FRN PANIC INITIATED, EXACERBATED BY MARKET MAKERS
Today's panic in the floating rate note
market has been simmering for months and is, in many ways, of
the market makers' own doing, traders and bank officials said.
    "For the last six months, there have been a series of crises
in the FRN market. Each has cut deeper and deeper into the very
fibre of the market," said a senior official at a U.S. Bank.
    As prices have fallen, he explained, the underwriters who
originally brought the issues have retreated. They have
divested themselves of the paper as quickly as possible,
unwilling to bear losses of the magnitude seen in recent panic
trading.
    In the virtual effective closure of the market for
perpetual floaters last month, bankers witnessed the
consequences of this kind of contraction of liquidity and
investor confidence.
    Fears were engendered about the possibility of this crisis
infecting the market in conventional dated FRN issues, which is
almost 10 times as large as that for perpetuals, with an
estimated 130 billion dlrs of debt outstanding.
    "The professionals are so nervous about holding inventory
that they will sell at any price," said an official at a leading
U.S. Bank, explaining the panic selling which has pushed prices
down sharply over the last two days.
    Bankers and FRN traders emphasised that today's trading was
unique in that it was driven exclusively by professionals and
that there was nothing fundamentally wrong with the securities
they sold.
    In highlighting this point, dealers noted that the
benchmark issues in the FRN market -- the two FRN's for the
U.K., Launched in 1985 and 1986 -- fell an unprecedented 50 and
40 basis points, respectively, at the opening this morning.
    Certainly, dealers said, Britain is no less credit-worthy
today than it was yesterday and the country's economic health
currently appears better than it has for some time.
    Pointing out that this kind of sovereign and supra-national
debt had not sagged on any fundamental weakness, one senior FRN
source said: "The idiocy of the situation is aptly shown by the
fact that these kind of borrowers can now tap the syndicated
loan markets at rates lower than their floaters currently pay."
    Dealers agreed that banking sector paper, which constitutes
a significant part of the market, was currently under pressure.
    Floating rate debt of major U.S. And Canadian banks eased
markedly in nervous trading last month on renewed investor
fears about the banks' exposure to Latin American debt.
    The U.S. And Canadian money centre bank FRNs, along with
Republic of Ireland paper, were hard hit again this week with
dealers citing one heavily-traded Citicorp note falling to
levels so low it is now effectively yielding 55 basis points
over Libor (the London Interbank Offered Rate).
    By comparison, the 500 mln dlr note which matures in 1998
yielded only a fine 20 basis point over Libid (the London
Interbank Bid Rate) when it was issued in January last year.
    Price declines of this size can really only be explained by
an understanding of the operating practices of leading players
in the market, dealers and banking analysts said.
    "This has to be understood as a matter between banks who
have a brief to buy low and sell high," one U.S. Bank source
noted.
    Another senior source at a U.K. Bank drew attention to the
enormous overhead costs and high salaries generated over the
last few years in the FRN market, which have to be justified.
    But even beyond the cost of running an FRN trading desk,
dealers said, is the way the securities are bought and sold.
    Although sophisticated on-screen dealing exists in most
markets, in the euro-markets trading is conducted by telephone.
    "If somebody calls you up and asks you to make him a price
in any issue, and you do, he can say "Right. You own five mln',"
a trader said, explaining market practice.
    The unfortunate buyer is then forced to unload the
securities just minutes later to yet another firm at an even
lower price, the trader explained.
    It is precisely this phenomenon that forced the rapid
downward price spiral earlier today, traders said, adding that
it is likely to continue until the markets either regain their
confidence or market practices change.
    One possible solution, dealers said, would be to initiate
trading exclusively through brokers' screens, so that only
those who wanted to buy bonds would have to "lift a bid" or buy
at that price.
    Meanwhile, bank regulators are apparently concerned about
the implications of the collapse in FRN prices.
    Traders in London said that the Bank of England has called
around to market makers asking whether they intended to
continue trading and what they calculated the losses to be.
    The Bank often makes periodic checks in the market, but
dealers said the latest enquiries were more specific.
    A spokesman for the Bank of England was not able to comment
immediately on the Bank's action.
    One trader at a major U.S. Bank here said that in addition,
the Federal Reserve Bank of New York's international capital
markets unit has phoned banks in London today seeking
information about trading in FRN's. He also said that this was
not an unusual procedure.
 Reuter
