The most important element fueling the globalization of capital markets is the global availability of capital, the necessity and willingness of investors to invest in markets other than their own.
Today, many are expressing concern that this liquidity may be drying up. Indeed, a spate of articles has appeared in the press announcing an impending global shortgage of capital, caused by shrinking supply and rising demand.
There is strong demand for capital in both developed and developing economies. This is especially true of the huge demand for capital in troubled regions: Trillions of dollars will be needed to reconstruct the East German economy, to meet the new demand for investment in the Soviet Union and the countries of Eastern Europe, and for the reconstruction necessary in the aftermath of the Gulf War.
At the same time, the supply of capital is constrained by several factors. Asset quality problems and capital constraints of major international banks have led to a severe contraction of lending. In addition, as the Bank for International Settlements recently warned, huge budget deficits in the United States and other countries are causing a sharp drop in national savings rates, thereby constraining capital investment and - ultimately - growth of the world economy.
Equally disturbing, Japanese investors are perceived to have retreated from the international market. Japanese purchases of U.S. Treasuries declined from $21.8 billion in 1988 to $1.7 billion in '89 to net sales of $9.7 billion in 1990.
This all sounds very alarming. But financial systems will adjust to accommodate capital requirements. Abundant evidence supports this view.
Each year, the world markets save and invest about $3 trillion. The estimates of huge capital demand cited above represent what countries and companies would like to borrow, not what they actually will borrow, in the global capital markets. Indeed, so far, there are few signs of a real capital shortage in the financial markets, the ultimate test of availability. In fact, there are growing signs that interest rates are falling as inflation remains at a low level or declines in the major economies.
The simple truth is that there is never enought money to go around. Spending and investment decisions are made in relation to one's actual resources. A balance somehow will be struck.
A few simple statistics illustrate this balancing. Consider the contraction of bank lending as reported by the Bank for International Settlements over the past five quarters - an especially sharp decline in first-quarter 1991.
During this period, however, the capital markets have remained quite accessible. Gross new issues of debt remained constant at around $60 billion each quarter in 1990 and jumped to $90 billion in the first quarter of 1991.
More importantly, with a few exceptions - notably Japan - the equity markets have been healthy. In the United States, over $30 billion of new equity issues came to market in the first six months of 1991. This volume is second only to the first half of 1987, when the U.S. stock market was charting record highs.
Capital will flow to the markets and industries that promise the highest rates of return. Despite the cloud over the U.S. banking industry, this has been a great year for capital raising for U.S. banks.
U.S. banks have raised approximately $6.2 billion of Tier 1 capital through July 15, 1991. This included:
* Over $2 billion of publicly issued common equity.
* Over $2.1 billion of direct and private placements of Tier 1 capital in the form of equity or convertible preferred stock.
* Nearly $1 billion of publicly issued convertible preferred stock.
* Another $1 billion of public straight preferred stock.
The capital raised by U.S. banks in 1991 is expected to double the highest amount raised in any single year since 1980. This clearly does not support the capital shortage theory.
In fact, these statistics simply show that capital flows to sectors where returns are expected to be superior. In January of this year Lehman Brothers' bank analysts were the first to proclaim that U.S. bank stocks had bottomed and began rating many of them a "buy."
We were right. After a steep decline at the end of 1990, bank stocks have significantly outperformed the S&P 500, appreciating approximately 50% since January.
Taking advantage of strong demand and improved valuations, numerous banks tapped the market for both straight equity and convertible preferred stock. The largest of these issues included global tranches, typically amounting to 15% to 20% of the total amount of an issue.
Outlook in Japan
We do not view the present time as opportune for Japan to raise common equity in the international markets. Continued uncertainty surrounds the stock market in Japan.
There is the perception of deteriorating credit quality of Japanese banks, particularly in light of recent downgrades. Equally disturbing, Japanese banks have experienced weak earnings trends. Finally, Japanese financial institutions in general have received unfavorable publicity in the international press.
There are, however, several positive factors that suggest the market may be available for Japanese banks now or in the near future. The Nikkei appears to have bottomed. Foreign investors have again become net buyers of Japanese stocks, particularly very recently. The Japanese economy has remained quite firm and interest rates are expected to decline.
Despite these positive factors, there is no denying the current negative environment. Investors, however, look over a longer period of time.
The Nikkei outperformed the U.S. market for most of the decade, ending at a level which brings the 10-year performance of the Nikkei in line with the appreciation of the U.S. market. Looking at the past five years and adding an index for Japanese banks, we see that the picture is much the same.
But since 1990 the picture differs dramatically, with both the Nikkei and Japanese bank stocks declining dramatically and signficantly underperforming the U.S. market. This recent picture of the market looks terrible but it must be put in perspective.
