Nordic Capital Markets, Corporates and Investors in the Credit Crunch

by Thomas Begley, Senior Director & Head of Fixed Income, Debt Capital Markets and Timo Teinilä, Director & Head of Capital Structure and Credit Ratings Advisory, Nordea

Problems of de-personalised finance

Capital markets have always been a platform of innovation. Over the last 20-30 years this innovation was significantly driven by deregulation and technology. Deregulation encouraged new methods and tools of financial intermediation and their application to a wider range of issuers and investors. Communication technology allowed linking market participants ever faster so that new issuance and investment opportunities could be offered to a global audience. Increased computing power made it possible to handle greater volumes of data on new asset classes, and to slice and dice portfolios into a range of new and more complex products that fit different tastes for risk.

From a system where 'I invest into someone I know and understand' we have moved to a less personal system where 'I invest into what can be modelled.

More powerful computing and data transfer also allow to slice the credit process into different tasks that can then be subcontracted to various specialists: brokers originate assets, structurers and arrangers repackage them, servicers handle cash flows, various agents monitor their performance etc. All of this has had a profound impact of de-personalising finance. From a system where ‘I invest into someone I know and understand’ we have moved to a less personal system where ‘I invest into what can be modelled’.

This development has brought real benefits to participants in capital markets. It has broadened borrowers’ access to capital, and enabled investors to diversify their risks. Banks and other intermediaries have been able to pursue different business models that in their view best matched their strengths and ambitions. However, times of crisis reveal the weaknesses of the modern world of finance. The criticism includes:

• Agency conflicts - the growing number and specialisation of players involved in the markets means that they have different incentive structures than the ultimate investors, and thus may not have full interest in protecting the other participants in the markets. For example, structurers of collateralised securities are accused of being interested only in a rapid turnover of their asset inventories rather than carefully analysing their underlying quality in sufficient detail.

• Information asymmetries have accentuated because of the fact that it takes a high degree of skills to evaluate different types of relevant information on highly complex structures. This is the case, for example, with mortgage backed bonds, whose full evaluation requires not only sophisticated computer models, but also the input data for the models, and a solid qualitative understanding about the models’ parameters and of the origination process of the underlying assets.

[[[PAGE]]]

One can correctly argue that the potential for agency conflicts or the existence of information asymmetries has always been an unavoidable feature of financial markets. However, a high degree of de-personalisation (also called marketisation) of finance accentuates certain problems in harder times:

• When transactions are less personal, trust is based on institutional sources like regulation or (rules of) certified information. A breakdown of a source of institutional trust (e.g., trust in credit ratings) damages liquidity much more than a breakdown of one individual relationship which is more easily digested by the markets. This induces significant collateral damage to investors as well as issuers.

• With conflicting interests of various parties, in a worst case, assets get stranded, making it harder for issuers and investors to restructure them, destroying value beyond the damage inflicted by fundamental drivers.

• A bigger number of less well known participants in a transaction make it harder to understand sources of problems and to manage the potential conflicts.

The effect of these weaknesses has been dramatic for a number of banks. A league table of the write-offs by international banks as of end July 2008 showed that the top ten banks had by then written off an aggregate sum of US$ 270 billion lost in mortgage-backed-securities, credit card receivables or leveraged loans, or related hedges gone sour. While the saga, unfortunately, still continues to hurt mainly US and certain European banks, Nordic banks have excelled by their absence from the negative league tables.

A high degree of de-personalisation (also called marketisation) of finance accentuates certain problems in harder times.

Will finance become more personal again?

Markets benefit a lot from less personalised finance. Thus, it will remain an important aspect of financial intermediation. However, personal, or relational finance has its place too. Wherever stakes are high, due to complexity, size or risk, issuers, investors and intermediaries prefer to conduct more careful due diligence at a more personal level, and contract only with parties they are comfortable with. When and where such behaviour is prevalent, financing tends to be more stable, and this point will be remembered by parties who pursued opportunistic contracting.

We expect that a number of factors will reverse some of the de-personalisation that has taken place. Possible changes in accounting rules may make it harder to do accounting arbitrage. Where firms are forced to disclose their risk positions more clearly, they will also do more scrutiny of the assets, and invest into deals they understand and issuers they know. The same will apply to investors and banks who burnt their fingers; a bad position is a good teacher of fundamental principles. Furthermore, the appeal of structured assets has revealed that investors take big exposures in model risk which is hard to diversify. Increasing exposure in specific names and reducing structured assets is a natural response to managing model risk. [[[PAGE]]]

Nordic capital markets

Denmark, Norway, Sweden and Finland, together with Iceland, represent a market of about 20 million consumers with relatively high per capita incomes, and their economies have performed strongly over the past ten years. Each country has its distinct economic characteristics and strengths that local investors have become familiar and comfortable with through historical and personal affiliation. With the exception of Finland, a member of the eurozone, all the Scandinavian countries retain their own currency. They have their own domestic capital markets with their individual idiosyncrasies, and even the domestic Finnish CP and bond market has its own features. They include a meaningful number of sophisticated investors and issuers, who know each other well on an institutional level, reinforced by good personal ties. These links have also prevailed in times of market turbulence. For example, commercial paper markets, which are considered among the most sensitive, have all functioned well and stayed open during the summer of 2007 when the ECP markets had great difficulties in providing funds for corporates. The graph shows month end outstanding commercial paper volumes in Sweden since January 2007, and makes this point very clearly. Outstanding volumes have barely moved, and spread widening for corporate and bank issuers has been limited to 5 basis points or less. The picture in both Finland and Norway appears very similar.

Does this then mean that Nordic investors ignore the increase in risk when it appears so well documented?

No, this is not the case. There is sufficient global convergence as Nordic investors can access international investment opportunities and thereby reap the higher spreads now available in credit markets. Consequently, spreads have adjusted in the Nordic markets too. Also, in the bond market both demand and supply factors have led to much lower activity, and in particular, the Norwegian high yield new issue market has been extremely quiet since spring 2007.

A bad position is a good teacher of fundamental principles.

Thanks to the local banks’ small exposure to sub-prime, SIV and other toxic assets, they have not been sellers of credit in local markets, which enable everyone to take a calm view on their positions and their valuation.

Opportunities in Nordic debt markets

Nordea has seen clear evidence that Nordic debt investors are taking advantage of the opportunities and increasing their exposure in local credits. Issues in the style of US private placements as well as junior capital issues (debentures, hybrids, subordinated debt) have seen great success while, for example, corporate hybrid issuance in public Eurobond markets has been largely closed for the past 18 months.

What these issues demonstrate is a clear statement by local investors that they consider the spreads now more in line with risk and that they are happy to make the due diligence effort to get comfortable with the deals. Also, liquidity has been demonstrated to be fickle when it is most needed, and thus, investors seem to focus on exposures where they are comfortable to take a buy-and-hold view.