements as the position changed hands," added Kemmish. It didn't take long before the whole system ground to a halt and even when the markets started to behave more rationally, the reduction in risk appetite continued to act as a disincentive for banks to trade with each other.
The restoration of liquidity and investor confidence in covered bonds as a rates product necessitated stable and visible secondary markets and the ability to transact in good size. By the autumn of 2007 it was hoped that the new issue market would provide stability, although the ensuing re-pricing of secondary debt (and the losses incurred in the process) failed to restore stability. This, coupled with the ongoing volatility in the underlying market, led the Financial Markets Association (ACI) to split the market in two for trading purposes. Covered bonds were to be divided between "core" and "non-core", with the core (Germany, France, Austria, Luxembourg and DEPFA – excluding structured) to be quoted at doubled bid/offer spreads, the remainder at tripled spreads.
This split inevitably led to disagreements from the Nordic issuers, who found themselves labelled non core. The European Covered Bond Council (ECBC) reacted by demanding that "any decisions adopted by market-makers represented in the ACI must be communicated to issuers prior to their release to market participants, and that above all, issuers must be allowed to comment before decisions are taken". In the autumn of 2007 it went on to announce proposals aimed at establishing a new working group to provide an advisory service to the market. The purpose of the new group was to "advise, whenever necessary on an ad hoc basis, of appropriate amendments to market-making agreements to facilitate a return to orderly trading conditions." The group consisted of one representative of the issuers of each of the eight largest covered bond jurisdictions, chosen by issuers within that jurisdiction, and representatives of the eight banks with the most market-making commitments in the euro jumbo covered bond market.
When the market did encounter substantial buying interest, as was inevitable after a contracted period of weakness, some thought the ECBC's directive on bid/offer spreads had fueled the volatility of the secondary market, depending on the jurisdiction to which the issuer belonged. As the issuers took the issuing banks to task for widening the trading spreads, those with a strong new issue franchise reacted by reducing the spread, only to then see inventories grow. The extent of price movements was accentuated by the fact that MTS, which had previously offered the quickest route to price discovery, had by this stage been deserted en masse. This meant that business was being conducted directly between banks that had reverted to calling each other by phone to ask for prices. The problem was that as management directives to limit risk were being implemented, this meant offsetting any increase in positions by selling something else, adding to the volatility.
Towards the end of 2007, following another suspension of market making in the lead up to Christmas, the ECBC again looked at how the concept of market making could be improved, or indeed improvement was needed at all. The expectation was that the backlog of 2007 issuance would be carried forward into 2008, while the functional secondary markets would assist in pricing new issues. In reality, analysts who optimistically predicted another record year for issuance in 2008 have since slashed their forecasts, the changed landscape resulting in a substantial backlog of mandated deals that are yet to be priced.
In jumbos, €32.29bn of supply (all currencies) was issued in the first quarter of 2008, a 45% decrease from the €58.83bn in the same period of 2007. Although not as stark, the downturn in all covered bond issuance has nevertheless been sizeable. In the first quarter of 2007, €67.21bn of covered bonds were issued; in the same period of 2008, the total declined by 39% to €40.76bn.
The secondary market has subsequently evolved a "gentleman's agreement" with respect to market making: requests for market makers to quote prices tend not to be made, with business instead being conducted either directly – where agreement can be reached – or through the inter dealer broker market. Some of the more liquid German and French covered bonds were migrating back to MTS as of mid-April, providing a glimmer of hope, and new issue conditions were also in the ascendancy with a number of Iberian issuers returning to the short end of the market. The return of interest in Spanish covered bonds saw a Banco Sabadell trade, the first public jumbo Cedulas to price since September 2007, described as, "interesting because it is one of the first issuers from the peripheral world that is beginning to accept it is a new world out there, and if you want to raise cash you have to pay the price" one trader said.
"Accompanying the significant improvement in spreads of bank's senior debt and some improvement in Triple A Spanish RMBS, sentiment for Spanish Cedulas was seen as improving, although negative ratings actions for a number of smaller Spanish domestic banks and ongoing supply priced with a high pick-up to secondary market spreads suggested that the environment remained difficult," said Bernd Volk, head of European covered bond & agency research at Deutsche Bank. He added "that investors have little possibility to switch their secondary market positions into new Cedulas issues, although the bid prices typically adjust to close to primary market spreads. On the other hand, investors willing to invest high volumes may have to rely on the primary market as the respective bonds may not be available in the secondary market in size."
The re-appearance of other primary market segments was seen as helping to facilitate a normalisation of secondary trading by providing new reference points around which appropriate secondary levels could be established. "Many investors who have been absent from the covered bond market for years have started to reappear with noticeable purchases at the new spread levels, said Ted Lord, managing director and global head of covered bonds at Barclays Capital. "Additionally, covered bonds are now looking increasingly attractive to corporate bonds and we have seen some investor flow into the market from this area. This new investor flow can only help the healing process in the secondary market going forward," he added.