Investors must invest a portion of their assets in Japan. Even today, many U.S. investors remain underinvested in the Japanese market. Because Japanese bank stocks represent a large percentage of market capitalization in Japan and generally perform in line with the Nikkei over the long term, Japanese bank stocks represent a fairly good proxy for the overall market.
But there is no denying the current negative environment surrounding Japanese bank stocks. The long-term outlook for Japanese bank stocks is currently perceived as more positive than the short-term prospects.
This type of environment creates the most opportune timing to issue convertible securities.
Reflecting similar conditions earlier this year, U.S. banks issued large amounts of convertible securities, primarily in the form of convertible preferred stock. Looking at how U.S. banks have typically raised capital over the past decade, the large amounts of convertible financings this year is unprecedented.
While current investor perceptions, especially in the United States, make it difficult for Japanese banks to raise common equity, we believe there would be signficant demand in the United States and Europe for convertible securities issued by Japanese banks, either in the form of subordinated debt or preferred stock.
There are good reasons supporting this view:
* Japanese banks remain among the strongest in the world and, despite recent downgrades by the rating agencies, have comparatively high credit ratings.
* There is a growing appetite in the United States for international equities, a market in which U.S. investors are generally underinvested.
* With dividend yields on Japanese bank stocks below 1%, the yield differential would be extremely attractive relative to convertibles issued by U.S. companies. There is a distinct investor universe for convertibles that has ample cash to invest.
Based on present market conditions, we believe Japanese banks could raise significant amounts of capital in the United States by issuing convertible securities at terms competitive with those available in the Euromarket.
This demand exists for convertible subordinated debt, which would count as Tier 2 capital upon issuance and Tier 1 upon conversion, and for convertible preferred stock, which would immediately count as Tier 1 capital.
Only one Japanese bank, Mitsubishi, has registered with the Securities and Exchange Commission and listed its stock on the New York Stock Exchange. Should the Japanese banks choose to tap the U.S. market through the issuance of convertible securities, we would expect most banks to utilize rule 144A to avoid the disclosure and ongoing reporting requirements.
Since banks have regularly issued in the Euromarket, we believe a global offering would be very feasible in today's market. In the current market environment, the issuance of convertible subordinated debt or preferred stock represents the best alternative for Japanese banks to raise capital.
A Euro issue, together with a 144A simultaneous placement in the United States, would represent the most effective way for Japanese banks to tap the external markets.
Another important source of financing for U.S. and foreign banks has been the issuance of perpetual preferred stock. The market for this product is almost exclusively in the United States. A significant percentage - well over half - of the issues has been sold to retail investors.
This market is presently closed to Japanese issuers, for the simple reason that no Japanese bank has taken advantage of a recent change in the commercial code which made large preferred issues possible.
Only one Japanese bank is registered with the SEC and can take advantage of the retail demand for this product. Without retail investors there will be a significant size limitation, as U.S. institutional investors have limited appetite for perpetual preferred.
With dividend rates above 8%, straight preferred stock will be viewed as prohibitively expensive by most Japanese banks. An opportunity may arise for Japanese banks to issue preferred stock if the Bank for International Settlements allows issues by offshore subsidiaries.
In this case, the use of an issuing entity located in a tax haven would reduce the cost of financing as proceeds could be lent to affiliates with tax-deductible interest payments flowing to the issuing entity.
The Securitization Route
The most dramatic form of raising capital in recent years has been indirect: shrinking the balance sheet through securitization of assets. Again, the U.S. market has been especially active.
In 1985 only $ 1.2 billion of nonmortgage asset-backed securities were issued in the United States. In 1990, almost $45 billion of issues came to market. The first six months of this year show the same pace of issuance as last year.
So far in 1991, credit cards are the dominant asset type, accounting for about 43.4% of the market. Next are auto loans at around 29.6% and home equity loans at 21.6%. Other assets account for the remainder.
The issuers, as you might expect, are the biggest originators of these services. So far in 1991 six issuers account for over 90% of credit card issues. The auto companies account for over 70% of auto loan deals. And five issuers account for over 85% of home equity deals.
The market for asset-backed securities is expanding rapidly as financial institutions manage their assets more effectively and the techniques developed in the U.S. market are now being extended to Europe and Japan.
Lehman Brothers is arranging or acting as dealer in numerous corporate receivables-backed commercial paper programs sponsored by Japanese banks.
This technique involves the formation of a special-purpose company to purchase receivables denominated in yen or dollars. The purchases are funded in the U.S. commercial paper market, with the receivables used as collateral. Limited credit support allows off-balancesheet treatment.
This financing technique represents a rapidly expanding part of the U.S. commercial paper market.
Total outstandings in the dealer market are approximately $369 billion; $48 billion or 13% are asset-backed commercial paper programs. Lehman Brothers' own outstandings of $86 billion represents about 25% of the market; approximately $14 billion or 16% are asset-backed programs.
