Was Westpac Derivatives Products a temporary fix for a bad credit rating, or simply a bad idea?

By Simon Boughey

In the early 1990s, Australia's Westpac had its sights set quite high. The goal was to extend its reach beyond the Asia-Pacific rim and become an international capital markets powerhouse. The bank established Westpac Derivatives Products (WDP)-a triple-A-rated derivatives products company-in November 1993 to defend and capture valuable bond and related swap business with highly rated counterparties, and to help pull itself into the top tier of bonds and swap market-makers.

Last year, Westpac decided to wind down WDP, and the decision is symbolic of the failure of the Australian bank's international ambitions. During the past couple of years it has drastically curtailed its ambitions and is now concentrating its efforts on the Australian and New Zealand markets.

When WDP was established, triple-A-rated credit subsidiaries were nothing new. Merrill Lynch had led the way with Merrill Lynch Derivatives Products, its separately capitalized derivatives products subsidiary, at the end of 1991. During the next several years a variety of poorly rated banks and investment companies established similar vehicles to allow them to compete in the international bond markets with the likes of JP Morgan and UBS.

But the company was nevertheless an ambitious step. Westpac DP was the first Asian company, including Japanese firms, to set up a DPC. It was initially capitalized by $200 million in the form of $100 million in cash and $100 million in surety bonds provided by Capital Markets Assurance Corp., a triple-A-rated U.S. bond insurer.

At the time, the decision appeared puzzling to some; the firm had recorded a $1.6 billion loss in 1992 and was already in the process of cutting its Eurobond operations and swap group in London and had already exited North America.

As Westpac retreated across the oceans to its home base, the triple-A sub seemed increasingly redundant. DPC's are expensive both in terms of the capitalization necessary to keep them viable, and the constant legal and accounting fees. As James Mather, who worked at Westpac in New York until 1994 and now heads Bank of Boston's swap group, says, "They asked themselves, 'Why do we need $300 million firewalled in a sub that we don't do anything with?'" Douglas Lucas, cohead of Swapco, Salomon Brothers' triple-A sub, explained that in the first nine months, Swapco's accounting fees and associated professional services amounted to no less than $1.8 million.

At the end, there were very few deals on Westpac DP's books. In August 1996, total notional principal amounted to only $2.8 billion, which, according to Lucas, would represent a very poor month at Swapco. When it closed down WDP, the bank moved all outstanding transactions onto Westpac's books.

Moving up

Westpac claims that the demise of WDP was not related to the trimming on its international ambitions but was entirely attributable to the recent improvement in its credit standing. In February 1996, in fact, the bank was upgraded to AA- by Standard & Poor's Corp. and to Aa3 by Moody's Investors Service in the middle of the year.

Westpac's new credit standing was good enough to allow it to deal with its local borrowers and end-users, such as Australian central borrowing authorities and Japanese securities firms, upon whom it depends. America's country manager, Jim Tate, says that WDP was designed to terminate as soon as Westpac's credit standing improved. "We said, 'The first day we get back to AA, it goes.' And we got rid of the bastard as soon as we could," he explains. He adds that the formation of WDP, with its considerable costs, stirred debate within Westpac and that the DPC was not "a loved thing in Westpac at all." Nonetheless, Tate maintains that WDP was fundamental to the bank's strategy of defending its core market during the period of credit weakness, and that it has paid for itself over the past three years.

Westpac now makes swaps markets in four currencies only-Australian, New Zealand and U.S. dollars and yen-from its London and Sydney offices, and trades all the associated option products. Australian and New Zealand dollars take pride of place and it makes markets in U.S. dollars "as a means of getting to Aussie and Kiwi dollars," says Tate. These days, Westpac has only 45 employees in its New York office, which trades fixed-income derivatives and foreign exchange instruments in its four key currencies as well as ECU and Deutsche marks.

Westpac now has only a marginal presence in Europe and is set to diminish still further. "We have scaled back to concentrate on the Australasian market," admitted a company spokesman in Sydney. He adds wryly that Westpac's slogan "Australia's world bank" has now been dropped.

Although Westpac denies that its decision to close WDP is not directly related to its retreat from the world stage, it admits that it never made as much use of the vehicle as it had once envisaged. Cynics have noted that there are now probably too many DPCs for the market and that forming a DPC is probably bad business for banks that have never been in the front rank of the derivatives industry.

Westpac's experience may have inspired its Asian competitors to try more efficient approaches. Japan's Dai-ichi Kangyo showed an innovative way forward for Asian and Japanese swap counterparties last year when it established an arrangement with Merrill Lynch whereby DKB pays a fee to "borrow" MLDP's credit when it needs to do business with a highly rated client. According to Richard Robb, head of swaps at DKB, there have been "lots" of deals run through the new arrangement since it was formed in February. "I would say that we have done more deals that we would have done had we formed a DPC by a factor of 10," he adds.

The Asian Development Bank wants to push terms to out to seven years and beyond.

By Simon Boughey

Recent forays by the triple-A-rated Asian Development Bank (ADB) into the Taiwanese dollar (MT$) bond market have laid the foundation for the development of a long-term MT$ swap market. Currently, the MT$ swap market is liquid only out to three years, but the ADB has issued and swapped its bonds at seven years-and is now examining the prospects of doing the same at the 10-year tenor.

