Bank liquidity crisis: They were extendible

How extendible notes work

Italian banks take the long road

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.

The legal restrictions that the US money market funds operate under include a limit on low-quality assets. One of the reasons why money market fund managers collectively took a step back from ABCP and other securities linked to structured finance is because of the opacity around who owns the low-quality assets that are at the heart of the sub-prime turmoil. The secondary effects of sub-prime contagion have resulted in a repricing of credit – especially of financials. As they are no longer price takers, money market funds are curtailing their investments in X-notes, which frequently are yielding sub-Libor spreads. "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.

This is important because it provides issuers with a 12-month grace period in which to plan a refinancing operation. But this grace period is a double-edged sword because the price of credit – in addition to risk appetite – has been transformed over the past year. Because of this repricing and a more conservative risk appetite profile, the vast majority of issuers that previously used the X-note market face a refinancing wave from August.

But there’s another twist. Although investors see these as short-term securities, some bank issuers have counted them differently.

"What is particularly pernicious about the X-notes was that there was a good number of borrowers that termed it as medium-term debt," says a senior financial institutions group banker.

For accounting purposes, many banks are able to regard anything over 12 months as medium-term debt. There can be little doubt that the key underwriters of these transactions, principally the big US investment banks, would have pointed out the strong track record of extension in X-notes.

Until 2007, 97% of extendible issuance did exactly what its name suggested would happen – it was extended. That track record means that those borrowers that are in, or are approaching, the final year of X-notes have largely done very well out of the structure.

But it was a poor deal for those that only entered into the trade in the past two years – and it is worth noting how issuance was booming until the onset of the credit crunch (see table, right). These banks are now facing the fact that they paid over the odds for what has become an 18-month or two-year note – numbers that look even worse when taking underwriting fees into account. Worse still, banks face having to find money when liquidity is short and spreads are at all-time wides.

"It was quite predictable that the X-note would fall over at the first sign of trouble," says a senior FIG originator of the X-note market. Of his clients, he claims those that did not engage in the sector are happier than those that did.

Money’s tight

Up until the crunch took hold, five-year money for a strong double-A-rated bank was priced at around three-month Libor/Euribor plus 15bp or lower – now such an issuer would be lucky to get a one-year note away for less than 25bp. X-note issuers have effectively given away an option to investors and asked very little in return – certainly there was no guarantee of investors not exercising their option at an inconvenient time. But it is easy to understand the justification treasurers would have used to ignore the one-sided optionality of these X notes. "Non-extension only happens rarely – and then look at what sort of names..."

The most notable incident of non-extension took place in February 2006 when concerns about the Icelandic banking system took hold. Some $2.975 billion of paper was put by investors. There was remarkably little fallout from this because investment banks stepped up and refinanced the relatively modest amount of paper in the term debt market. Icelandic banks were active again in the X-note sector in January 2007.

Tough for the minnows

But banks are now operating in a very different world. The constraints on liquidity during the latter part of 2007 do not bode well for certain banks that will need to refinance X-notes during the coming year. No doubt such banks as RBS, which of UK banks has the biggest exposure at $7.7 billion, will have little difficulty finding the money. But the relative minnows of the financial markets, such as Alliance & Leicester, might find it more difficult. The mid-size UK mortgage bank obtained a £4 billion secured loan from Credit Suisse in November 2007 so it could refinance MTN and CP debt due in 2008. But A&L also issued $2 billion of extendible notes in May 2006 and a further $1 billion in April 2007.

If, as seems likely, these deals have been put by investors in August or September 2007, that’s another $3 billion the mortgage provider needs to find in the second half of 2008. And the bank will feel the pain of any refinancing – although the 2006 notes were issued at Libor less 2bp, the general consensus in the market is that the Credit Suisse loan would have cost somewhere in the region of 1% to 1.5% over Libor. Given A&L’s new circumstances, it is hardly surprising that it has said that future mortgage lending will be supported by its retail deposit base for the time being.

Investors such as Cunningham at Federated are confident that the money market will be back as a financing force during 2008, and she is most likely correct. That does not change the fact that the recent crisis has repriced credit and educated regulators and banks’ boards about the need to be aware of the risks that an over-reliance on short-term money poses.

Take the UK banks – whose recently issued liabilities have among the shortest durations of all European banks. Because Northern Rock has been such a high-profile casualty of the capital market’s failure it will surprise no one if UK banks are encouraged to extend the term structure of their liability portfolios when they have the opportunity to do so.