Insto Bond Diary
Following news that Northern Rock had been forced to call on the Bank of England for emergency funding, rumours have been flying around about some Australian financial institutions running into difficulties.
Speculation emerged early today that regional banks, Adelaide Bank and Bank of Queensland, had made similar calls to the Reserve Bank of Australia for emergency funding.
The rumours were swiftly dismissed by Adelaide Bank and the RBA, but sentiment remains skittish. The regional banks have come under pressure because of their perceived reliance on securitisation. While wholesale or securitised funding does make up a significant proportion of the funding of regional banks both Adelaide Bank and Bank of Queensland do have large retail deposits to call upon.
“This is why investors and rating agencies place an emphasis on diversity of funding sources,” said an investor.
In addition to a sizeable deposit base, the regional banks have also been able to access funding through private debt placements to fixed income investors, demonstrating the relative diversity of their funding.
The non-bank financial companies however may face more significant challenges. These entities are reliant on securitisation for funding and the lack of access to the capital markets could stress test their business models.
With higher spreads being demanded by the capital markets, non-banks can either pass on the costs to consumers, which would see them ceding their competitive advantage, or absorb the increased cost of funding. The non-banks may have to go back to the drawing board to some degree.
“They started their operations offering niche products in the areas where the banks did not operate. Because of the cheap cost of capital their business became volume driven. They may have to return to their initial model,” said an investor.
“The one positive for them is that they are all in the same boat, it’s just a matter of degrees,” said an investor.
‘Sentiment could change and we could see a return to normality, albeit in a different pricing environment. If that happens, it will be business as usual for the non-banks. The challenge they may face is adapting their business models, and the risks lie in this transitional period when the cost of funds are increasing, ‘said an investment banker.
For the time being, some mortgage-backed issuers are calling on the larger banks to help them ride out the storm. “We are hearing that the larger banks are gathering more requests from the non-bank lenders to provide warehouse funding to ride out a period of illiquidity,” said a fund manager.
Some non-banks have been forced to fund a high proportion of their assets via stand by lines, running up high costs, and they will be forced to come to the market soon.
“There are RMBS deals that are trying to get done but at this stage it’s all talk and no action. There’s not a huge appetite. Buyers don’t want a AAA or AA mortgage backed security at the spread they are being offered, when they can pick up other things at more attractive comparable spreads in this new environment,” said an investor.
According to sources, there are two non-bank prime issues and a sub-prime issue waiting in the wings.
And investors are demanding quality as well as price.
“Those coming to the market will have to offer pristine loan pools,” said a fund manager. “Pricing should be around 2003 or 2004 levels plus perhaps a small premium given market conditions,” said an investor.
For the issuers it may be more a matter of size than cost and they may be willing to give up spread in order to raise more funds while they are available.
Cash remains king and investors, issuers and banks need liquidity.
“There are stocks that I want to sell but the trading banks have to make markets before I depart with my cash. I need to remain as liquid as possible because I don’t want to be caught out. At the same time I want to be able to be able to capitalise on opportunities. There is a lot of distressed selling. Some sellers missed earlier opportunities to get out and now they are exiting at any levels. As a result we are seeing securities offered at what we think is very cheap levels,” said a fund manager.
***Primary kicks off before Northern Rock fall (14 September 2007)***
After weeks of inactivity, action in the primary market finally kicked off again with issues from GE Capital, Westpac and ANZ.
GE was first off the mark on Wednesday with a A$200 million five year issue, pricing at a spread of 52 basis points. Westpac then stunned the market with a A$850 million three and five year issue, pricing at 32 and 42 basis points.
"It's great to see the primary market back on its feet. It’s difficult to know exactly where the market is in terms of price, but we felt it was reasonably priced," said an investor.
A day of rumours followed on Thursday as to who would follow suit with ANZ stepping up to price a A$550 million three and five year deal at similar spreads to the Westpac deal of the previous day.
According to the lead managers both deals benefited from strong domestic participation from a range of investors.
"It was a very successful issue with minimal switching and broad participation across 30 accounts," said Mark Sherwood, director-syndicate at ANZ
"It showed that provided the borrower is prepared to price at the right levels, there is sufficient demand in the market," said a banker.
"A line in the sand has been drawn, and the issues have created the reference point that the market needed," he said.
There were a number of other positive developments offshore as the decline in the volume of US commercial paper eased and three month Libor fell to its lowest level since 3 September.
The bank bill swap rate has also fallen back to below 7 per cent. “There was a lot of fear and loathing about CP rollovers, which didn’t materialise,” said an investor.
Despite positive developments, there was more bad news for credit in offshore markets.
UK based mortgage lender Northern Rock, rated A+/Aa3/A+, has applied for emergency funding from the Bank of England.
According to reports that emerged late on Thursday evening, Northern Rock had made a call to the Bank of England as a lender of last resort - the first time a financial institution had taken such action since 1998.
Central Banks around the world have been actively injecting liquidity to aid financial institutions and keep the cash markets ticking along. The Bank of England has been reluctant to step in.
In a statement the Governor Mervyn King said providing liquidity in a crisis would only serve to encourage "excessive risk-taking and sows the seeds of a future financial crisis."
Northern Rock does have existing cash bonds in the domestic markets, with trading activity likely to be in limbo. The Credit default Swaps are likely to become inverted with the shorter dated CDS contracts to trade significantly wider to the longer CDS. This is based on the assumption that, if there is a default it will occur in the near future as the lender faces a short term liquidity squeeze, or not at all.
"Northern Rock’s spreads (over swap) in their AUD FRN’s were previously 160bps for the Mar 09’s and 150bps for the Mar 11’s, though this latest development will no doubt see them widen by a multiple three big figures plus. CDS pricing will probably invert sharply and much in the same fashion that Countrywide did a few weeks back when their 1 year CDS went north of 1000bps, though liquidity will once again be an issue and where trades get done at could be anyone’s guess," said a nabCapital credit report.
The UK lender has a market capitalisation of GBP2.7 billion in assets but has a 15 per cent share of the mortgage market. It funds activities predominantly through the issuance of mortgage backed securities and covered bonds.
As liquidity in the capital markets has dried up, Northern Rock has been left with a funding shortfall.
"They have been brought unstuck by a wholesale funded operating model," said Ken Hanton, senior analyst fixed interest credit research, nabCapital.
"Any non bank lender that relies predominantly on wholesale funding was always going to run into this problem which is why the retail banks are the safest bet - assuming the loan book isn’t dominated by weak borrowers like low docs or non-prime borrowers," said an investor.
"Borrowing costs are cyclical. It’s clear that Northern Rock, though aware of this, were caught off guard. Had it been a slow process to higher borrowing costs, then Northern Rock would have slowly passed on those costs, as well as made more of an effort to build its capital base in term of quantity and quality," added the investor.
"They tried to access the markets recently without success. They’re a good institution and their deals have performed well but investors have been aware of their reliance on capital markets and have been hesitant of late," said an investment banker.
As Northern Rocks equity has been hit hard, falling by over 5 per cent prior to media reports, the decline in its market values has made it a potential takeover target.
Based in Newcastle, England, Northern Rock is the second largest mortgage lender in the UK and is regulated by the Financial Services Authority. In 1997, Northern Rock converted into a bank from a building society.
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