The ADB, based in the Philippines, issued its first MT$ bond in 1995 when it placed MT$2.6 billion of seven-year notes in the domestic bond market, becoming the first non-Taiwanese issuer ever to tap the market. When the proceeds of these notes were swapped into floating-rate U.S. dollars, the ADB also captured the distinction of becoming the first entity to execute a long-dated swap in the MT$ market, says Juan Limandibrata, the senior treasury officer in Manila. This issue was jointly lead, managed by Chiaotung Bank of Taiwan and China Trust Commercial Bank with a syndicate of eight managers. The swap was written by Chiaotung.

Last year, the ADB came back to the Taiwanese market with a much bigger MT$7 billion seven-year note, led by China Trust and Grand Cathay Securities with a team of three syndicate managers. This time, the swap was chiefly written by Citibank with a smaller portion taken by China Trust.

On both occasions the swap was written into floating U.S. dollars, as the great proportion of ADB's loans are U.S. dollar-denominated. The ADB organized a competitive bidding process involving five banks, which included domestic names and overseas banks with local subsidiaries in Taipei. Limandibrata declines to disclose the exact sub-LIBOR level achieved in these swaps, but says that each time the after-swap cost of funds was "well through" what could have been achieved in the developed bond markets. The ADB hopes to hit LIBOR less 10­20 basis points in its more orthodox strategic transactions, but these transactions "considerably exceeded that level."

The first bond issue in 1995 was almost certainly cheaper to the borrower on an after-swap basis than the second because it was priced flat to government bond yields. The 1996 issue, by contrast, was priced at a spread of 17 basis points to the government bond curve. Limandibrata says that the second offering was priced more generously to achieve secondary market liquidity and to target institutional investors who had not bought tickets in 1995.

The ADB was pleasantly surprised by the strength of the swap bids for both issues, as the MT$ swap market has no real liquidity beyond three years. This means the houses winning the deals were not able to lay off the position in the interbank market. In developed, liquid swap markets, a house that pays into a new issue swap normally looks to offset this position quickly in the interbank swap market by receiving a fixed rate-hopefully at a rate that is significantly wider than the one at which it paid into the new issue. In the Taiwanese market, however, the swap houses must offset the positions through their corporate lending programs, which provide a regular supply of fixed-rate MT$.

Nonetheless, the liquidity of the MT$ swap market will improve as more borrowers seek to place bonds and swap back into U.S. dollars. Consequently, more houses will be willing to run books beyond three years as profit-making opportunities increase.

The ADB could have placed the bonds in the short-term sector of the market where swap market liquidity is deepest, but it wished to establish a long-term benchmark to match its loans, all of which are long-term. Moreover, the Taiwanese government is a big issuer at three years and the ADB did not wish to compete for buyers. This also deterred it from issuing at 10 years, which was originally its favored maturity.

The bulk of the notes were placed in Taiwan. Foreigners can buy Taiwanese paper by opening a local bank account in Taipei. The issue of these bonds and the consequent swap business falls within the ADB's traditional mandate to help developing countries not only in the form of loans but also by fomenting activity in nascent capital markets.

Of its 1997 budget of U.S. $2.6 billion, U.S. $600 million has been allocated for borrowing in the Asia/Pacific bond markets-all of which, of course, must be swapped back to floating U.S. dollars. The ADB is contemplating another issue in MT$, and is also looking at the Hong Kong dollar, the Korean wan, the Thai baht and the Indonesian rupiah markets, says Limandibrata. Before any borrowing decision can be finalized, quite lengthy discussions with the relevant governments must first be completed, he adds.

Q: What derivatives products are the most active in Hong Kong?

A: In Hong Kong equity is king. There was a 70 percent increase in volume in futures and options on the Hang Seng Index in a year where most volume was flat to off. There are also lots of warrants issued on individual stocks and baskets such as the Hang Seng Index. And there's a new stock exchange in Kuala Lumpur that's active.

Q: What about the over-the-counter market?

A: The swap market in Hong Kong is quite active now since the monetary authority created a Hong Kong interbank rate. Now there is a yield curve to trade from. The swaps range from three months all the way out to 10 years. In fact, we launched a swap contract that's different from the swap contract that was started before. It's now averaging 1,100 contracts a day.

Q: Who are the biggest players in Hong Kong?

A: A lot of derivatives players came to Hong Kong when Japan cooled off. Things are changing rapidly. There are a lot of investment banks in Hong Kong, and that's where the derivatives are. Morgan Stanley was first, and Hong Kong Shanghai Bank is also very big. We see a lot out of the French banks such as Banque Nationale de Paris and Banque Indosuez. There are a lot of investment banks moving into Singapore.

Q: What about the currency markets? Who's leading the pack?

A: Hong Kong is the fifth-largest currency center in the world. The currency market is dominated by the Bank of China, Citibank and NatWest.

Q: Are you worried about what will happen when China takes over in May?

A: I see it as a great opportunity. Our market is 6 million now, and when China takes over we'll be 1.2 billion. We're planning to launch a new index of Chinese stocks in the near future and build a proprietary electronic system to complement the open outcry system.