Even when the credit crunch started to unfold and unleash a harsh reality for the future of European securitizations, the continent's covered bond market at least looked poised to step up as a beacon of security for risk-adverse investors still looking to put money to work.
However, with economic conditions worsening, issuers are finding fewer investors, those remaining have tighter limits.
The second half of 2008 was marked by significant spread widening, liquidity collapsing and issuance nearly disappearing. The period was further defined by credit differentiation, which remained strong, and saw state-guaranteed bonds and agencies offering cheap alternatives while Jumbo supply remained at a standstill.
So the early January 2009 pricing of BNP Paribas's E1.5 billion ($1.97 billion) triple-A-rated Jumbo covered bond came as something of a surprise. It signaled that, for the right price, investors are still willing to put money to work.
The French bank sold the first jumbo covered bond since the collapse of Lehman Brothers in September. The deal has a five-year maturity, carries a coupon of 4.125% and was launched at mid-swaps plus 110 basis points through three bookrunners - Commerzbank, Danske Bank and Royal Bank of Scotland.
BNP's new issue is surprising because most analysts predicted little activity for the first half of 2009. They certainly did not expect the market to kick off with a structured covered bond.
However, the French structured covered bond is seen as safe and BNP as a well-established covered bond issuer - two factors that could explain why investors were willing to take the product.
"Overall, it was still quite a surprise as everyone thought investors would prefer a legally backed covered bond because of the extra analysis that must generally be done with a structured covered bond," said Claudia Vortmueller, a senior covered bond research analyst at Commerzbank.
The deal signals a new world for covered bonds. The BNP deal priced at 110 basis points and by Monday last week had already tightened by 10 basis points - demonstrating that, for the moment, covered bonds are more expensive than pre-crisis levels. This has led some market players to question the value of BNP's covered bond compared with its recently launched E5 billion five-year senior unsecured offering, which had traded at a similar spread. Its five-year CDS was also quoted recently around 54 basis points.
Pricing for covered bonds is expected to continue at this level until three major issues are resolved. Future pricing hinges on the market proving that the business model works, that the underlying markets will stabilize and that the sector can manage without state support.
Vortmueller said that in the first half of this year the market will remain open to national firms and banks with sustainable business models, be it for structured or legal covered bonds, since investors don't expect governments to let these banks down. However, she said that there is also talk that highly sophisticated investors could opt for better spreads found in triple-A rated RMBS.
BNP's ability to bring a deal to market does not change the overall fact that investors aren't ready to scale the market in 2009. "While, in fact, we do believe that an issuance window might open up for individual issuers with stable credit quality, provided a sufficiently high spread premium is being paid, the primary market is still likely to remain closed for many issuers given a lack of demand," said Ted Packmohr, covered bond analyst at Dresdner Kleinwort.
There are currently too many uncertainties to come up with a precise estimate for new issuance in 2009.
The 2008 new-issue volumes of roughly E100 billion do not compare to the significantly higher issuance volumes of the years before. By September 2008, the market had all but closed down. Nonetheless, for the right deals, investors have signaled that they are still willing to buy.
"We saw issuance last year from markets that were expected to be difficult, like Spain, which then managed to successfully place two inaugural cedula deals during that period," Vortmueller said. "The market was open for selective issuers; investors have been picky, but they would have been there if secondary market had been there."
Secondary Issues Remain
Market-making issues remain and difficulties should continue well into 2009. "The primary market had shut down due to bad news from the underlying mortgage markets and/or issuers," Vortmueller said. "In addition, what we saw in secondary markets were more sellers than buyers. The secondary market collapsed because the underlying markets didn't function well, and investors still say that without two-way pricing, they could become reluctant to buy the primary product."
Two years ago, Dresdner suggested stabilizing Jumbo trading by strengthening transparency, while keeping the basic concept of interbank market making. However, with the markets now further distorted, Packmohr said that salvaging the concept of interbank market making looks impossible.
"One should keep in mind that the financial crisis has also brought about a painful change for investment banks' trading desks, putting their old volume-based business model to rest," Packmohr said. "In the 'old world,' covered bond trading was mainly a support function of the bank's primary business ... providing liquidity and supporting issuers' placement targets.
Based on their different market-making requirements, Packmohr said that the major houses had a fairly large headcount and many desks were running large books. With bid-offer spreads regulated at comparatively tight levels by the market-making agreement and trading with investors usually happening at even tighter margins, profit and loss were mostly influenced by trading positions on the market direction.
The financial crisis has shifted the volume approach to what he termed as a "lean and mean" model. The lower issuance volumes mean many houses no longer make sufficient revenues in the primary market business to compensate for the substantial price risks in secondary trading. Electronic trading with customers, as a result, is now becoming more important, and bid-offer spreads are being determined more directly by the real demand situation.
"One can easily see that the profitability of this new trading approach benefits from market intransparency to a fairly significant degree," Packmohr said. "It is therefore becoming all the more difficult to achieve a solution jointly backed by all market participants to support transparency and liquidity."
Vortmueller said that one suggestion that has been discussed to improve trading is the creation of a two-tiered system: an interbank/dealer platform and a bank/investor platform. However, investors are reluctant to accept this solution and would prefer to see a trading system where all the quotes go through directly.
These suggestions do not change the fact that the creation of a fixed, well-defined dealer group might create a more reliable trading basis. "This would be a signal to investors that the issuer feels obliged to maintain the best possible liquidity while increasing performance pressure for investment banks at the same time," Vortmueller said. "Furthermore, the issuer himself may take responsibility and express his readiness to provide a two-way market. For example, he could guarantee a bid price to investors, if required, and hold out the prospect of filling short positions for market makers by taps."
Down the Road
Credit news is likely to remain negative and heightens market price risk. For investors with rating requirements, the security of covered bonds even in the most senior markets, such as the German Pfandbriefe market, has disappeared. According to Packmohr, part of the distrust stems from covered bonds that have proven susceptible to spread risks despite top ratings.
As a result, an increasing number of triple-A ratings have primarily become dependent on a high level of overcollateralization rather than being based on the inherent credit strength of the pool assets and the quality of covered bond legislation. But according to Packmohr, the value of such overcollateralization might be called into question in the event of a collapse of issuer credit quality.
"On the covered bonds front, French and German paper had until relatively recently continued to be sold, but appetite for covered bonds issued by issuers in the rest of Europe had fallen away earlier," said Salim Nathoo, head of securitization at Allen & Overy. "Changes in legislation that allow public supervision of structured covered bonds as has been done in the U.K. could create a more level playing field and perhaps entice investors back to the market."
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