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Wednesday, 13 December 2017

The deals: 1974 to 1983

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  • IFR Asia Review of the Year 2010

IFR’s top 40: The following selection of deals represent, if not the “best” transactions from the past 40 years of the capital markets, then IFR’s favourites. The deals stand out for a variety of reasons, but a couple of things unite them all: their ambition and their creativity. Two words that, for good or (sometimes) ill, sum up the capital markets industry in that period.

1974: Citicorp/First National City Bank’s US$650m FRN – first floating-rate note in the US

As many innovations are, the US$650m floating-rate note issue for First National City Bank (through holding company Citicorp) was controversial when it arrived in July 1974.

US laws at the time banned banks from paying more than 7.5% on long-term deposits and more than 5.5% on passbook accounts. Rival banks, worried that the new structure would divert funds that would otherwise be deposited with them, argued vehemently that the new issue violated those laws. The issuer, and its underwriter First Boston, countered that issuing through the holding company meant that the deal didn’t violate the law. After rival lobbying efforts, the latter view prevailed.

The interest rate on the notes floated at one percentage point above US Treasury bills after an initial period when they were guaranteed to pay 9.7%.

As Associated Press reported at the time, the concept was designed to offer small investors a high yield, but with an assurance that the yield would increase when rates rose.

Investors loved the issue, snapping up the paper on the morning they became available for sale. The impact was immediate, with New York Bank of Savings immediately following suit. The scene was set for all the floating-rate bond issues that followed.

1976: New York City Pension Fund US$1bn block trade – then largest ECM deal

It was by far the largest block trade in history. When the New York City Pension Fund decided in January 1976 that it wanted to sell US$500m of stocks and purchase another US$500m to create what was in effect an index fund, it turned to the only firm that could execute the trade: Goldman Sachs.

As detailed in “The Partnership”, Charles Ellis’s history of the bank, Goldman was asked to bid a single price to buy the existing portfolio and to create the new portfolio specified by the pension fund. And it had to do the whole thing “on-risk”, which meant a total exposure of US$500m.

Head of block trades Bob Mnuchin prepared to get approval from the firm’s management committee. He expected a barrage of questions. “They only asked five questions,” he later told Ellis. “And each question was laser-like in its focus on a key trading factor. We answered the five questions and there was a moment of silence and then everyone agreed. It was a go!”

Acting in great secrecy, Mnuchin’s team executed myriad trades, but ended up charging the pension fund just US$2.9m – for transactions totaling US$1bn.

It was a remarkable result, properly reflecting Goldman’s prowess in the block business.

1977: US$100m deal for Bank of America: the first private-label MBS

The creation and growth of the private-label mortgage-backed securities origination and trading business on Wall Street in the late 1970s and early 1980s at Salomon Brothers in New York is legendary.

It was also a critical turning point for Wall Street, ushering in a 30-year era where the bond market was king, bond traders became the most highly rewarded heroes of investment banking, and securitisation became one of the most lucrative and innovative pockets of finance.

Of course, the “revolution” that took place at Salomon Brothers in the spring of 1978, when the very first mortgage finance department on Wall Street was formed, also arguably led, 30 years later, to the worst recession in the US since the Great Depression.

How closely the two historical events are linked has been hotly debated. Lewis Ranieri, the “godfather of securitisation”, who led that very first Wall Street mortgage department, has gone on record in recent years as saying that it was not the concept of securitisation itself, but the new exotic mortgage loans, lack of liability, and growth of the subprime industry that ultimately sealed the fate of the pre-crisis housing/credit bubble.

Either way, the invention of MBS without government backing was a seminal event in the history of Wall Street.  Immortalised in the best-selling 1989 book “Liar’s Poker” by Michael Lewis, the story of MBS typically focuses on the brash Ranieri, a Brooklyn-born, hard-nosed utility-bond trader plucked from obscurity at Salomon to lead the brand new mortgage department because of his street smarts, drive, and aggression.

Liar’s Poker focuses on the ascension of Ranieri’s powerhouse mortgage-finance business, whose profits accounted for more than half of Salomon’s overall profits by 1981.

The creation of the first collateralised mortgage obligation in 1983, for Freddie Mac, only served to spread the wealth as other banks got in on the lucrative MBS industry. Salomon and First Boston completed that first deal.

