Nothing makes a man or a market as truly immortal as a massive speculative investment gone badly wrong…

Newedge - Blain's Morning Porridge - August 31 2011

By Bill Blain, senior director, special situations, Newedge

The ECB was apparently in buying Italian Government debt ahead of yesterday’s auction. Since the auction was hardly a screaming success, one has to ask why the whole market didn’t stage a massive dip? If the ECB has to buy up old bonds to ensure the success of new funding… who is the new buyer? We suspect there isn’t one…..

Meanwhile…. back at the ranch..

As we’ve always said, its all about banks – can they withstand the mounting pressures upon them? In the US it’s about dodgy mortgages, in Europe the latest wobbles are about dodgy accounting for govt debt – covered in yesterday’s porridge. But are there signs things are getting better? Have we overplayed our earlier worries/concerns about European bank funding?

Suddenly every bank is issuing Covered Bonds, with a deluge of new issues finding willing buyers - according to syndicate heads. In the secondary markets, we're seeing buyers scrabbling to buy the higher-yielding names, including covered bonds issued by Spanish, Italian and Irish issuers. While prices edge higher, even previous detractors of the sector have started to sniff around inquiring where bonds are currently priced.

The Financial Times opines the slew of 'deals is particularly significant given market worries about the health of Europe's banks'. It suggests buyers, (left cash-hefty after the summer), are delighted to have 'quality' assets to buy.

But, does rising demand for covered bonds mean the threat of a bank liquidity/funding crisis is lower? Perhaps - but more likely it’s a crisis delayed. While covered bonds do represent a strong and higher quality funding route for banks, they are limited in aggregate size, they deserve more debate (especially about underlying asset quality and transparency), and closer examination of why they can't replace access to broader senior/money market investors.

Ask not why the covered bond market suddenly looks so vibrant, but what it says about the state of bank funding that’s it the only avenue open to them! How did we get to a stage where banks can apparently only fund on a collateralised basis – the bond market equivalent of going to the corner Cash Converters Pawn Shop? (Remember the adage: “banks only lend to people who don’t need to borrow, or they demand your crown jewels”.. and reverse it…)

[If I may digress for a moment: Covered bonds once represented just a small part of the bank funding spectrum. In pre-crisis days a diversely funded bank would make sure its funding load was well distributed across the widest range of products and therefore the greatest number of potential investors.

The bank would address the more sophisticated buyers through capital issuance of Tier 1 and Tier 2 subordinated debt, liquidity buyers through senior debt, buyers looking for lower risk/close to government risk via covered bonds, short-term investors through money markets and CP, risk takers through structured MTNs and CLOs, and economic structure buyers through mortgage-related products like RMBS.

In theory the diversified buyer base world worked well. But, in reality, buyers became concentrated: bank-owned SIVs bought most of the Lower Tier 2 and RMBS issuance. Real money accounts were only interested in high yielding Tier 1 debt because it returned more than senior debt for apparently little additional risk. (Ha! how wrong were they?) Banks funded each other through the issuance of floating rate senior debt - each bank buying each others debt, encouraged by the low 20% capital ratio set by the Basel Committee.

Today, the market is fundamentally changed, and, perversely is much more limited. Areas like RMBS and structured CLOs have become very much niche markets - although both still have strong investor followings. Bank Tier 1 and Tier 2 capital are obsolete, effectively consigned to the dustbin by regulators keen to see banks reliant on equity as core capital (don't ask me why - probably because they don't understand the beauty of debt capital forms...)

Senior bank debt appeals to few buyers as it's direct bank risk - and no-one likes banks. Covered bonds at least offer investors some attractions: high credit ratings (due to their structure) and high yields relative to now risky Governments.]

Fade out of lecture room… back to market:

The arguments for buying covered bonds are well understood. Covered bonds remain obligations of the issuing banks, but are collateralised by access to underlying assets. In the event the bank can't pay back, then the investor has access to the assets to repay the obligation. Typically that's done through a discrete pool structure or legal segregation of the collateral. Blah blah blah...

Higher yields than governments and the better perceived liquidity of covered bonds come at a high price to issuing banks. The amount of covered bonds a bank can issue is clearly limited by the assets it can pledge to collateralise them. Furthermore, pledging assets to a bond means they aren't available to 'enhance' the overall credit quality of the whole bank anymore.

What's less discussed is the effect on the banks, the robustness of the structure in default, and the transparency of the market. A quick trawl through the news wires will reveal investors expressing serious concerns about collateral pool information - when it's unclear what the levels of non-performing and otherwise distressed mortgage repayment levels are, or how the LTVs in the collateral pool are performing in the generally declining European residential markets. If you don't know how the assets are performing today, what comfort do you have as to original underwriting standards? In terms of the structure – experience of defaulting banks that had issued RMBS demonstrated the mechanisms set in place to 'administer/sell' collateral didn’t always work – there are always costs and delays.

Another concern is the effect of banks cherry-picking their best assets into cover pools, leaving their less robust assets available for sale in the event of 'crisis'. Should equity buyers be worried by banks that issue covered bonds to the max? Perhaps.

To cut a long story short, we are not saying covered bonds are bad. They aren’t. The current demand for covered bonds is great as it relieves some funding tensions - but it does not cure the fundamental crisis: ensuring banks have strong and sustainable funding routes going forward.

If any readers would like more on the covered bond market and access to pricing levels and runs, please give me a shout! And buy the way: I’m a buyer!

Elsewhere.. Are regulators getting somewhat ahead of themselves? The European Banking Authority - they of the stress tests - has come out with proposals that would put yet more responsibility on the EFSF. The fund would not only be responsible for bailing-out governments, but also guaranteeing bank funding. If we can't get EFSF approved as is, how to get it approved in an even more complex form...?

Out of time...