Bank liquidity crisis: They were extendible

BANK TREASURERS USED to have it easy. They had so many channels of liquidity to source. And investment banks would always come up with ever-more ingenious ways to help them do it.

Those were the days. It has been a different story since August 2007. The closure, since the credit crunch, of $2 trillion-worth of distribution channels in the form of securitization, CDO and leveraged loan markets was bad enough. The unexpected need for banks to fund $400 billion of structured investment vehicles (SIVs) and asset-backed commercial paper conduits was a further body blow to hopes that the financial markets would take the sub-prime debacle in their stride. Money market investors simply stopped buying anything linked to structured finance and in doing so killed off the rationale for SIVs and certain types of conduits. That disruption, plus the absence of any meaningful trading between banks in the inter-bank markets, means that the sub-prime crisis appears to have hit the short-dated money markets hardest.

The world’s leading central banks have acted to ease the liquidity and credit crunch, most recently on December 12. And yet as the market digests the latest action by the authorities to alleviate continued stress in inter-bank funding, it is worrying that the money markets are again the source of liquidity risk and will greatly contribute to the funding headache banks and financing companies will face in the coming months of 2008.

But another crisis is looming, which has gone largely unnoticed by most market participants.

When calculating their financing requirements for 2008, many banks have to face the stark reality of unexpectedly refinancing $245 billion of money market debt from the third quarter of this year. This is the volume of extendible notes, or X-notes as the market often calls them, that have been put by money market investors since the credit crunch. The total size of this market was $315 billion, of which $173 billion is yankee bank issuance. Between August and December 2007, $245 billion of X-notes were not extended as short-term bank credit was repriced. The non-extension rate for yankee bank issuance was 84%, and 81% for corporates. Of issuance from US brokers, some 75% was not extended.

Shifting balances

The balance of power has shifted in the money markets. Investors now call the shots – they are no longer price takers but price makers – and they have been quick to exercise it in the X-note market.

"I’ve been in this industry for 26 years. It’s truly been a buyer’s market, if you have had cash. That doesn’t happen very often," says Debbie Cunningham, chief investment officer for money market funds at Federated Investors Inc. Money managers such as Cunningham are operating in a new environment.

"I’ve been in this market for 26 years. It’s truly been a buyer’s market. if you have had cash. That doesn’t happen very often" Debbie Cunningham, Federated Investors

"Typically, a [double-A-rated] yankee bank would have funded, pre-July, probably at Libor minus 8bp. And a first-tier ABCP issuer would have funded around Libor minus 5bp," says Cunningham. The commercial paper market offered extremely aggressive funding at these levels from one month all the way to one year.

But after the crunch took effect everything changed. During the worst period of August and early September, the spread was plus 60bp for banks and 100bp for ABCP. Although recent central bank market operations have stopped the market’s deterioration, the pricing still points to a dislocated money market. Investors are still demanding something like Libor plus 25bp for bank CP and plus 50bp to 60bp for ABCP. Although that is much lower than it was in the September time period it remains dramatically wider compared with historical norms.

13: unlucky for some

The reason why banks are facing the refinancing of $245 billion of securities after August is bound up in the nuances of the US money market sector. No security with a tenor greater than 13 months is deemed a permissible investment for funds regulated under the 2a7 rule of the 1940 SEC Investment Company Act. So-called 2a7 funds were a key driving force behind the extendible note sector. These securities were dreamt up in 1988 by Goldman Sachs and arbitrage the difference between a straight 13-month note and the extra spread normally associated with longer-term paper – say, a five-year note (see box for more detail on X-note structure).

The term extendible refers to the option that funds are given on continuing their investment in the security. Extendible notes give investors the option of extending the length of the deal beyond the scheduled maturity date. So while the initial tenor on a typical X-note is 13 months, neither side of the transaction participates with the expectation that it will end so quickly.

The rationale for money market investors is relatively straightforward. These notes would be the longest and highest-yielding securities in their portfolio. To increase the likelihood of extension they receive a spread equivalent to Libor less 1bp – some 7bp over and above what they would have got for traditional non-extendible 12-month CP. They are then incentivized to stay within the transaction, so for every additional year they get paid additional basis points until the final maturity is reached.

Many extendibles operate for as long as five years or even more but the tenor does not breach SEC regulations for 2a7 accounts because every month the investors can give 12 months’ notice that they want their money back.