A deal too far for private banks
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A deal too far for private banks

Tier 1 perpetual CMS-linked products, once in high demand from private investors, have shown their dark side. Some deals have lost 20% of their value. Their highly illiquid nature means investors could be left high and dry. How did these inappropriate products come to be sold to an unsuitable investor base? Alex Chambers and Helen Avery report.

Private banking survey 2006


Twelve months ago the European constant maturity swap-linked tier 1 market was in the midst of an unprecedented boom. Now it is dead in the water, with investors left holding a product they should never have bought in the first place.

For European financial borrowers, the CMS deals provided a low-cost funding opportunity. For yield-hungry retail and high net-worth investors, fixed upfront coupons of around 6% had great appeal, even if a perpetual, callable and highly structured security was not a normal investment product. Between the beginning of 2004 and the end of the first quarter of 2005, over €17 billion of euro-denominated CMS-linked paper was issued. Of this, €4.9 billion was issued in the form of vanilla floating rate notes, €9 billion was lightly structured with a higher coupon, and €3.33 billion took the form of yield curve steepeners.

Dazzled by the high upfront coupons, investors were either unaware of or willing to ignore the implicit risks involved in these highly complex and illiquid products. CMS-linked products are beneficial in a steep interest rate curve environment. Could unsophisticated investors have predicted a flattening of the two- to 10-year curve from around 180 basis points in March 2004 to just 50bp at the end of 2005, or understood what that would mean for their investments?

Take pity on investors that purchased these securities. They face unrealized losses of capital of around 20%, and there is little they can do to unwind their positions. “We have a market trading in the low 80s, and if you really wanted to deal in size you’d find that price little more than an aspiration,” says a senior debt capital markets banker.

The question, as is often the case when it comes to structured products, is whether these CMS-linked products should have been sold to unsophisticated investors, and who should take responsibility: is it the issuer, the structurer/investment bank, the intermediary or investor themselves?

It’s a grey area that allows everyone to pass the buck. As one lead manager of several CMS tier 1 deals tells Euromoney: “Hopefully, the people selling these deals to the end retail investor explained how these deals could perform if the curve flattened.” Often, it seems, it is a forlorn and misplaced hope.

Opting out

Some of the leading financial issuers in Europe drove the boom in CMS tier 1 supply, led by Groupe Crédit Mutuel (which issued €1.8 billion of deals, according to Dealogic), Deutsche Post (€1.45 billion) and Deutsche Bank (€1.22 billion). It was a derivative-led business, and banks such as BNP Paribas and Deutsche Bank that have strong derivatives franchises were at the vanguard. Since September 2004, BNP Paribas has been the bookrunner on €2.1 billion of CMS-linked deals, and Deutsche Bank has led a little under €2.1 billion of new issues.

Not all investment banks chose to participate in the market. Some had a problem modelling the swaps needed to take a forward view on the interest rate curve. Others took issue with the whole concept. One such bank was Credit Suisse First Boston.

“We had real concerns about the boom in tier 1 CMS-steepener products. We had a view that raising permanent capital by way of a perpetual, highly structured interest rate instrument to be sold to retail clients was not appropriate,” says Anthony Faulkner, head of FIG capital markets at Credit Suisse First Boston. “Our private banks shared this view, as did several issuers. These deals were a very interesting case study on how the market can work to provide a short-term result that is less desirable in the long term.”

Tier 1 issuance has historically been a strategic consideration for treasurers, but there was an unseemly scramble among issuers, encouraged by investment bankers, to take advantage of market conditions that prevailed at that time.

Not all issuers were seduced. A treasurer at one of Europe’s largest financial institutions says: “Without trust you can forget about a long-term presence in the market. That’s why we haven’t done certain deal structures. We have completely abstained from the CMS market. Good deals only work out if both sides are happy.”

