Although the deterioration in credit conditions was sparked by the US housing sector, many of the tangible examples from the fallout surfaced within European entities and curtailed what might have been an otherwise productive summer. Andrew Stein reports.
A degree of irony emerged in the debt markets this summer as the dollar-denominated market for investment-grade unsecured debt continued to churn out supply, even amid the recognition that the roots of the liquidity squeeze lie within the US housing market, while other markets with fewer direct ties to US mortgages lie dormant.
Much of the turbulence across asset classes was sparked by anticipation of losses and/or funding problems at those entities with mortgage-related exposure. As the pervasiveness of the credit squeeze unfolded, it focused more on liquidity, particularly in the short-term markets. While there is still some uncertainty regarding the impact that the liquidity problems have had on major US institutions, thus far, most of the tangible fallout at major institutions has come from non-US firms.
There have been notable losses at US hedge funds, including some closures at Sowood Capital and Bear Stearns Asset Management, for example, the situation at Countrywide Financial continues to unfold, and Citi recently said that its third-quarter profit would be 60% lower than a year earlier. Yet developments at IKB, WestLB, Northern Rock and UBS are perhaps the most serious to emerge and have participants sensing a vague split between the markets, which has been manifested in terms of issuance in the respective currencies.
During the months of July, August, and September the US dollar market received more than US$185bn in new supply, while there was a fraction of that issued in euros and sterling.
One DCM head at a US-based bank recently alluded to that separation in sentiment. "We often speak to our colleagues in London to get their sense of conditions. And right now it is a sense of surprise, bordering on shock," he said. "They don't know where the next disclosure will come from, and when the news does surface, it raises questions about how that particular institution became so involved."
One institution that faced questions after its liquidity dried up amid sub-prime exposure was Germany's IKB, which recently said it faces a net loss of €700m-€800m for its fiscal year ending in 2008 as it rectifies the situation. It added that will attempt to be fully transparent about how it arrived at "such a difficult situation”. KfW, which owns a 38% stake in IKB, said it is set to cover IKB obligations that could amount to €8.1bn. Germany's Landesbanken also established €3.5bn in coverage for the bank.
Northern Rock demonstrated the ramifications of what can happen when depositors turn on a bank following liquidity problems. After word that Northern Rock had turned to the Bank of England for emergency funding, depositors immediately withdrew more than US$2bn equivalent from accounts and subsequently forced the bank to look at all options, including a possible sale.
Those concrete examples, as well as the freezing of certain CDO funds, placed European investors in a precarious position, and they have only just started wading back into the new issue market.
"With the sub-prime situation leading to steep losses in some CDO funds, European investors stepped back from the unsecured debt market during the summer, partially as a way to preserve liquidity in the event of ongoing investor redemptions," says Josh Witz, director, debt capital markets at Societe Generale. "European investors are gradually loosening the purse strings as the iTraxx crossover index returns to the 300bp area after previously reaching the 500bp mark at the height of the volatility."
Although the week when the various US broker dealers reported third-quarter results was closely watched for signs of just how far the credit contagion had spread, investors will also closely watch the results from the likes of BNP Paribas and Deutsche Bank for tangible signs of how much they were impacted by the credit squeeze.
While concerns of equivalent problems, or worse, continue to circulate in the US, investors have taken advantage of the fragile tone and inconclusive concerns to request securities from some highly-rated issuers. A group of about five-well known asset managers were cited behind transactions earlier this summer that were said to be prompted by reverse enquiries. Some participants call that reverse enquiry process somewhat of a misnomer and have classified the positions more as anchor orders. In any event, those accounts playing significant roles in the recent issuance, especially those acting on behalf of insurance companies, are finding the current conditions ripe for picking up incremental yield.
"In terms of reverse enquiries, we first look at securities we will be comfortable with. We have also recently taken the approach of keeping an eye on credits that have short-term funding needs," says Matt Meyer, head of public fixed income for AIG Investments. “For most borrowers, the recent liquidity problem has been technical in nature and not a fundamental problem."
For managers handling insurance accounts, the prospect of additional yield is especially appealing as those portfolios will not necessarily feel the same pain as the securities may not need to be marked to market, and the instruments are still money good and can be held until maturity.
Following that initial supply catalyst from those asset managers, underwriters with mandates lingering on the horizon subsequently brought the conversation to investors through aggressively weighing their interest in certain names that were contemplating transactions.
Rare Yankees
The liquidity squeeze in the short-term money markets also prompted some rare issuance in the term markets, including some from Yankee borrowers. Deutsche Bank rarely pays up for 10-year dollar-denominated money, yet the firm was compelled to complete its first trade at that part in the curve amid the dysfunction in the money markets. And while it may have previously received better levels on euro-denominated issuance, the depth of the dollar market and the ability to execute a quick transaction made it a compelling choice.
"Money market volumes are unnaturally concentrated in the overnight. While we are enjoying liquidity in the overnight, we want to manage our needs to stay comfortably within overnight limits," said Deutsche Bank's Group Treasurer Chris Whitman at the time of the transaction. "So when you see Deutsche Bank and other issuers that are rarely seen further out the curve in the market on the same day with 10-year fixed-rate deals, there is a broader message about market liquidity there in itself."
Other notable credits that recently surfaced at the back of the curve include Blackrock, IBM and American Express Corp, as well almost all the broker/dealers.
Meanwhile, transactions from companies, both with euro and dollar-denominated balance sheets, are finding the dollar market open for benchmark-sized trades, even if they are arriving with notable concessions.
As the fall started, AstraZeneca, which keeps its balance sheet in dollars, tapped the market for US$6.9bn to finance a portion of its MedImmune acquisition. The US$2.75bn 30-year tranche of that A1/AA- offering priced 170bp over Treasuries in early September and progressively narrowed to 151bp over by mid-month.
Italy's Enel, which keeps its balance sheet in euros, also sought out the dollar market to secure funding for a portion of its additional 24.97% stake in Endesa. The US$3.5bn three-part A1/A/A trade came after the company said it would need to raise the equivalent of €10bn in debt to finance the acquisition. Enel's US$1bn 6.80% 30-year portion priced 209bp over Treasuries and narrowed to a market of 195bp–192bp once freed to trade.
In addition to the senior supply, issuers looking to raise hybrid capital also found refuge in the dollar-denominated retail market this summer, as the market was good for about one transaction a week. RBS demonstrated that viability in September as it chose dollars for a US$1.45bn offering (upsized to US$1.6bn with the greenshoe) in an exercise that also meant it did not cannibalise any of the other markets it was contemplating.
Despite the various factors that have pushed dollar market issuance, there are factors that could gradually drive US borrowers towards the euro and sterling markets. Amid the perception that the FOMC's 50bp Fed Funds rate cut in September added much-needed liquidity to the credit markets, the reduction also sent the dollar tumbling against the euro and the pound.
While foreign exchange rates are not a determining factor on a trade, the recent lows for the dollar and subsequent expectations for rate cuts in Europe and a correction for the euro has some US issuers looking abroad. Supply from borrowers such as Illinois Tool Works has the potential to provide investors with the diversification and liquidity that had evaporated during the summer. The manufacturing firm issued €750m in seven-year notes rated Aa3/AA at mid-swaps plus 67bp to an investor base of 88 accounts.
"Some US issuers are attracted to the euro market as a way to lock in the current FX rates as the principal repayment would be less in dollars should the euro decline from its current levels," says SG’s Witz. "For debut issuers, such as Illinois Tool Works, a physical roadshow is still standard as investors want to meet management face-to-face. That meeting gives investors an added degree of comfort with management for unknown or rare borrower as well as a sense that the company is committed to the investor base."