Banks Face Funding Stress

European Institutions Resort to Potentially Risky Swaps to Generate Liquidity

Article from The Wall Street Journal
By DAVID ENRICH

LONDON—European banks, increasingly concerned about their ability to access funding, are devising complex and potentially risky new deals that enable them to continue borrowing from the European Central Bank.

The banks' maneuvers, which include behind-the-scenes swapping of assets among financial institutions, could heighten risk across Europe's already fragile financial system, say some senior industry officials and regulators.

They also are a sign that struggling banks across Europe are preparing for a period of prolonged reliance on financial lifelines from the ECB. The Continent's intensifying financial crisis has made it difficult for many banks to obtain funding from customary market sources.

Some banks are exhausting their supplies of assets—such as European government bonds and certain types of asset-backed securities—that the ECB accepts as collateral and that the banks haven't already committed to other uses, according to bankers and analysts. Others are scrambling to stockpile such assets to comfort analysts and investors worried about the banks' abilities to weather a long-term freeze in bank-funding markets.

Meanwhile, signs of stress continued to bubble up in the European financial system. ECB purchases of Italian and other euro-zone government bonds on Wednesday largely failed to halt the sell-off of struggling euro nations' debt.

And some European bank customers are balking at doing business with the banks. Norfolk Southern Corp. has decided not to use any European banks to refinance a credit line out of concern about the banks' future health, according to people familiar with the matter.

To ensure that their access to ECB loans continues, the banks are entering into a variety of complex transactions with other financial institutions to come up with billions of euros worth of assets that they can pledge as collateral to secure ECB loans, according to bankers and industry officials.

Some regulators and bankers are worried. By transferring potentially risky assets among a wide range of institutions, the so-called liquidity swaps have the potential to "create a transmission mechanism by which systemic risk across the financial system may be exacerbated," the U.K.'s Financial Services Authority warned in a July consultation paper.

Last month, the Bank of England hosted a meeting for a small group of risk officers from major international banks. When the conversation touched on liquidity swaps, a number of executives, including a senior UBS AG executive, voiced similar concerns as the Financial Services Authority, according to people familiar with the matter.

The scramble for ECB-eligible collateral highlights the tenuous state of Europe's banking industry. Traditional sources of bank funding, including institutional investors and fellow banks, have largely fled amid concerns that many lenders are sitting on huge piles of risky government bonds and loans to shaky borrowers.

That has left a funding vacuum that a growing group of banks are filling with loans from the ECB.

In the increasingly popular liquidity swap, banks transfer illiquid assets such as non-investment-grade loans to corporations or to finance public-infrastructure projects—and which aren't eligible to serve as collateral for ECB loans—to investment banks or insurance companies.

In return, the investment banks or insurers provide government bonds or other liquid assets that the original bank can use as collateral to secure loans from the ECB. The investment banks apply a discount to the assets they are receiving—shielding them from some potential losses—and receive commissions on the trades.

Euro-zone peripheral bonds fell back after the European Central Bank stepped back into the market to provide support. But how long can the ECB continue doing this and will it continue working? And is it all too late for Greece?

A number of French, Italian and other European banks, including bailed-out Franco-Belgian lender Dexia SA, recently have entered into such transactions, according to people familiar with the matter.

"It's a way to improve your liquidity and to get liquid some assets that are not liquid," said a senior Dexia executive, who says he has crafted billions of euros of such trades in recent months.

The Frankfurt-based central bank accepts a wide variety of assets as loan collateral, including European sovereign bonds, securities comprised of mortgages and other assets, and "covered bonds" backed by loans and other assets on banks' balance sheets.

The ECB's extensive loans to banks have put its own balance sheet at risk, many analysts say. Partly to protect banks in the periphery, ECB officials suspended rules that had confined the central bank to only accepting investment-grade government bonds. As a result, the ECB now holds junk-rated Greek, Irish and Portuguese bonds.

ECB officials insist their balance sheet is safe. The central bank has taken steps to protect itself, including doubling its capital base.

At the end of October, euro-zone banks had borrowed a total of nearly €600 billion ($811 billion) from the ECB, up from €495 billion at the start of the year, according to data from individual central banks. Among the biggest borrowers are banks in France and Italy, with each country's sector having borrowed a total of more than €100 billion at the end of September, up sharply from prior months.

At giant French bank Crédit Agricole SA, executives said last week that they are taking steps to "rapidly increase" their holdings of assets that can be pledged as collateral. Among those actions are bundling together large numbers of mortgages and other loans into asset-backed securities that the ECB will accept, according to a person familiar with the matter.

Some executives are pleading with the ECB to accept a wider array of assets. "In the name of the smallest Italian banks, I will ask [the ECB] to look into the possibility to broaden access to ECB liquidity by expanding the type of collateral offered," UniCredit SpA Chief Executive Federico Ghizzoni told an Italian newspaper Wednesday.