But traditional means of exerting pressure on treasurers to issue were certainly applied. “I’ve been approached by every major bank saying company ABC has been doing CMS deals, so you should as well,” says the treasurer. “But we didn’t see any value in these instruments. They are clearly not in the interests of investors that don’t tend to look closely at the fine print. We are one of the largest retail financial companies in Europe. These deals could end up in our client base, and it would have meant disaster for all of our other banking and insurance business if the deals had gone sour.”

The logic unravels

There was some logic to the idea of using CMS-linked coupons. In a low interest rate and low volatility environment investors were in search of yield, and linking a bond’s spread to a 10-year maturity provided investors with just that.

There was also increased interest in floating-rate products generally due to fears of higher rates and widening credit spreads, but the traditional short-end floating-rate benchmark was unattractively low. Three-month Euribor was only marginally above 2% in early 2004. A bank that issued tier 1 perpetuals with a call in year 10 would only provide a spread of 100bp or so over Euribor – still not attractive compared with high interest cash deposit bank accounts.

As the curve was steep, structurers looked for a long-end floating rate benchmark, and the answer was found in the constant maturity swap 10-year reference rate that re-fixes semi-annually. At the beginning of 2004, when the first deals were launched, the difference between three-month Euribor and 10-year CMS stood at around 250bp.

The first wave of vanilla CMS-linked deals were purely floating rate and gave investors 10-year CMS plus a small spread of, say, 10bp, with a coupon capped at around 8% to 9%. This was a reasonable alternative to traditional fixed-rate preference shares that retail investors had previously participated in. But once the private banking middle market had become full on this particular structure, bankers became more aggressive.

To increase the appeal of these deals and attract private investors, issuers and investment banks introduced a fixed above market coupon for the first year of the deal – frequently set at around 6%. But, as demand faltered, the periods of the fixed-rate coupons were extended – in some cases out to as long as five years. The result was that, rather than considering the product as a floating-rate note with implicit risks, investors were focusing on the high coupons offered in the first year or two, and disregarding what might happen next.

The later versions of the bank CMS product, known as the steepeners, not only offered investors a fixed coupon for the first few years – the coupon then switched to four times the difference between the 10-year and two-year CMS.

Issuers were content to provide upfront, above-market interest rates for a fixed period because of the attractive economics on offer. The all-in after-swap economics of the deals allowed strongly-rated bank borrowers to raise tier 1 capital at a cost in the region of Euribor plus 50bp. That was a saving of 50bp to 70bp compared with a traditional tier 1 security such as a preferred share.

How the numbers add up

Financials institutions have long used retail investors as a funding base for traditional tier 1 issuance. Non-innovative tier 1 deals lack the economic incentive to redeem them at the call date, something that traditionally ruled out institutional investors.

By contrast, innovative capital has a coupon step up at the call date, and this incentive to call attracts institutional investors who are assured that they will get their money back at the expected date. The problem for issuers is that regulators have deemed this as being inconsistent with the concept that capital is permanent. Basle bank capital regulations do not allow innovative capital to exceed 15% of total capital.

As financial issuers like tax-deductibility and prefer hybrids because they do not dilute equity holders, they have generally already used up their 15% buckets. But they are still on the hunt for cheap capital, and retail and private banking networks can offer an alternative source.

However, investors that went looking for a big coupon have taken a big risk that the bond will not be called. And unlike with traditional tier 1 retail-targeted bonds, CMS tier 1 issues do not offer much of a return if the bond has entered the second stage of its coupon structure.

Once the fixed rate coupon period – typically one or two years – expires, the return the investor receives switches to the difference between two- and 10-year CMS rate multiplied by four. Most deals have floors, ranging from 2% to 3.75% (although at least two deals have no floors at all). By December 2005 the two- to 10-year swaps curve was worth just 50bp, so the return to investors could be as low as 2%.