But while Ranieri is often given all of the credit for creating the mortgage “monster”, as some might say in hindsight, it was actually his original boss at Salomon, Robert Dall, who was the brainchild behind the very first private MBS.

Dall, one of the few master-traders of Ginnie Mae MBS securities in the early 1970s, created the first private issue of mortgage securities (working with fellow trader of Ginnie Mae securities Stephen Joseph) for Bank of America in 1977, almost a year before Ranieri was even in the picture. The deal was for US$100m.

That first private MBS deal was “something that just came out of my head and happened”, Dall told the New York Times in 1986.

Ginnie Mae had been securitising government-guaranteed mortgages since 1970, but its bonds suffered from a serious flaw: an embedded prepayment option. Mortgages could be paid back in full at any time, leaving investors with a heap of cash to reinvest.

Moreover, refinancing risk meant that investors would get their money back when interest rates were at their lowest – something investors were unhappy about. Dall and his peers begged Ginnie Mae to offer some type of protection to bond investors, but the GSE did not want to.

The BofA deal of 1977 changed everything. It was the first that tried to address the prepayment issue – by introducing a nifty technique called “tranching”. The simple transaction had specific maturities and credit characteristics that would appeal to a much broader array of investors.

However, the prepayment conundrum persisted throughout the initial years of the nascent MBS market, spawning MBS research and trading desks that sought to understand the complex mathematics behind predicting mortgage prepayments and taking bets on which maturities/credits to buy.

With that initial 1977 private “pass-through” MBS deal, however – as simple as it was – Dall and Joseph for the first time persuaded insurance companies and pension funds to share some of the risk of American borrowers. That had never happened before.

Dall never quite got the credit he deserved. Just months after he chose Ranieri to trade the new mortgage securities and create a market for the new asset, the latter had squeezed his boss out of his position.

Ranieri’s determination to find new investors in such securities – including lobbying the US Congress to persuade more states to consider mortgage securities as “legal” investments – combined with his creation of five-year and 10-year bonds from 30-year mortgages, led him to be the dominant figure in mortgage finance in the early 1980s. But Dall and Joseph also deserve their place in Wall Street history.

1977: Texas International’s US$30m junk bond – Drexel’s first junk-bond

For a little known oil and gas company and a second-tier investment bank, Texas International’s US$30m subordinated debenture – Drexel Burnham Lambert’s first junk bond – began a journey that hit the heights before it all fell apart.

The deal’s enormous 11.5% yield – half as much again as other better-known credits were paying – forced investors to take notice and those who bought the initial issue were well rewarded, even if both the company and Drexel subsequently found themselves in trouble.

The collapse of Drexel – and the eventual jailing of “junk bond king” Michael Milken – is a well-documented story, but the firm’s contribution was a lasting one.

TI’s first deal and the subsequent Drexel-led boom of junk bond issuance conclusively demonstrated that there was a place in the bond market for issuers beyond the charmed circle of long-established giants.

More than 30 years later and the high-yield bond market is a staple source of finance for growing companies and M&A financing – and a huge source of juicy yield for investors.

1977: EEC’s first Eurodollar deal – a US$500m two-tranche issue

The European Economic Community’s first Eurodollar issue – a US$500m deal divided into a US$200m five-year and a US$300m seven-year – was a vital step in establishing the legitimacy of the Eurodollar market.

For much of the 1970s, the Euromarket was still something of a backwater, seen as the stamping ground of low-quality US corporates.

That had changed by the late 70s, with official borrowers such as the EIB and the European Coal & Steel Community, plus sovereigns such as Australia and Norway, issuing deals. But the EEC’s transaction was nonetheless a hugely significant stamp of approval for the market from one of the region’s premier borrowers.

Lead managers were Deutsche Bank, Credit Suisse White Weld and Paribas.

The Agefi International Bondletter (still to be rechristened IFR), said the deal’s five-year tranche got an “extremely warm reception”, though it acknowledged that the seven-year “did not enjoy the same interest”.

The deal laid the foundations for the explosion of the Euromarket in the early 1980s, when a change in macroeconomic environment – rising interest rates, inflation and new monetarist policies – transformed the market into a mainstay of international financing.

