Germany's regional states -- the Länder -- are faced
with tough choices regarding their funding programmes.They realise that Emu will present them with new challenges, but
also new opportunities. But they have yet to come to a conclusion
on the best way to face up to them.The strongest states are
increasingly looking to go it alone in diversifying their investor
bases. The smaller ones, however, need to improve the reception to
their pooled jumbo financing.And all the German Länder may
need to acquire ratings before they can achieve a truly
of their debt.
THE GERMAN LÄNDER are keenly aware of the challenges that an increasingly competitive capital market in Europe will provide after monetary union. But they appear to be less certain of the best way to prepare for it.
When the euro is in place, investors are likely to look to new credits which offer a pick-up over government bonds. Regional states, as quasi-sovereigns which sometimes have better economic fundamentals than the sovereign, will be a prime option. Many bankers expect a Europe-wide regional and municipal market to develop in the coming years.
Germany's Länder are the largest and among the strongest economically of Europe's regions, and as such should be well placed to take advantage of the new financing opportunities once the euro comes into being. The Länder have been leading the way in trying to find a more diverse audience for their bonds in recent months, but they have been adopting different strategies.
The regions perceived as Germany's strongest -- Bavaria, Baden-Württemberg and Sachsen-Anhalt -- have been sufficiently confident about their credits to go it alone for jumbo financings targeted at an international as well as domestic audience.
The smaller regions, with lesser financing requirements and arguable lesser credits, have on two occasions sought to pool their funding to create one jumbo transaction to rival Bunds and to surpass jumbo Pfandbriefe -- but to date with poor results.
Some Länder have tried both approaches. For example in late October the state of Hessen launched its first non-domestic sale of state treasury notes, a DM1bn deal led by Helaba, Merrill Lynch and Paribas. Apart from its participation in the two pooled jumbo Länder transactions in 1996 and in January this year, the transaction marked the first time that Hessen had issued a public jumbo transaction.
Hessen embarked on a six day roadshow, which took in Frankfurt, London, Paris and Amsterdam from October 10 to October 16. Bankers said that the exercise was as important in helping educate Hessen funding officials about the needs of international investors and the nature of the Euromarkets as it was in explaining the Hessen credit to investors.
"The Hessen officials wanted to understand how the process works," said an official at one of the leads. "But we were also a little surprised at how little investors knew about the state."
Hessen's story was one of tight fiscal discipline, with its gross borrowing requirement expected to fall from DM8bn in 1995 to DM5.5bn in 1999; low inflation, at just 1.2% in 1996; and one of the highest nominal GDP per capita ratios of any region in Europe, with its $37,000 per capita far outstripping the total for Germany of $28,000, and a similar distance ahead of countries such as Austria ($30,000) and the Netherlands ($26,000). Hessen was marketed as one of the strongest three German regions, alongside Bavaria and Baden-Württemberg.
Hessen chose an unusual maturity date of January 30, 2008 which was designed to enhance the impression that the deal was a liquid, institutional benchmark. The next supply of 10 year Bunds will have the same January 2008 maturity -- Hessen wanted investors to view its deal as a kind of Bund surrogate.
Hessen officials were at pains to point out during the roadshow that its decision to launch an internationally targeted deal on its own did not mean it would not participate in future pooled jumbo Länder transactions.
"Hessen's aim is to have as many funding instruments as possible available to it," said a banker. "That includes grouped borrowings."
Hessen's deal was by no means a runaway success -- syndicate members reported that the deal was poorly timed and was on the aggressive side -- but it was certainly better received that when Hesse took part in the pooled borrowings.
Indeed, the verdict among most German and international bankers appears that the Länder involved in the group financings should be awarded nine out of 10 for their theoretical approach to tapping a broader international investor base, but that they should get at best three or four out of 10 for the practices they have used in the process.
The basic principle underpinning the launch of the first pooled jumbo transaction -- the Länderschatzanweisung Number One launched by seven Länder last August -- was similar, say local bankers, to the principles which have guided the Pfandbrief issuers so successfully to the international market.
By grouping together the borrowings of seven states with a jumbo DM4bn 10 year transaction, and by assembling a cosmopolitan group of 10 bookrunners and nine co-lead managers, it was assumed that the septet of Länder would guarantee liquidity for international institutions.
In addition to the sheer size of the issue, a further guarantee of liquidity was offered through the lead managers' commitment to make markets in the bond in lots of up to DM25m at a spread of no more than 10bp. The seven Länder hoping for a magnificent innovation were Berlin, Hamburg, Hesse, Nordrhein-Westfalen, Rheinland-Pfalz, Sachsen-Anhalt and Schleswig-Holstein.