Top 10 Bookrunners of CMS Linked Tier 1 Issuance – 1 Sept 2004 to 30 Nov 2005

Rank Bookrunner Deal value ($m) No of deals % share
1 BNP Paribas 2,164 14 16.8
2 Deutsche Bank 2,099 11 16.3
3 Morgan Stanley 1,444 9 11.2
4 Merrill Lynch 1,383 9 10.7
5 Lehman Brothers 1,184 6 9.2
6 ABN Amro 989 7 7.7
7 HSBC 953 5 7.4
8 JPMorgan 929 8 7.2
9 UBS 489 4 3.8
10 EFG Eurobank Ergasias 275 3 2.1
Total 12,875 32 100.0

Source: Dealogic

That is not much compensation for holding the most subordinated class in a bank’s capital structure with no guarantee that you will ever get your money back. An investor with straight exposure to the 10-year CMS rate was receiving 3.6% at the end of 2005.

It is therefore no wonder that all the CMS variants are trading well below par, whatever their level of innovation. For example, the €250 million deal for Oesterreichische Volksbanken, the Austrian savings bank, lead managed by BNP Paribas and JPMorgan in September 2004, offered a fixed coupon for the first 12 months. Considered a lightly structured deal, it now pays the 10-year CMS plus 10bp. At the end of 2005, the bonds were trading at just 79 cents on the euro.

One of the more structured deals to come to the market was a A200 million deal for Greek bank EFG Hellas, lead managed by Deutsche Bank, EFG and UBS in March 2005. The deal pays a fixed coupon of 6.75% for the first two years. But investors are clearly not so much concerned about that as the fact it will pay four times the difference between the two- and 10-year CMS rates in 15 months’ time. In late December, an investor would have struggled to find a bid above 80 cents on the euro for the EFG bonds.

The market goes flat

Once the curve flattened, the advantages these securities offered quickly evaporated. “If you look at the sensitivities of a vanilla CMS-linked bond they are related particularly to forward yield curve movements. Prices increase if the curve beyond the respective reference rises,” says Jochen Mächtlinger, interest rate strategist at Dresdner Kleinwort Wasserstein.

Mächtlinger said that it was a surprise that the curve flattened, as normally a rising rate environment leads to steepening. “Normally, the curve tends to bull-steepen and to bear-flatten as shorter yields have a higher volatility. The bullish flattening we saw last year was to some extent due to structural factors, such as the stable demand for long-dated assets, resulting from the hunt for yield and also pension reforms.”

So, have investors simply been the unfortunate victims of a set of unexpected circumstances? “Fundamentally these instruments have a place. It’s just that the curve has flattened dramatically,” says David Soanes, head of debt capital markets at UBS.

Soanes is correct. If the curve had behaved as expected, investors would now be sitting pretty.

But this does not address the underlying problem of how appropriate it is for financial institutions to raise regulatory capital in structured product format and sell it to non-institutional investors.

Faulkner at CSFB says: “Private banking clients or retail investors buy many varieties of structured products. It is not uncommon for these to use part of the economics of the later years to maximize investors’ initial return and coupon. What marks these transactions out as being different is that they are perpetual and likely to be illiquid. The principal exit strategy for retail investors is to sell them back to the issuer.”

But it’s not that easy. As Faulkner explains: “On one hand, if the issuer is unwilling to do this as the instrument is core capital then retail investors are left in an unenviable position. This is detrimental to issuers in the longer term as it will impede the further flow of funds from the retail sector to underpin the capitalization of financial institutions. Alternatively, if investors have a broader relationship with the issuer this can lead to pressure on the issuer to buy back the instrument to maintain the wider relationship. Such pressure is inconsistent with the concept of perpetual capital that is embodied in a tier 1 instrument. We were surprised that the regulators did not take a greater interest in this market for those reasons.” Bank treasurers would need to go back to their regulator to get permission to buy back an instrument.

Another problem is the chronic lack of liquidity in this market. “Tier 1 CMS-linked issues have suffered from lack of liquidity compared with dated senior issuance as there is no back-stop bid,” says Chris Jones, global head of EMTNs and structured notes at HSBC. Jones explains that liquidity is limited by the inability to asset swap because the deals are perpetual and, as capital instruments, are difficult to unwind.

