Blood flowing around the clot. Markets functioning to keep the ‘real economy’ moving along. This will take some of the bid for bank LIBOR funding away as well.

Credit Recap

Source: Bear Stearns Credit Research.

The wave of new supply has continued to come at even wider concessions than August and September. New issues have been coming at 25 bps to over 40 bps, in excess of the 5-10-bp discounts we saw pre-credit crunch.

The disconnect between LIBOR and the 5-year Treasury yield has invited more high grade new issuance. Typically, commercial paper of high grade issuers comes at LIBOR +10 bps. In the current market environment, LIBOR is artificially higher than many argue it should be, because banks (particularly in Europe) have been shepherding cash. Banks have had little excess cash to lend to one another as they face their own year-end reserve needs and prepare for the potential funding needs of SIV maturities, which they cannot readily refinance and must take onto their own balance sheets. Thus, the price of short-term inter-bank borrowing remains well above the typical 12 bps over Fed Funds. In fact, 3-month U.S. LIBOR at 5.15% is 90 bps over an expected 4.25% Fed Funds, and 115 bps over a more aggressive 4% FF estimate. By comparison, new high grade 5-year issues have been coming at T+135 to 170, or 4.65% to 5%-well below LIBOR of 5.15%.

We expect this window of cheaper-than-LIBOR capital markets financing could continue for some time, perhaps months-at least until the credit markets are comfortable that the SIV problems have been resolved and banks have restored whatever Tier 1 capital they feel they need. Bank-owned SIVs holding portfolios of bank-issued notes, mortgage ABS and CDO liabilities have not been able to refinance the commercial paper funding these SIVs, and they have been forced to either liquidate the portfolios at a loss or take the SIVs on balance sheet and fund the maturities that come due, absorbing more of a bank’s capital.

5-Year Treasury-Based Financing Cheaper to Issue Than Commercial Paper

Source: Bear Stearns Credit Research.

More subordinated bank and financial issues are on the horizon, and even infrequent non-financial issuers are getting ahead of this expected supply. Notice in the table below of recent new high grade issuance, there are plenty of issuers who haven’t tapped the capital markets for several years (for example Kellogg, McCormick, Nordstrom, Rockwell). We think they are tapping the markets now for several reasons: first, as we said, 5-year Treasury based financing is cheaper to issue than commercial paper; second, issuers like to have fresh financing benchmarks along the curve; third, 10s/30s curves continue to flatten as spreads widen (even though yields are not changing that much), encouraging longer-dated new issuance; and fourth, syndicate desks (including reverse inquiry from investors) are encouraging issuing before the expected wave of financial issues comes to market throughout the first quarter of 2008.

Banks, brokers and financial companies are in need of capital, to repair balance sheets from write-downs and replace capital that is tied up in unsold positions like SIVs and unsold LBO funding commitments. We have seen recent bond issues by Bank of America and Wells Fargo, although banks need to watch their credit ratings and need to issue non-debt capital. Most common equity of most financials has been beaten down, so the likely product will be preferred, hybrids and subordinated securities which generally come to market at significantly wider spreads than where the already-wider bonds are trading. Wachovia recently announced its plan to sell $500 million of 30-year subordinated debt. From our discussions, many banks want to sell long-dated hybrid and preferred issues, yet there is thin institutional demand. Since these deals will likely need to be distributed through retail channels, the market can only slowly absorb just a few deals at a time, and we understand a long line is forming to sell paper. Barclays, for example, just issued a $1-billion 7.750% perpetual preferred, and last week Citigroup sold a $7.5-billion private 11.000% preferred.


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