Bank of America readies a benchmark
THERE ARE NOW no significant debt houses that feel comfortable ignoring covered bonds – an increasingly important product for banks. However, sceptics are asking if they will stick around this time. Many US banks have tried covered bonds before. Around the birth of the jumbo Pfandbrief in 1995 a number of banks ramped up their efforts but soon retreated. And who could blame them? Issuers took full advantage of the increased competition by slashing fees or even asking for a subsidy. And the costs of market-making covered bonds in secondary markets are intense.
It was not just the US firms that ran for the hills. Commerzbank stepped back following the 1998 Russian debt crisis. In fact for years issuers and investors have suffered from various investment banks’ wavering commitment to the product. Even Deutsche Bank dropped down to seventh position in the league tables in 2005 before recovering its poise last year.
But why is there now a sudden rush of US investment banks trying to get into covered bonds? Only Morgan Stanley has persevered over the years and even then lacked much market presence at times. Some of the other US banks have paid lip service or only tentatively increased their presence. Most notably, these include Goldman Sachs and Citi, both of which have had titular heads of the product for several years without seeming to bring the full power of their institutions to bear.
Although in the past four to five years market discipline has returned and issuers have started reluctantly to pay modest fees, it still seems strange that investment banks are frantically throwing resources at the sector.
A bank wanting to build a dedicated covered bonds team from scratch will be looking at annual salary costs in the region of €3 million to €4 million for between five and seven personnel – depending on the origination, structuring, syndication, sales, research and trading model. Throw in the usual overheads, and with fees of two basis points running on jumbo deals, it is clear that you need to run a lot of deals to make a decent crust. The profitability picture improves when derivatives are included; dealers might gain another basis point for arranging an interest rate swap, more if a currency swap is involved.
The banks leading the pack on, say, 50 jumbos in a good year might be able to clear €20 million or €25 million. For those in the more modest reaches of the league tables, the mathematics might look rather more Micawberish.
Even by the famously mercurial standards of the international capital markets, there was an unusual amount of movement among covered bond bankers in 2006, with individuals shuttling between employees as frenetically as footballers anticipating a transfer deadline. Nor has there been any let-up in the early part of 2007, with Lehman Brothers – absent from the market for years – the latest to announce the appointment of new covered bond recruits.
Other banks that have been active in the market for several years have been repositioning themselves to focus more conspicuously on the primary market. Credit Suisse, for example, moved from a modest 20th in the covered bond league table in 2005 to 17th in 2006, but expects to climb up from that position, having recruited Richard Kemmish from Dresdner Kleinwort a year ago to spearhead its covered bond origination effort in Europe. "Credit Suisse has had a commitment to the covered bond market for many years and is of course dominant in the Swiss franc market," says Kemmish. "It is no secret that we are one of the top five trading houses in the market, but primary origination in covered bonds in euros is a relatively new area of focus for Credit Suisse."
JPMorgan is another house that commands strangely modest league table positions in covered bonds, and which strikingly managed to drop out of the top 20 altogether in 2006, after being ranked 11th in 2005. "Our secondary covered bonds market business is profitable and we expect to lead more primary issues in 2007 after a relatively slow 2006," says Carl Norrey, head of JPMorgan’s frequent borrower business in London.
It is not hard to understand why so many banks are scrambling to penetrate the jumbo covered bond market. At a very crude level, covered bonds are regarded as one of the few remaining ways of accessing chunky league table material and generating fee income at the same time. It’s not a great deal of fee income, and some bankers say it hardly covers their (market-making) bills. But most insist that the covered bond business is no longer the famously unprofitable game that it was some years ago. "This is a profitable business with plenty of opportunities to expand beyond Europe and so it makes sense for us to be active players," says Christof Juetten, head of covered bonds at Goldman Sachs, who says that the sector is an important component of the firm’s broader franchise in the space for sovereign, supranational and agency borrowers.
Others agree that in the context of a wider debt capital market operation, the covered bonds business is not one that can be overlooked. "Issuers do recognize the importance of bringing transparent and properly priced deals to the market, and of course that involves paying reasonable fees to ensure that transactions are solidly executed and supported in the secondary market," says Derry Hubbard, head of covered bond syndicate at BNP Paribas. "So it is not unattractive in terms of revenue flows, and it also generates profitable ancillary business in areas such as derivatives."
That may be. But in isolation, fees on covered bonds remain measly. "One of the conundrums of this business is that although it pays fees those are very skinny," says Tim Skeet, managing director and head of covered bond origination at Merrill Lynch. Skeet joined Merrill in June 2006 as part of that bank’s re-entry to a market it had abandoned in 2001.