Although they declined to comment, regulators in France and Germany are rumoured to have ruled out further deals of this type.

Private banks to blame?

Private banks, which face constant criticism for selling complex structured products to their clients, must take some responsibility for the products they advise investors to buy. Most onlookers would agree that the CMS-linked deals are unsuitable. “We keep a recommended list of structured products for private clients and I have not seen these on it. CMS-linked products are exceptionally complex, and are certainly not like a straightforward currency or interest-rate swap. They also raise questions about tax suitability,” says a consultant to private banks. “You could understand a corporate buying these to offset risk, but not for an investor looking to enhance income yield. There is a potential unlimited downside.”

Yet it is fair to assume that of the €17 billion of CMS-linked issues, a sizeable amount was sold through private banks. Indeed, at the time of issuance, many syndicate officials named their own private banking networks as buyers. Finding private banks that admit to the large losses incurred by these deals, however, is not easy. The response from BNP Paribas Private Bank, the private banking arm of BNP Paribas – lead bookrunner on these deals was: “Since 2003, BNP Paribas Fixed Income, like many other investment banks, has been an arranger on several of these tier 1 CMS-linked deals. These products often gave significant fixed rate coupon(s) the first year(s) and then coupons indexed to the 10-year swap rate. The flattening of the yield curve and the credit spread widening often affected the mark to market by 10% to 20%. Those products have been proposed to private banking clients in the context of an expectation by the market of an increase in interest rates and always as a means of diversification of bond portfolios. The investments account for only a very minor part of the private bank total assets”.

Deutsche Private Wealth Management – the private banking arm of the second leading investment bank borrower of these deals – could not offer any officials for comment.

It’s refreshing, therefore, to find at least one private banker willing to admit his network has sold the bonds, and is dealing with the potential losses investors face.

Clive Bannister, CEO global private banking at HSBC Private Bank says: “A number of HSBC Private Bank clients have purchased these products in the past. Current trading prices are lower than the bank would like, mainly because liquidity in these markets is not as strong as was anticipated.

“However, it is important to know that the structure of these deals is not in question, and that they have been issued by reputable partners. Private banking customers holding these CMS deals are aware of the current performance and are in constant dialogue with their relationship managers.”

Many private banks have well-constructed arguments about why they declined to get involved in the market. Andy Halford, director of structured products at Kleinwort Benson Private Bank, says: “We’ve looked at CMS-linked products. Most of our clients are sterling based and with a flat yield curve in sterling frankly we don’t think there is value in them at the moment. You’re getting a high coupon generally only in year one and then x times spread between the two- and 10-year, so you have to have a strong view that the 10-year swap will be higher than the two-year swap rate after year one. I wouldn’t have thought there were many individuals that have that view. We did a lot of work on a few CMS-linked deals and we realized they weren’t the sort of thing to sell to clients.”

The private banks of Merrill Lynch, Citigroup, UBS and Credit Suisse also toe the official line that they did not deem these products to be appropriate for their clients.

One private banker, albeit off the record, disagrees. “Should they be sold to private clients? Well, it depends on who is buying them and who is selling them. Some clients are sophisticated enough to understand these products. But the people selling them have to understand them as well. I will not condemn these deals as some of them have made money, but they must be sold in the appropriate manner.” Another private banker adds: “Not all of the CMS-linked products have lost value, but they are definitely complex instruments and should be considered as such.”

More worrying are rumours that private bankers did not want to sell CMS-linked deals to their clients, but were under pressure from their investment banking colleagues to do so. If correct, private clients’ worst fears are confirmed: private banks with links to investment banks cannot be trusted to give independent advice. One head of a European private bank says that the rumours are believable, but only if a private bank is not a core business of a banking group.

Although it is hard to know where the fault lies, there’s no doubt that the institutions involved in selling CMS tier 1 deals are bracing themselves for calls from irate clients, or even worse. Euromoney understands that at least one European financial institution that issued CMS tier 1 deals is already compiling a dossier in preparation for a potential lawsuit from a disgruntled investor.

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