An interesting article in Reuters yesterday puts attention on sovereigns, supranationals and agencies (SSAs) posting collateral. The article points out that UBS had a big business with SSAs that was increasingly unprofitable and capital intensive. As a result of UBS’s pull out of almost all their FICC businesses, other dealers are calling SSAs to talk about posting collateral with not much headway.
UBS exit reprises swaps collateral debate
By John Geddie
Thu Nov 1, 2012 12:57pm EDT
LONDON, Nov 1 (IFR) – UBS’s decision to close down its public sector business because it was too capital intensive has reignited the debate whether this business is sustainable without issuers changing their ways.
As things currently stand, the majority of sovereign, supranational and agency (SSA) issuers only have one-way credit support annexes (CSAs) – contracts that require banks to post collateral to these issuers when out-of-the-money on swaps, while not receiving collateral when the situation is reversed.
One-way CSAs only became a problem when the cost of liquidity increased in the aftermath of the credit crunch. The sovereign crisis has made the situation even more punitive for many banks.
The SSA outfit at UBS fell victim to the bank’s desire to be capital light, said a senior UBS official, adding that fixed income is seen as very asset intensive on a risk-weighted basis.
“SSA clients have been very inflexible at looking at two-way CSAs and with capital so scarce and expensive, the numbers just didn’t add up,” a senior UBS DCM banker told IFR.
The overwhelming reaction to UBS’s retreat from SSA was one of shock, with rival banks adding that it was “unfathomable” that UBS wasn’t running a profitable business in SSA.
But UBS’s legacy swap positions have come under internal scrutiny because of additional capital charges from Basel III.
“We’ve called all the SSAs and said this is a cautionary tale. If you don’t do it more people are going to pull out,” said one fixed income head.
In order to appropriately price funding and credit costs under more punitive regulatory requirements, banks have been inching up quotes on swaps for their clients over the last two years. The hope is that eventually a hike in prices across the board will make it untenable for issuers not to enter into two-way agreements.
The UK’s Network Rail has already signalled it is aiming to sign two-way collateral agreements with all its swap counterparties before Christmas.
“It was a very simple decision,” said Samantha Pitt, group treasurer at Network Rail.
“Under Basel III the cost of hedging is getting higher and the number of counterparties you can hedge with is getting smaller.”
So far, some of the smaller European agencies have changed tack but it is the supranational issuers that have refused to budge.
Borrowers that have agreed to two-way CSAs have still insisted on asymmetrical thresholds, where the triggers or posting requirements are different for each side – normally in favour of the higher-rated party, which is usually the borrower.
Network Rail believes it will be the first SSA issuer to have zero thresholds.
“You speak to the issuers and they think that the banks have it all too easy – they don’t have to do a lot of work, all the deals sell by themselves, and banks don’t add much value to the process,” said one SSA syndicate official.
“The reality in the dealer community is that there is pressure in terms of margins because issuers require banks to do transactions which are often uneconomical…they are trying to maximise the pain threshold that banks are willing to take.”
Some of the most active banks in the sector have already stopped bidding on swap contracts, losing the business to new entrants that are looking to aggressively increase market share.
Those with the highest market share believe, however, that for many new entrants their exuberance may be short lived.
“The SSA business has always been challenging from a return on capital perspective and I suspect will be the first of a few moves in this direction. At long last we will see either local players or a small number of global players pull back,” said one head of sovereign trading.
WHO’S NEXT UP?
But at present it is far from certain other issuers will follow Network Rail’s lead.
Another senior UBS official said that unless another house exits the SSA business, the current furore will probably blow over. An origination official at a rival bank said it would come to a head in the next six to 12 months as issuers fill up lines with some of the lesser-rated counterparties that have been bidding aggressively in the swaps market.
“We will have to see how this plays out, but let’s not forget this is a very competitive market and many of the sovereigns and supranationals will not be impressed with this increased pressure to change their ways,” said a funding manager at a European agency.
A small group of Washington supranationals is reported to be pushing the issue among the SSA community at present. However, the UBS official added, the dealer group has been pushing the issue with the major borrowers in the market for four years, and has still made little headway. (Reporting By John Geddie, Additional reporting by Chris Whittall, Editing by Helene Durand, Alex Chambers)