1977: European Investment Bank’s ¥10bn issue – the first euroyen deal

While the first Samurai bond came before the launch of the Agefi Bondletter, the first euroyen deal – from the European Investment Bank – arrived in time to be recorded in our pages.

What a deal it was. The traditionally laconic Bondletter hailed the 10-time subscribed new issue with an outbreak of unbridled enthusiasm.

“The adjectives used by eurobankers to describe the placement are: ‘prodigious’, ‘miraculous’, ‘phenomenal,’ fabulous’, ‘over-whelming’, ‘unprecedented’, ‘fantastic’, ‘sensational’, ‘stupefying’, ‘unbelievable’, and so on!”, the Bondletter wrote, deploying a rare exclamation mark.

“Some bankers even said that they would be able to absorb the whole of the issue themselves.”

The seven-year deal had been the subject of a lot of excitement in the market since Japan’s Ministry of Finance gave the go-ahead in March 1977.

Even before the bond priced in April that year, the Bondletter confidently predicted it was certain to be “an incredible triumph”, and speculated whether it could become a “refreshing competitor” for the euro-Deutsche mark market, which German banks monopolised ruthlessly.

A consortium of banks led by Daiwa Securities didn’t disappoint, printing the ¥10bn issue with a coupon of 7.5%.

There was only a trickle of euroyen bonds in the following years. But following the deregulation of Japan’s financial system over the first half of the 1980s, issuance rocketed and rapidly overtook the Samurai market, reaching over ¥6trn in 1994.

1979: IBM US$1bn two-tranche issue – the largest industrial borrowing

The deal was a controversial, but landmark, event. It was the first corporate transaction to raise US$1bn – though it did it in two equal tranches (seven-year notes and 20-year debentures).

It was notable as much for who didn’t arrange it, as who did. Morgan Stanley had a long-standing tradition (that still pertained in the US, even if it had faded elsewhere) that it would only work on deals on which it was sole lead manager – and it declined to take part because IBM (a long-term Morgan Stanley client) insisted that Salomon Brothers be involved as a co-manager.

After a desperate bout of soul-searching, Morgan Stanley walked away, rather than accede to the demand, leaving the deal to come via Salomon and Merrill Lynch.

A bit of gloating from Morgan Stanley could have been forgiven, as the two lead managers went on to lose a significant amount of money on the trade. As the Agefi International Bondletter reported, some US$300m–$400m of the US$1bn could not be placed and the bonds quickly traded down – to between 94 and 95 on the dollar against issue prices of 99.4 and 99-5/8.

“Yesterday’s fools are today’s heroes,” the Bondletter said.

In hindsight, though, that phrase could be just as easily reversed, as the deal marked a decisive democratising of the markets, with the whitest of white-shoe firm being usurped by upstarts – something that would set the tone for the 1980s and beyond.

1979: GMAC’s US$100m seven-year notes – the first bought deal

GMAC’s first Eurobond issue was a momentous enough event in its own right, but the real reason the US$100m seven-year bond stands out was that it was the Euromarkets’ first bought deal.

It was greeted in typically restrained fashion by the Agefi Bondletter, which wrote: “The issue is underwritten by Chemical Bank International, AMRO, CS-FB, UBS and WestLB. There is no underwriting or selling group but each manager is selling the bonds to other securities firms at a re-allowance of 1.125%.”

As with many of the developments in the early days of the Eurobond market, the concept was credit to CSFB’s presiding genius, Hans-Joerg Rudloff.

The idea was simple. The banks involved simply bought the deal from the issuer with the intention of selling down to other investors, thereby guaranteeing a simple, and transparent, execution for the borrower.

The implications were far-reaching as it put much of the power when it came to accessing the market in the hands of the borrower, which could survey the range of bids from contenders and pick the most appropriate (read: most aggressive).

The development meant winning banks were “on-risk” for the deluge of bought deals that followed in the ensuing years. The potential for mistakes – and accompanying losses – and the requirement for large capital commitments was obvious to everyone even at the time.

1979: Congoleum’s US$448m buyout loan – a pioneering LBO

It wasn’t the first LBO, but up to that point, such deals – then known as “bootstrap financings” – were fundamentally small-time.

The Congoleum deal was, however, the one that made the market sit up and take notice that sizeable buyouts backed by high-yielding loan financings were possible.