So far, so good. But Länderschatzanweisung Number One hardly had an auspicious start when, a week before its launch, the state of Bavaria voted with its feet by launching a jumbo bond on its own. One Frankfurt-based banker describes the Bavarian bond -- a DM1bn 10 year issue priced at 17bp over Bunds and jointly led by Bayerische Landesbank and ABN AMRO -- as having been a "very strong statement which obviously sent out a confusing message to international investors".
IF investors were confused by the Bavarian initiative, the other German states were highly displeased, largely because Bavaria (along with Baden-Württemberg) has long been viewed internationally as the strongest of Germany's Länder.
The feelings of the Länder which participated in the pooled deal are probably best summed up in three words spoken by Georg Schwarz, funding director at the ministry of finance in the Rheinland-Pfalz capital of Mainz , when he says: "I was unamused."
But while the other Länder could scarcely be blamed for the independent actions of Bavaria, according to bankers there were a number of other factors over which they could and should have exercised more influence. Above all, the critics say, the Länder could have offered investors a much better and more consistent service of communication, and ought also to have shown a willingness to compromise on the deal's pricing, given its importance as an innovative structure aimed at paving the way for many more similar transactions in the future.
As one disgruntled banker in Frankfurt argues: "These states were basically taking their own views on the structure of the issues without listening for a moment to the investment banks which had the experience of liaising with the international investors they were trying to reach. The first issue came to the market extremely quickly and, at 17bp over Bunds, it was much too tightly priced. We told the Länder very clearly: this is not the way to broaden your investor base. They chose not to listen."
If the first deal surprised and bemused Frankfurt-based investment bankers, the second bewildered them, for any number of reasons, leading one to ask caustically: "Do they have Bloomberg screens in Mecklenburg-Vorpommern?"
This is a pointed reference to the pricing of the follow-up transaction this January, which bankers complain was way off the mark in relation to the only existing benchmark, the Länderschatzanweisung Number One, which was trading at the time as high as 23bp over Bunds.
By contrast, the 10 Länder participating in Länderschatzanweisung Number Two requested public and private sector bank consortia bidding for the DM4.5bn mandate to submit competitive pricing bids at a spread of no more than 16bp over the Bund.
"If anything the second deal was even worse than the first," says one banker. "It was crazy to make the private sector banks bid for the deal in competition with the Landesbanks, because it is pretty obvious which group was going to come up with the more aggressive bid."
The winning bid -- at an extraordinarily tight 15.5bp over Bunds --came from a domestic group made up of Bankgesellschaft Berlin, Bayerische Hypothekenbank, DGZ, Helaba, NordLB and SüdwestLB.
Had both this group and the private sector consortium (which submitted a 16bp bid) tendered identical bids, says the same banker, the mandate would have been awarded -- bizarrely -- on the outcome of a lottery.
"The rumour," this banker goes on, "was that the bids originally asked for by the Länder were even tighter than 16bp. It was a disappointing approach because it indicated to us that nothing mattered other than pricing -- critical aspects such as research and placing power were considered secondary to pricing."
One foreign banker in Frankfurt who participated in the unsuccessful bid is a little more stoical about the episode. Asked if he was unhappy to have lost the mandate, he responds: "Yes and no. Of course we don't like to lose mandates but we decided along with a number of other large local and international banks what the right price should be, and we were underbid by half a basis point.
"If you are absolutely clear in your mind about where the pricing should be you shouldn't necessarily be unhappy if somebody else offers to do it more cheaply."
In fairness to the Länder, as more than one Frankfurt-based banker is quick to point out, their treasurers are acting in a very different, highly politically charged environment from those responsible for funding at other German issuers. And at least one funding director -- Schwarz at Rheinland-Pfalz -- is unrepentant about the pooled Länder issue for a number of reasons.
First, he argues: "Every day the newspaper headlines in Germany tell people to save money, and it is our responsibility to access funding at the lowest possible cost. We look at every pfennig."
Cutting costs to the very minimum, Schwarz implies, also extends to the finances which would be involved in securing an investment grade rating, which the Länder -- against the advice of their private sector banking advisers -- elected not to do.
"Our attitude to ratings is very clear," he insists. "As long as the federal government is rated triple-A, then our implied rating should be exactly the same. We're the state and if creditors don't trust the state..." Diplomatically, perhaps, Schwarz leaves this sentence unfinished.
Against this background, Schwarz adds, why should a Land such as Rheinland-Pfalz incur the time and expense involved in jumping through the hoops which ratings agencies inevitably hold up.