For months, European banks have been pursuing innovative strategies to address their real or perceived collateral shortages. Several Greek banks, for example, recently issued government-backed bonds that analysts say are likely to serve as collateral for ECB borrowings.

The use of the swaps transactions is becoming increasingly prevalent, bankers say. "They are becoming more frequent because in this environment, you want to have additional insurance policies," said a top executive at a major European bank, who has worked on the deals.

—Aaron Lucchetti, Geoffrey T. Smith and Brian Blackstone contributed to this article.

Write to David Enrich at david.enrich@wsj.com

Article from The Wall Street Journal

Why Munis Are Worth a Look

Article from The Wall Street Journal

Municipal bonds faced two key tests this past week—and came out looking sturdy.

The first was a spike in Italian government bond yields that culminated Wednesday with a global flight from risky assets. Muni prices rose, a sign that investors ran toward them, not away from them.

The second was Thursday's bankruptcy filing by Jefferson County, Ala., the largest municipal bust ever. It was expected, but it could have gotten investors thinking that Jefferson was a harbinger rather than an isolated failing. Instead, muni prices held firm.

"Municipals have held on to their place as the second-safest investment in America behind Treasury bonds," says Greg Serbe of Lebenthal Asset Management in New York.

That No. 2 position might be a blessing for yield hunters, because ravenous demand for Treasurys has cut their yields, which move in the opposite direction of price, to a pittance. That has left muni yields looking high by comparison.

On Thursday, 10-year triple-A munis yielded 2.54%, versus 1.97% for the 10-year Treasury. Before the 2008 financial crisis, it was rare for munis to pay more than comparable Treasurys, Mr. Serbe says.

Municipals compare well against corporate bonds, too. Companies must prosper to pay what they owe whereas many munis are backed by the ability to tax. Most munis escape federal taxes and some avoid state taxes, too. They're often a good deal for investors with high tax rates, but the Treasury yield squeeze has left munis with broader appeal.

For an investor who pays 25% in income taxes, the 10-year AAA muni yield is akin to getting 3.4% on a taxable bond—a percentage point more than the highest-quality 10-year corporate bonds pay.

Investors can get even higher yields by picking bonds with lower credit ratings or longer maturities. Someone who expects the economy to get better should buy shorter bonds (around five years) with lower credit ratings (say, double-A-minus instead of triple-A), says Kathy Jones, a fixed-income strategist at Charles Schwab.

As growth resumes, the issuer will benefit from higher tax receipts, and if interest rates move higher, the investor will be able to buy a new bond with a better rate when the old one matures.

An investor who expects the economy to get worse should favor longer bonds (20 years) with high credit ratings, Ms. Jones says. The issuer will be able to weather the downturn, and the rate will prove attractive if policy makers keep core interest rates low for years to come. For the investor who doesn't know whether the economy will get better or worse (roughly all of them), a blend of these two approaches is best, Ms. Jones says.

The key, of course, is picking the right bonds. Some municipalities face budget shortages in the near-term. Others assume unrealistically high returns in pension accounts for their workers, a tactic that lets them set aside less money today but could leave them short years from now, says Robert Novy-Marx, a finance professor at the University of Rochester.

There is another risk to be wary of: a "super-downgrade." Because the big ratings firms—Standard & Poor's, Moody's and Fitch Ratings—review their muni ratings only periodically, there is a chance that they can miss a city's rapid deterioration and then downgrade its bonds by several notches in one swoop, which could cause a steep selloff. It happens only rarely, but owners of individual bonds should be aware of the possibility.

So how to pick munis now? The first step is to consult with financial advisers who specialize in them and understand the risks. Investors should also make use of emma.msrb.org, a website run by the Municipal Securities Rulemaking Board, where they can look up issuer financial information and see what other buyers have recently paid for bonds.

Matt Fabian of Municipal Market Advisors, a Concord, Mass., consultancy, points to the New York City Transitional Finance Authority's 20-year bonds, rated triple-A ("extremely strong") by Standard & Poor's, as a long and safe issue of the sort Ms. Jones cites. The 20-year bonds can be repaid early (or "called") in 10 years. Their "yield to call" is 3.92%.

For a shorter bond with a slightly lower rating, the Allegheny County Hospital Development Authority of Pennsylvania, rated double-A-minus ("very strong"), has five-year bonds that yield 2.14%. Inexperienced bond buyers should stick with double-A-minus and higher ratings, Mr. Fabian says.

Investors looking for broad muni exposure can find it in bond funds. The first choice is whether to use a state-specific portfolio for maximum tax benefits or a national one for the broadest diversification.

"For residents in high-tax states like New York and California, it's hard to beat state funds, but others should stick with national funds," says Jeff Tjornehoj, an analyst at Lipper.

Don't just look for top performers with low fees; consider volatility as well, Mr. Tjornehoj says. Also, funds might be a good bet for investors who want the high yields that lower credit ratings bring but need diversification to reduce risk.

