The credit crunch has become a real-world problem because when the cost of debt capital rises, everything is worth less. How are investment banks shaping up for the challenge ahead? Alex Chambers reports.
RARELY HAVE THE fortunes of the fixed-income markets been so keenly scrutinized. Six long months after the debt market first seized up it is still not functioning as it should. Normally the credit cycle turns in response to economic slowdown. But except for US sub-prime mortgage-backed securitizations and associated securities, most disintermediated credit has not yet deteriorated significantly. Now the fear is that economies will falter because of the credit cycle or, more specifically, the credit crunch. Many analysts are saying that the US has already entered into a recession. It will not be a big surprise if the UK and Spanish economies both begin to feel the effects of the fallout from the effective closure of the securitization market on their housing sectors.
So what began as a domestic credit problem has grown in significance and might well have global macroeconomic ramifications unless the credit markets quickly get back to some level of normality. But a return to normality is proving difficult – and not just because few banks with a significant presence in the debt markets have walked away completely unscathed from the disruptions caused by sub-prime, structured finance, CDO and leveraged loan origination. Fear and uncertainty continue to afflict investor sentiment in credit. Although the money markets might appear to be returning to normality, the debt capital markets are still not offering the type of execution that banks’ treasurers, for instance, are used to and that allows their institutions to make a profit on their own future lending.
There were hopes that January would begin as it always has. Plentiful investor liquidity would flush out borrowers and the new-issue market would get going. Unfortunately, that has not been the case. Bankers talk of corporate bond mandates stalled as treasurers decide to wait for better market conditions. There has been an excellent reception to sovereign, supranational and agency borrowers – few other issuer types have enjoyed a return to normality.
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"In the New Year, markets start afresh, whether you’re a trader, an investor or an issuer – but the first weeks of the year have been incredibly difficult"
Martin Egan, BNP Paribas |
"In the New Year, markets start afresh, whether you’re a trader, an investor or an issuer – but the first weeks of the year have been incredibly difficult," says Martin Egan, head of primary markets at BNP Paribas.
And bankers such as Egan say that there could be more volatility and nervousness in the coming months because of uncertainty surrounding many financial institutions, including investment banks, but also because of the fallout from monoline insurers losing triple-A ratings. Most bank officials predict with very little optimism that these concerns might ensure that the market’s difficulties will continue into the second quarter. It will take at least that amount of time for clarity to emerge on a wide range of issues, which will allow things to start to get back to a semblance of normality.
"We have gone from a seller’s market to now, where the pendulum has swung completely the other way," says John Winter, head of European investment banking at Barclays Capital. "We are bracing ourselves for an extended period of volatility and are encouraging our clients to recognize that. The ability to predict with certainty where a deal is going to price is very difficult. The other variable we haven’t had to deal with in a while is the prospect of real economic slowdown. That’s challenging to get a hold on because it is hard to predict where the hits will come from."
Make no mistake, though debt market officials might be busy getting on with the job of trying to service their clients, they are struggling to predict what will happen in 2008. A revision of the expected norms of the debt business is currently under way.
"Our client base, both on the issuer and investor side, needs to grasp the fact that the recovery in the capital markets is not going to occur in the short term," says Zia Huque, global head of debt syndicate at Deutsche Bank. "Liquidity in capital markets is very different now – it is much improved from the fourth quarter of 2007 but it is vastly different to the first half of last year. Liquidity will come back but as we look at flows across primary and secondary markets it will be a fairly volatile environment." Huque predicts flashes of liquidity, which will be met with euphoria and a flurry of deals before the market steps back and reflects.
Not only has the long-awaited credit bear market appeared, the prospect of recession stalks bond markets. Write-downs and provisioning against likely deterioration in credit have grabbed all the headlines. But if the US economy does suffer its first proper setback for more than five years, it will be tough for corporate and financial credit across the globe and not just the US. Can the economies of China, India and Europe take the strain? These are just some of the uncertainties that investors face. Is now perhaps the time to take risk off the table?
It is now clear that much of the five-year rally in credit was not just a function of the benign economic backdrop and a low-yield environment but also because of leveraged investors. Many credit investors were provided with leverage by banks, or were bank vehicles, albeit off-balance-sheet ones. Unfortunately for the near-term health of the bond markets, banks are capital constrained right now. This means leverage, and with it liquidity, has been withdrawn.
"We have real money accounts driving primary issuance," says Roberto Isolani, head of debt capital markets at UBS. He says that the absence of leveraged players has cut oversubscription of transactions. "That means that new issues are more difficult because they have to be tailor-made," he says. "All of the transactions are very name-specific. A lot of the deals are the result of very careful discussions with investors – more than I’ve seen for a very long time. The change in circumstances has revived the role of syndicate managers and sales forces. For a while, syndication had become a technical appendix of origination – I can see the change, particularly for financials names."