"I know what would be involved," he says. "We would have to hire at least one extra person to work on the rating issue full time, which would cost between DM150,000 and DM200,000 per year."
A second key reason offered by Schwarz for the pooled jumbo structure has to do with the funding requirements of a state such as Rheinland-Pfalz.
"Our borrowing needs may be high in our eyes but in a global context they are very small," he says. "A normal issue size for the federal government would be DM10bn, whereas we are a medium sized state with a population of about 4m which has a total annual funding requirement of about DM7bn."
With this relatively small requirement, Schwarz says that it is generally cheaper for the state to fund itself via the local Schuldschein market which, conveniently, tends not to worry too much about niceties such as ratings.
Schwarz adds that the Länder remain committed to the concept of the pooled jumbo issues and that they came very close to launching Länderschatzanweisung Number Three this July, but balked at the costs relative to the Schuldschein market.
Schwarz also comments that whatever the market may have said about the first two pooled jumbos, the experience has been valuable for the Länder.
"We learned a great deal from Länderschatzanweisung One and Two," he says. "And when we come to do Number Three we will change some technical details. For example, we would not fix the pricing on a Friday, and we would include a clause allowing for the bonds to be redenominated into euros."
This, at least, will be welcome news to members of the German investment banking community, who appear to agree that pooled jumbo issues from the Länder are here to stay.
"I think the Länder will press on and establish a full yield curve," says Werner Humpert, vice president at Merrill Lynch Capital Markets in Frankfurt, "because in the long run they want these issues to be seen as a Bund substitute."
In spite of the negative press coverage which followed the two pooled jumbo issues, the Länder do find support for their actions from a number of local bankers.
On the vexed issue of ratings, for instance, one observer in Frankfurt says: "It is not a decision that any of the Länder involved in the pooled deals could have taken on their own. They would have needed to consult all the other Länder as well as a host of regulatory bodies, and ultimate decisions would have been based on political as well as economic reasons."
THE political constraint, other bankers add, is transparent enough: while theoretically Germany's system of Finanzausgleich ought to have ensured that each of the Länder would command the same rating, there is no guarantee that this would have been the case. No individual Land, say local bankers, could possibly have taken the risk of being assigned a credit rating lower than the triple-A each of them is convinced it merits.
Seven of Germany's Länder are rated by Standard & Poor's (S&P), which the agency reports has caused some confusion among investors. The key point about each of these ratings -- covering the states of Bavaria, Baden-Württemberg, Hessen, Lower Saxony, North Rhine Westfalia, Rheinland-Pfalz and Schleswig-Holstein -- is that they are stand-alone ratings which S&P has assigned because they are the guarantors of their respective Landesbanks.
In no case has the debt of any individual state been rated by any of the leading agencies, leading one S&P analyst to say that the ratings now assigned to the seven Länder should be regarded as "implied rather than official".
Those who argue that the Länder were probably right to shy away from the ratings agencies would find support from Moody's in Frankfurt. Last August, the agency released a curt bulletin which did not explicitly name the Länderschatzanweisung structure but which was very clearly a thinly disguised commentary on the issue.
Entitled More is Not Necessarily Merrier, this report
accepted the theoretical wisdom of the idea, remarking that
"mammoth forays into the debt markets can reduce overall financing
costs, enhance primary and
secondary market liquidity and allow the issuer(s) to bask in some not unwelcome publicity."
The problem which such a pooled structure would face in securing a rating, says Jürgen Berblinger, managing director of Moody's Deutschland, is that any such rating would need to be based on the weakest link in the chain rather than on the strongest, which in itself is an ample explanation as to why a state such as Bavaria would not countenance participating.
"Bondholders making claims under such an arrangement," explains the Moody's note, "have to pursue each individual obligor for its proportional liability under the indenture and cannot claim against any one obligor for the failure of others to pay. The credit quality of a multiple-issuer facility with several liability might therefore approximate [to] that of the weakest obligor in the group -- a fact which Moody's could reflect in its rating of such instruments."
Despite this, Moody's clearly thinks that more pooled instruments (from the states as well as other borrowers) are probably in the offing. "We believe the benefits of jumbo issues will induce those with common financing needs -- such as local authorities -- to attempt to pool their borrowing requirements into multiple-issue bonds," the report notes.
"We further contend that this process will be given a fillip by the admittedly tortuous slog towards monetary union in Europe, which will eliminate the advantages currently enjoyed by some local authorities of issuing in their domestic currency."
Although many of the Länder seem committed to the longer term development of the pooled jumbo structure, it is also evident that a number of the Länder are prepared to follow the example of Bavaria and go their own way via individual benchmark transactions targeted at an international audience.
