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US firms cheer credit mart by pushing out hybrid deals

US hybrid capital issuers forged their way into the market with five deals this week, totalling almost $3.5bn — even though global capital markets were battered for two days by fears of a crisis in the US subprime mortgage market.


Bad news shakes markets as analysts ask if it's 'Game Over'

Markets were hit with a barrage of bad news related to the subprime meltdown this week.

On Tuesday the Dow Jones Industrial Average plunged 242.66 points and Treasury prices soared in a rush to quality assets after New Century Financial Corpsaid it had received a subpoena from federal prosecutors in a previously disclosed criminal investigation into accounting problems and trading in the company's shares.

New Century is a Reit that became the US's second biggest mortgage lender to subprime borrowers — people with high amounts of debt or weak credit credentials.

With defaults mounting, NewCentury said this week that its lenders were cutting off its funding, causing its shares to plunge to $1.66 on Monday before they were suspended. In early February they were worth $30.

Separately, General Motors said it had agreed to pay about $1bn to make up for subprime lending losses at GMAC.

H&R Blockthis week disclosed more losses on subprime mortgages, reporting in a quarterly filing with the SEC that it had cut the carrying value of certain mortgage assets by another $29.2m at its Option One unit, which extends mortgages to people with bad credit.

One thing is certain — that the volatility is not over yet.

"We've been asked to give some perspective on what point do we have to get to before we can safely say the markets have overreacted and overshot to the downside," said David Rosenberg, North American economist for Merrill Lynch.

"Everything that is happening now has to be viewed in the context of having come off the longest period of ultra-low volatility in recorded history and the longest period without a meaningful daily correction since 1954."

Rosenberg believes the US could be heading toward what he calls a "growth scare".

"If what we are seeing now turns out to be a plain vanilla correction that only involves pricing in some recession risk, but not experiencing a recession, the average decline in the S&P 500 is 16% and the correction lasts 13 weeks," he said.

"But if we do end up seeing a recession, then it's game over: the historical record shows the average decline in the S&P is 34% and the average duration is 37 weeks — more than double the magnitude and triple the duration of classic non-recessionary correction."


The riotous flowering of US hybrid capital issuance in the past 18 months has created a new, volatile bond market through which to measure the temperature of global confidence in credit. And when US subprime mortgages are the focus of concern, US hybrid capital deals are at the sharp end of any potential trouble. Early in the week, hybrid spreads of some bank issuers were slammed by fears of subprime losses. By Wednesday, credit card lender Capital One's hybrids had slipped as much as 28bp on the week.

"Last week we had bids for everything. Now there are only about one or two dealers making markets, because the rest have run for cover," said one trader.

That was Wednesday. By yesterday (Thursday), everyone was optimistic again, as equities traded more strongly.

"The market feels fine," said one banker who had been all gloom earlier in the week. "People want to keep buying credit product."

By Thursday the hybrid market was wider by about 5bp across the board, from as much as 10bp wider earlier in the week.

"The uptick in financial stocks has given people confidence that we will be able to trade our way out of this subprime mess," said one head of credit trading. "Sentiment is shifting to the positive side. There are a lot of people looking to put money to work."

Punching out hybrid issues through this up-and-down week were XL Capital, CIT Group, Merrill Lynch, Arizona power company PPL Corp and US Ag Bank FCB, a farm credit bank.

Although every deal came at a concession to secondary spreads, underwriters were determined to look on the bright side and deem the transactions a vote of confidence in the credit markets generally.

"The positive takeaway on this is: even given this volatility, investors are still comfortable buying subordinated risk," said a debt capital markets banker at one of the leading hybrid bond houses.

Jim Merli, global head of syndicate at Lehman Brothers, said: "We have continued to see strong demand in the new issue credit markets — albeit at wider levels, as investors are demanding a bigger new issue premium, given the increased volatility. The strength of demand in primary issuance is a positive signal for the overall market."

First to come was XL Capital, the Bermuda insurer and reinsurer, with a $1bn perpetual non-call 10 year hybrid issue. It was priced at 200bp over Treasuries, after XL was said to have chased 180bp. The bond widened 15bp after pricing.

Next was CIT Group, the US corporate finance company, which tapped a blowout 60 year non-call 10 hybrid it had issued in January. The $250m reopening was sold at 185bp over Treasuries to yield 6.354% and then widened to around 190bp bid.

This was a far cry from the original deal in January, which drew an $8bn book at 6.106%, or 130bp over.

On Thursday, as the stockmarket recovered and confidence in credit was restored, Merrill Lynch struck, with a $1.5bn perpetual non-call five year dividend received deduction (DRD) eligible bond at 50bp over Libor. It was mostly sold to institutional investors.

"Investors certainly got a concession on the Merrill trade to compensate for the choppiness in the markets, but everyone feels good about the deal," said one trader.

Arizona power company PPL Corp, one of the few 'five B' credits to come to market, also offered investors a juicy concession.

It increased its 60 year non-call 10 deal from $400m to $500m and priced it at 220bp over with a coupon of 6.7% to yield 6.732%.

"That's too cheap," said one senior syndicate manager. "Their underlying 10 year trades at worst around 125bp, so they priced almost 100bp back. Dominion Resources, meanwhile, has non-call 10s trading 75bp back of senior debt and they are similarly rated. Granted, Dominion would also have to pay a concession to come to market, but taking that into account I still think PPL paid about a 20bp concession."

A Kansas-based farming credit bank, US Ag Bank FCB, also came to market with a $225m perpetual non-call five year deal at 165bp.

"The market feels better today, or at least it doesn't feel any worse," said the senior syndicate manager on Thursday. "We've stabilised at wider levels."


Just a repricing

Some bankers argued that investors were exploiting the subprime worries as an excuse to push for extra spread on new issues. "Some of the smarter accounts are trying to push for more and more new issue premium while they can," said one syndicate head. "I take this as a positive sign of the overall health of the market, that people are not moving wholesale away from credit, just repricing the risk inherent in credit."

Even so, concerns about subprime mortgage exposure cannot be brushed under the carpet.

New Century Financial, one of the most aggressive lenders in the US, has either been banned from operating or is being investigated by attorneys general in at least six states.

Some analysts fear the subprime problem could affect lending generally, spark a credit crunch, send housing prices tumbling as much as 10% this year and force the US into recession.

Whether this is all media hype or not, equity investors wake up every day to screaming headlines. And as one head of high grade bond trading said: "All we do is track equities."

Concerns about subprime losses are also hitting the credit market in other ways. "If you are a chief investment officer, responsible for all the investments across fixed income, equity and mortgage markets, and all of a sudden MBS cheapen up, your thoughts will be 'why buy credit at these levels when we can buy mortgages at these new cheaper levels?'," said one syndicate manager. "It can hit us, just from an asset allocation point of view."

For the foreseeable future, market participants expect credit to be volatile from one day to the next.

"We've gone from a market where any day was a good day to print a trade to one where issuers have to be a lot more thoughtful, a lot more selective," said a debt capital markets banker.

So why do issuers insist on coming in the midst of a sell-off?

"When you get an unexpected increase in volatility, it plants a seed of doubt in their heads," said the DCM banker. "They suddenly can't tell whether it will be worse next week or better. A few weeks ago issuers were of the opinion that the market would get better and that they might as well wait and see.

"Now, they worry that next week could be worse and they jump, even though they don't like printing at wider levels."

Danielle Robinson

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