Deutsche Bank and Fubon Securities Investment Trust (Fubon SITE) are finalizing a deal to pioneer a way to clean up Taiwan's precarious mutual funds industry, imperilled by huge amounts of investments by bond portfolios into structured notes that will lose money as interest rates go up. Market participants worry that falling NAVs could spark a market crash similar or worse to one experienced last summer when investors redeemed $8.8 billion in the space of just three days.
According to market sources, Deutsche and Fubon Site will formally propose a structure to the Financial Services Board - the securities regulatory branch under the Financial Supervisory Commission - by "the end of January".
FSC chairman Kong Jaw-sheng declared in mid-January that he would announce a plan to clean up the bond funds within a month. The outlines of such a scheme are now becoming clear.
Over the past two years, Taiwanese investors, particularly corporate treasury desks, poured at least $18 billion into structured bonds embedded with inverse floaters - bonds with floating-rate coupons inversely linked to interest rates. A typical example would be a return of 4% minus six-month Libor, which now stands at 2.8%, or 1.1%. With interest rates now forecast to rise as high as 4%, these bonds are expected to be way out of the money.
This risks became apparent last July, when illiquidity problems caused a cash crunch at a smaller bond house, United Securities Investment Trust, which in turn forced it to reduce the fund's net asset value (NAV). This is taboo in Taiwan, where underdeveloped bond markets have created a situation where fund houses can only attract assets by maintaining NAVs, which means for troubled portfolios never marking them to market.
Although United was undone by a default in its portfolio, the drop in its NAV and the subsequent market panic has now raised the spectre of another crash because of the presence of all of these structured bonds, eagerly arranged when interest rates were low.
The summer redemption panic was severe: the total Taiwanese bond market fell from $67 billion to $57 billion in just a few weeks. Regulators and fund managers are spooked at the damage another wave of redemptions could do. The authorities have declared the subject too sensitive to even be discussed openly, and many fund houses are refusing to talk about it.
In the meantime, most fund houses have sought to delay any reckoning by transferring these portfolios to the banks in the form of structured deposits, in which the banks provide a modest guarantee and allow the fund houses to book thesm as deposits. This is a short-term tactic to avoid having to market portfolios to market, and risk seeing the NAV drop.
The FSC has apparently taken a hard line against this, arguing that investors deserve to know their investment's true NAV, and that counting funds as a deposit is merely a cosmetic device.
Bankers agree that the fund house must still offset the losses at maturity. "Yes it's just cosmetic," says one bank executive, "but the fund is very ugly. We're trying to make it prettier and buy some time."
Fund houses are reportedly using the breathing space to bargain with issuers to restructure notes into different maturities, in order to spread out the ultimate pain and make it more manageable. Flexibility may allow some fund managers to pair discrete bits of losses against profitable bits of the portfolio and mitigate the impact on the fund's NAV. Nonetheless, the FSC is said to have put a halt to more of this tactic.
Instead, the FSC is now bargaining with various investment banks and fund houses to create a solution, not a delaying tactic, which would see the banks issue derivatives correlated to interest rates, so that fund managers will have products they can use to arbitrage away the damage from inverse floaters.
Of course, investment banks will take a loss on such products, so they are demanding hefty premiums. The bond fund managers realize they have to pay some premium, but are said to balk at the investment banks' asking price.
"They're ripping off the SITES," says one mutual fund house executive. "But the bond fund managers are desperate. It's a buyer's market."
Fubon Site and Deutsche Bank are said to be working on a solution that would strip the structured bonds' principal obligation from the interest obligation. Such a move has to be done right away, before interest rates move even higher. The investment bank can sell the interest obligation to one party and the principal to another, such as a life insurance company, albeit at a discount.
For fund houses with liquidity or parent companies with deep pockets, this kind of deal will allow them to cut their losses and still keep the bond fund's NAV stable. For more endangered bond houses, they will have to sell off the best parts of their portfolios to ensure the NAV does not wobble.
"The cardinal rule is that the NAV cannot go down," says one mutual fund company executive. Otherwise, a panic could result - one even worse than what happened in July. "Certain ugly funds must cut their losses now or these will become huge later."
The FSC is reportedly brokering a deal between Fubon SITE and Deutsche Bank, with the premium level the main sticking point. But the authorities want to see Fubon SITE go first. It is the country's largest fund house, partly as a result of acquiring United and other beleaguered SITE in the summer. It also has the backing of a large financial holding company and is better positioned to eat a loss than other domestic fund managers. Later on the government is expected to press state-owned banks to offer similar solutions but at reduced premiums, market sources say.