The clear trailblazer in terms of direct funding via the international capital market to date has been the former eastern German state of Sachsen-Anhalt, which began the process following a recent change in legislation which allowed public sector borrowers to issue up to DM40bn worth of securities with maturities of below one year, DM20bn of which was allocated to the federal government with the balance earmarked (should they want it) for the states.
Sachsen-Anhalt was the first (and to date the only) Land to take advantage of this new ruling, launching a DM500m Euro-commercial paper issue in May.
"The issue there," says Karsten Møller, executive director at Goldman Sachs in Frankfurt, which arranged the Sachsen-Anhalt facility, "is that the German money markets are tremendously underdeveloped. There has been very little product, especially as the biggest issuer in the past, the Treuhandstalt, does not exist any more.
"As a result there is enormous demand from foreign central banks in particular, but also from fund managers, for money market instruments. And our view was that the German states should take advantage of that and use it as just another way of globalising their sources of capital."
One obvious drawback in promoting the Sachsen-Anhalt CP programme overseas, however, was the fact that the borrower was unrated. "It is clear that a number of foreign investors cannot buy the paper because it is not rated," concedes Møller.
"That does not mean that we cannot get international investors to participate, but there is no doubt in my mind that if it was rated it would have much broader international appeal. But DM500m is a small programme, given the global demand for government or state Deutschmark-denominated commercial paper."
To date, other German Länder have not responded to the Sachsen-Anhalt initiative by following it into the Euro-CP market. "The best thing that could happen for Sachsen-Anhalt's CP programme," Møller adds, "would be if five or six other states also set up a CP programme, because it would make the total volume that much more significant."
Aside from its CP programme, however, Sachsen-Anhalt has forged ahead with a series of Eurobond issues aimed at cultivating an investor base outside Germany. A pointer for this came at the start of the year when, significantly, Sachsen-Anhalt chose not to participate in the second pooled jumbo structure, even though it had been one of the original seven in the first issue in 1996.
In March of this year, for example, Sachsen-Anhalt became the first German state to incorporate a euro-fungible clause into a public bond issue, with a DM500m five year bond led by NordLB, ABN AMRO, BGB, BZW and CDC providing a clause in its documentation to the effect that it would be redenominated into euros at the start of the third stage of Emu.
In June the region issued a further 10 year DM1bn euro-fungible transaction via WestLB, Commerzbank, Dresdner Kleinwort Benson, HSBC Trinkaus and Société Générale, launched at 12bp over the 2007 Bund.
In addition to a euro-redenomination clause, this transaction used the fixed price re-offer mechanism, and was actively promoted prior to its launch by Sachsen-Anhalt's treasurer, Axel Gühl, through a series of presentations in London, Paris and Germany. Over 60% of the issue was placed outside Germany, primarily with accounts in the Netherlands, France, Switzerland and Austria.
Another DM1bn transaction for Sachsen-Anhalt followed at the end of August, with a 10 year bond led by ABN AMRO and Deutsche Morgan Grenfell, again targeted at international institutions. This issue was priced at 14bp over the government curve, with both leads reporting a healthy level of international demand for the paper: DMG indicated at the time that some 55% of its allotment had been sold to Dutch institutions, while ABN AMRO reported that 45% of its ticket was placed outside Germany.
Looking to the future, Gühl has been on record as saying that he is aiming to diversify the state's investor base further in 1998 and beyond, possibly through new issues in French francs, US dollars and sterling.
Clearly, Gühl has already been successful in doing much of the preparatory work necessary for expanding his state's investor base, and wins unqualified praise from a number of bankers for his willingness to break with tradition and tap international markets independently.
"Gühl really has guts," says one Frankfurt-based banker. "He took a lot of flak, especially from some of the smaller Länder, when he started going to the international market because he is being held responsible for breaking up this cosy club of borrowers, but he deserves all the credit he has been given for his strategy."
Sachsen-Anhalt is intent on continuing its individual approach, and in late October appointed Morgan Stanley Dean Witter and Salomon Brothers to lead manage an opportunistic DM1bn bond.
Bankers also report that Sachsen-Anhalt is readying itself for a credit rating which, once again, will mark an important break with tradition for the Länder. The rationale for this is simple enough: while Sachsen-Anhalt has already enjoyed success in developing an investor following in European countries such as France and the Netherlands, this only represents half the job in terms of international investor diversification.
If Sachsen-Anhalt is to go the distance, say bankers, and add institutions in the US and the UK to its growing band of international followers, it will have no choice but to secure a recognised credit rating. EW