Article

by Mark Ford

Some letter of credit markets are changing substantially in the wake of the so-called credit crunch that has hit the US' financial sector particularly hard. Some of America's leading retailers are the latest victims of US banks' reluctance to issue L/Cs, while the municipal bond market has been thrown into disarray, prompting issuers to turn to L/Cs to enhance products.

As far as L/Cs are concerned, the impacts of the credit crunch have not been negative for everyone. Some international banks with stronger balance sheets are replacing their US counterparts in fastgrowing markets for securities-enhancing L/Cs. Other financial institutions are rediscovering that trade finance business can be very good business after all.

Top US stores

By April, a clutch of famous US retailers had announced that their banks had refused to renew their L/Cs on the same terms they use to reassure their suppliers that they will be paid. Sears Holdings, with 3,800 stores across the US and Canada, said Bank of America had refused to renew a USD 1 billion L/C under existing terms. The news sent Sears' shares tumbling 3.2 per cent on the day of the announcement.

For a retailer, losing an L/C facility means it may have to tap cash funds to pay suppliers, although Sears said it still had access to an alternative USD 1.5 billion L/C which it could employ.

HSBC Holdings Plc and Bank of America have cancelled USD 265 million in L/Cs for women's clothing retailer Talbots. With 1,150 stores under the Talbots brand name, some 271 outlets under the J Jill brand name and a big direct marketing operation, lack of access to credit is a big problem for the retailer, which relies to a large extent on goods supplied from Asia.

Talbots appears increasingly hard pressed to find the cash it would need to pay cash up front in the absence of an L/C facility. The retailer had USD 25.5 million in cash at the end of February this year, compared with USD 35.9 million a year earlier, according to data compiled by Bloomberg. Sears is more strapped for cash than it was last year too. According to a regulatory filing by the company, it had USD 1.62 billion in cash on 2 February 2008, less than half the amount it had on the same date last year.

Talbots appears to have transferred some trading risks from US banks to its mainly Asian suppliers, which the company says are prepared to work on open account terms with payment due within 45 days of delivery.

Other retailers reeling from the reluctance of US banks to provide credit include Borders Group, the US' second largest bookstore chain. In March, it announced the company was up for sale after it failed to obtain credit to finance store and technology improvements.

Municipal bond market

One area where L/Cs are playing a distinctly different role these days is in the US municipal bond market, in which states, cities, counties or their agencies (the municipal issuer) issue municipal bonds to raise funds. Bonds bear interest at either a fixed or variable rate of interest.

A specific set of issues plagues variable rate bonds, which can be corporate as well as municipal bonds. This type of bond is typically a debt instrument with a longterm nominal maturity for which the interest rate is periodically reset - typically every seven, 28, or 35 days - through a Dutch auction.

One of the impacts of the recent turmoil in financial markets has been that bidders are now only prepared to buy these bonds at interest rates much higher than they used to be, which is very expensive for the municipal issue. When some variable rate bonds have come up for renewal, there have been no bidders at all.

Municipal issuers, such as student loan provider Montana Higher Education Student Assistance Corp (MHESAC), have been hit hard. Earlier this year, when more than USD 1 billion worth of MHESAC's bonds came up for their regular auctions, there were no buyers. This meant MHESAC had to pay existing owners of the bonds a higher interest rate. Now MHESAC says it wants to refund the bonds and use less expensive borrowing options.

But according to the Ambac Financial Group Inc, using L/Cs can be a way to mitigate the impact of interest rate hikes on auction rates and other variable rate debt. It reckons issuers and their advisors could consider what they call L/C wraps, under which if the issuer or borrower defaults on payments, then a right to force redemption with an L/C draw can be exercised. This type of credit enhancement aims to persuade bond buyers to hold bonds at reasonably low interest rates.

The practice of backing municipal bonds with L/Cs is not new, and some banks are pulling out of that market because they feel it has become too risky. This is particularly the case with US banks, although it seems non-US banks are stepping up to take their place.

In March, State Street Bank withdrew an L/C it promised to the Massachusetts Turnpike Authority (MTA) for its USD 127 million in variable rate bonds. The North American operations of Citibank and Comerica Bank are other banks not prepared to take on the market volatility and credit constraints wrought by the credit crunch. These banks have not written a single L/C this year, according to Thomson Financial data.

But with demand for such L/Cs rising, banks stepping into or upping their positions in this market include Spain's second largest bank, Banco Bilbao Vizcaya Argentaria. It is providing L/Cs through its Grupo Banco Bilbao Vizcaya unit on two issues for a total of USD 267.2 million. Other liquidity providers growing in the US market include HBOS Group member, Bank of Scotland, KBC Bank, Bank of Nova Scotia, Allied Irish Bank PLC and Harris NA, owned by its parent company, Bank of Montreal.

These new players are responding to better margins on this type of L/C business, with prices forced up by the supply shortage caused by the previously big players backing out of the market.

The premiums are attractive. L/Cs costing 10 basis points (10bp) by AA-rated issuers before the financial markets were thrown into turmoil are now fetching 30-40bp, while lower-grade issuers may be paying even more. A three-year L/C that nine months ago would have been priced at 15-25bp for an A-rated issue would probably fetch between 30-45bp today, one banker said.

As a result, this particular cloud appears to have a silver lining, and with municipal issuers increasingly forced to turn to L/Cs to keep their debt payments low, this particular L/C market is burgeoning. According to Thomson Financial, the US states, cities and agencies that sell municipal bonds bought L/Cs worth USD 5.5 billion in the first quarter of 2008, more than double the value of L/Cs they bought in the corresponding quarter last year.

Some US banks are hanging on in this market and writing plenty of business. Bank of America, for example, remains the largest L/C provider in the municipal market. It backed USD 1.16 billion of bonds in the first quarter of this year, topping the USD 1.1 billion that the entire industry backed a year ago. Other US banks still in the market are JPMorgan Chase & Co, which wrote USD 871 million of L/C business in the first three months of 2008 compared with USD 130 million in the same period last year. Bank of New York Mellon backed up nearly USD 397 million of municipal bonds with L/Cs in the first quarter of this year - a more than a fourfold increase over the USD 88 million of L/C business it wrote in the same market a year ago.

Safe haven

A return to bread-and-butter banking lines appears to be an attractive proposition for banks that now recognize that risky business lines, such as the sub-prime investments that contributed to the credit crunch, may not be a good idea.

International lawyer Robert Parson recently told the Dubai-based Khaleej Times that he sees traditional trade finance products such as the L/C making a comeback, bolstered by the new rules and procedures introduced in UCP 600. "There is a trend back towards more tightly structured trade finance products and the L/C that was looking for a boost after many years of pulling up," said Parsons, a trade finance specialist with Clyde & Co.

One US bank making for the relatively safe haven of trade finance is East-West Bank. It says that areas of its business are under a lot of pressure due to adverse market conditions, but it is managing to increase non-interest income on the back of its growing L/C business.

East-West Bancorp, the parent company of East-West Bank, recently reported financial results for the first quarter 2008. The bank's first quarter results included a USD 55 million provision for loan losses. But core non-interest income was around 11 per cent higher than the same quarter in the previous year - an increase that East-West says is largely down to increased branch fees and L/C fees and commissions.

Mark Ford's e-mail is markford@gotadsl.co.uk