Congoleum, a linoleum and other floor covering manufacturer, was an ideal LBO candidate, with very little debt, strong cashflows, a stable of lucrative patents and a roster of long-term contracts.

CSFB, working with the Prudential, other investors and the company’s management, offered US$38 a share – 50% more than the shares were trading at the time – to buy the company, in a deal worth US$474m, using debt totalling US$448m.

The deal’s success for pretty much everyone involved, followed very quickly by a similarly structured and CSFB-arranged acquisition of Ward Foods by Terson, laid the foundation for the buyout boom that became such a feature of the 1980s.

1981: World Bank’s US$210m five-year notes – the first currency swap

Although it may not have been the first such transaction, the World Bank’s legendary US dollars to Deutsche marks/Swiss francs currency swap with IBM unquestionably gave the technique the seal of approval.

The US$210m 16% notes due 1986 were swapped with IBM into fixed-rate Deutsche marks and Swiss francs.

As that eye-catching coupon (16% for World Bank risk!) suggests, one reason for the deal was to manage interest costs at a time of elevated yields in US dollars.

As the Agefi Bondletter wrote: “The basic principle is that the issuer obtains funds in non-dollar currencies at ‘reasonable’ interest costs while remaining fully hedged as far as the foreign exchange exposure is concerned. This consideration makes the actual cost of funds in dollars less important than the cost of the forward cover. It may well be that prime borrowers won’t care if they pay 17% or higher in dollars as long as they get their Swiss francs at 7% or the Deutsche marks at 10%”

The Bondletter wondered “whether more borrowers will follow in the footsteps of the World Bank and IBM in using long-term forward foreign exchange contracts in conjunction with dollar note issues”.

It is clear now that the answer to that question was “yes – and then some”.

1982: World Bank’s US$100m Swiss franc-linked bond – the first dual-currency bond

The World Bank was, as so often before and since, the borrower at the heart of the latest market innovation, in this case the first dual-currency bond.

The US$100m seven-year bullet deal included a built-in fixed Swiss franc value on the capital amount and the coupons, with the proviso that if the US dollar conversion of the coupon or principal on payment dates was lower than the US dollar face value of the payment, then the US dollar face value was payable. The coupon was fixed at 6-5/8%.

“The appeal of this offering is fundamental. Whether the Swiss franc depreciates or appreciates against the US dollar, the investor will benefit either way through the fixed exchange rate,” the Agefi Bondletter said.

The then strengthening US dollar ensured that the take-up was strong, and the notes were trading as high as 101-1/4 a week after pricing.

The deal’s lead managers were Swiss Banking Corp (books) Credit Suisse and UBS.

The Bondletter added: “The transaction was prepared in close liaison with the Swiss National Bank and is unlikely to be followed up by another issue in the short term.”

That turned out to be true, but it wasn’t long before such structures became a regular feature of the markets. Hats off, once again, to the World Bank.

1983: EEC’s ECU4bn-equivalent financing package – the deal that saved France

Divided into four tranches, each notable in their own right, it was a blockbuster transaction that stunned the Euromarkets.

The US$1.8bn seven-year FRN, which was upsized from US$1.5bn, was the largest Eurobond up to that point, and, indeed, the largest capital markets transaction launched by any entity apart from the US Treasury or the UK government. The ECU150m three-tranche fixed-rate issue, meanwhile, was the largest ECU deal by that point in the relatively new market’s development.

Both tranches were organised by CSFB, acting as what the Agefi Bondletter called a “super-leader”.

The next piece was a US$1.3bn seven-year Euroloan which was so popular that it attracted US$2.215bn at the management level even before launch into general and saw lenders drastically scaled back. So popular was the deal that the Bondletter chose to list the international banks that didn’t take part, rather than those that did.

The final chunk was a US$350m four-year Eurobond, via Deutsche Bank, that was also warmly welcomed.

The money was being raised to bail out France which was facing the very real possibility of default.

The Bondletter, still run by a Frenchman, it’s worth remembering, makes this entirely clear without rubbing it in: “NB. Within the hour of the EEC ECU4bn-equivalent global financing being signed, the funds will be on-lent to France via a ceremony which will take place in the room next door.”

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