For investors who want longer-dated bonds, Mr. Tjornehoj likes the USAA Tax Exempt Long-Term Bond fund, which ranks in the top 14% of funds by performance over the past three years. Its average credit quality is triple-B and its average effective maturity is 17 years. It has a yield of 4.67%, and costs $47 a year per $10,000 invested.

For shorter bonds, the Vanguard High-Yield Tax-Exempt fund has an average effective yield of 11 years. "High yield" is usually synonymous with "junk," but less than 10% of the fund's holdings are junk bonds, or ones rated below triple-B. The average portfolio quality is triple-B, the yield is 4.41%, and Mr. Tjornehoj says the fund ranks in the top quarter of its peers for performance over the past three, 10 and 15 years. It costs $20 per $10,000 invested.

For exchange-traded fund buyers, Mr. Tjornehoj recommends Market Vectors Long Municipal Index, which yields 4.51%, and PowerShares Insured National Municipal Bond Portfolio, which yields 4.59%. Don't let the name of the latter fund mislead. The municipal insurance business is in sharp decline due to the loss of triple-A credit ratings among insurers. Investors now price bonds as if the insurance didn't exist, Mr. Fabian says.

"It means you have to pay closer attention to the finances of issuers," he says, "but it also means there are wide differences in yields and plenty of bargains for investors who know how to find them."

—Jack Hough is a columnist at SmartMoney.com. Email: jack.hough@dowjones.com

Bonds Offer Investors Security With Little Yield

Written by Dr. Don Taylor, Ph.D., CFA, CFP
Published November 10, 2011
Article from Fox Business

Dear Dr. Don,

As someone trying to diversify the way I save my money, I've been spreading my savings into money market accounts, certificates of deposit and Treasuries. Are there different advantages for someone trying to save and eventually build a bond ladder to prefer EE savings bonds versus Treasury notes, or Series I savings bonds versus Treasury inflation-protected securities, or TIPS? I'm not really looking for marketability of these products, just a good place to park my hard-earned savings.

-- Jorn Jump-start

Dear Jorn,

When someone tells me they're looking to park their money somewhere, I think short-term investments, not bond ladders. They don't want to put their investment vehicle on blocks; they want the flexibility to invest elsewhere. That person doesn't want a bond ladder.

The problem with parking money short term is that you have to figure out when to take the money out of park and put it back to work in other longer-term investments. Market timing is more art than science, and the typical retail investor is going to struggle with this decision.

Money market accounts and high-yield savings accounts are likely to earn you a much better yield than a money market mutual fund in today's interest rate environment, but things are pretty ugly when it comes to yield in these short-term accounts.

A bond ladder has you investing at regular intervals over a fixed investment horizon. When the shortest rung matures, the proceeds are used to invest in the longest maturity of your planning horizon. You can build a 3-, 5-, 10-, 20-, or even a 30-year ladder. You can pick short, intermediate, or long-term funds, or even buy a fund that invests in TIPS and have your investments professionally managed.

What's good about Treasuries and savings bonds is that they give you the opportunity to invest in longer maturities than you can with the typical CD. Savings bonds have the added advantage of allowing the investor to defer income taxes due on the investment earnings until the bonds are redeemed or mature.

Series EE savings bonds and U.S. Treasury securities are really good at protecting principal but not all that good at protecting your purchasing power from the ravages of inflation. Series I savings bonds and TIPS offer inflation protection along with safety of principal but not much more in today's low interest rate environment. TIPS aren't tax-deferred unless held inside of a tax-advantaged retirement account, so you have to pay as the money is earned in a taxable account.

You're putting your hard-earned money aside to fund future life goals. Figure out what those life goals are, and you'll have a better idea of your investment horizon and can make better choices as to how to invest the funds.

One mistake that people make is keeping their money in short-term investments, waiting for the right time to move into longer-term investments. You're treading water, but after taxes and inflation, you're underwater in terms of your portfolio's purchasing power.

Don't wait to build an investment ladder. 

Build a stepladder if you don't want to be "long and wrong" and then make it an extension ladder as longer-term interest rates head higher.

My dilemma in advising you in designing a fixed-income portfolio is that the fixed income market has gotten so ugly (low yields) that it's hard to recommend retail investors to go into longer maturities, even in a laddered portfolio. TIPS have been bid up to the point where I don't find them attractive. And Series I savings bonds, while they offer inflation protection and tax deferral, offer no real return over and above inflation, and the Treasury limits their purchase to $5,000 per year.

There's a host of asset classes out there besides Treasuries, CDs and savings bonds. Depending on your investment horizon and your attitude toward risk, you also could consider corporate bonds, municipal bonds, real estate, stocks, commodities, or mutual funds and exchange-traded funds, or ETFs, that invest in these assets. Yes, there's risk, but a well-diversified portfolio of assets will mitigate that risk with the potential to build wealth over time.

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Article from Fox Business