Despite the growth of this market, regulators are scrutinizing the techniques involved, particularly credit enhancement. The regulators want to determine whether true securitization has occurred and these assets are truly moved off balance sheet. Regulations are not clearly established nor are they uniform among BIS member countries.
The determination of whether a true sale has occurred, from both a financial accounting and regulatory reporting perspective, is tied to the residual risk born by the sponsor.
The second issue is to determine whether the use of special-purpose corporations conforms to rules regarding consolidation. This is also related to the type of credit enhancement used.
These are currently hot topics and are having some dampening effect on development of the market. Nevertheless, we expect the pace of securitization to accelerate globally, as issuers or sponsors find new structures to answer these regulatory challenges.
Consolidation of the U.S. banking industry continues. There are many motivating forces behind this year's large bank mergers.
But, at least in part, they can be considered capital raising exercises. These mergers raise capital through large consolidation savings and by enhancing access of the new entities to the capital markets.
In the first big merger, NCNB/C&S Sovran will become NationsBank. This merger of equals creates the fourth-largest bank in the United States with approximately $118 billion in assets. The anticipated cost savings are $379 million annually, to be realized within three years.
Fleet Norstar/Bank of New England is a transaction assisted by the Federal Deposit Insurance Corp., making Fleet the dominant New England bank. The merger will create cost savings of $350 million annually and Fleet will raise almost $700 million in new capital including a capital injection from Kohlberg Kravis Roberts & Co.
Chemical Banking/Manufacturers Hanover, another merger of equals, creates the third-largest bank in the United States. Cost savings are expected to reach $650 million. The new Chemical plans to raise $1.25 billion in common stock.
BankAmerica/Security Pacific, an in-market merger, creates the second-largest bank in the United States. Cost savings are expected to be $1 billion annually, to be realized within three years.
Mergers that generate these large cost savings effectively generate capital. They also enhance access to the capital markets.
In Japan, similar mergers have occurred between Mitsui Bank and Taiyo Kobe Bank (now Mitsui Taiyo Kobe) and Kyowa Bank and Saitama Bank. While the employment practices in Japan may prevent immediate realization of significant cost savings, over time these mergers should enhance the combined banks.
Three methods of capital raising will dominate the 1990s:
* Traditional capital markets.
Despite the huge demand for capital, we believe that the banks will find the global capital markets to be accessible. As always, the type of financing available will depend on the state of the issuer's domestic market, as well as the issuer itself and the conditions in external markets. Market conditions generally have been favorable this year.
The large amount of financings in the United States demonstrates that U.S. banks agree with our most often repeated advice: take it when you can, not when you have to.
Capital is always a scarce commodity and capital raising is by definition opportunistic. Take advantage of opportunities to raise capital when they arise.
The second method of capital generation, securitization, will expand in all countries as a global asset-backed security market emerges. Banks will act more and more as asset managers, rather than asset accumulators. Regulators will be scrutinizing the techniques utilized and related capital standards are likely to become more uniform.
Consolidation of the banking industry will continue. Economies of scale and rationalization of the banking market are strategic and financial imperatives for banks, their shareholders, and their regulators.
Banking institutions will increasingly tap the global capital markets for their capital needs. Rule 144A will have a favorable impact on access to the U.S. market.
The availability of capital will depend on the perceived state of the industry and the health of specific institutions. But more importantly, it will depend on the promise of high returns to investors. The consolidation movement is viewed as a positive development and will enhance access to capital.
As a full-service investment bank, Lehman Brothers looks forward to offering our resources to assist financial institutions throughout the world to satisfy their capital requirements.
GARY M. TALARICO
Senior Vice President Financial Services Group Lehman Brothers
Gary M. Talarico is a senior vice president in the financial services group, investment banking division, of Lehman Brothers. Mr. Talarico is responsible for investment banking services to Japanese financial institutions and selected U.S commercial banks.
Mr. Talarico joined Lehman Brothers Kuhn Loeb in 1983. He spent 1985 to 1988 in the Japan investment banking department, in Tokyo, returning to New York in 1989.
Prior to joining Lehman Brothers, Mr. Talarico was assistant to the director of the Japan desk at the U.S. Trade Representative Office, part of the Office of the President. From 1980 to 1982, he worked for Yamaichi Securities in Tokyo.
During his four years in Lehman Brothers' Japan investment banking department, Mr. Talarico was responsible for developing the firm's investment banking relationships with Japanese financial institutions and selected japanese corporations. He is experienced in a broad range of transactions, including financing in the U.S. and Euro markets, private placements, restructuring, and mergers and acquisitions.
In the past year, Mr. Talarico has advised several Japanese banks regarding specific acquisitions in the United States. He has lived and worked in Japan a total of seven years and is fluent in Japanese.
Mr. Talarico holds a master of arts degree in international economics and Asian studies from the Paul Nitze School of Advanced International Studies of the John Hopkins University, and is a member of the SAIS advisory board.