Market for Exotic Bonds Collapses in London

The market in London for an exotic variety of bank bonds collapsed Tuesday, producing paper losses of as much as $2 billion for banks and other participants in the market.

The stagnation of trading in so-called perpetual floating rate notes, or “perps,” may inflict losses on several U.S. banking institutions, although federal banking regulators and banking sources said the loss at any large individual institution is not likely to jeopardize its health.

Among U.S. banks with units known to have underwritten or made a market in perps are Bankers Trust and Morgan Guaranty Trust. Other firms trading in the market include Merrill Lynch and First Boston Credit Suisse. Their exposure to possible losses could not be learned.

The collapse, however, has underscored the untested riskiness of a wide variety of similarly esoteric securities traded in the London Eurobond market and owned in considerable quantity by many major U.S. banks and other financial institutions.

The size and complexity of the Eurobond market have grown so fast in the past two years, regulators say, that the new securities have outstripped the ability of traders and investors to predict their market behavior and comprehend their risk.

“The authorities would have liked to see the sellers of this stuff do a better job of describing the risks of holding the paper,” said Charles M. Lucas, a vice president at the Federal Reserve Bank of New York. “The public policy concern is that the buyers don’t fully understand what it is they’re buying.”

Until now, the risks have been only conjectural. “This is the first instance I know of where one of these new inventions has stopped dead in its tracks,” said Paul M. Sacks, president of Multinational Strategies, a consulting firm specializing in global capital markets.

Perps, which resemble U.S.-style preferred stocks but trade in London like short-term bonds, represent a tiny portion of the Eurobond market, with about $18 billion outstanding out of $500 billion of all Eurobond issues.

But they have become popular borrowing vehicles for European banks during the past 18 months to two years. Citicorp is the only American bank known to have issued perps. The largest buyers have been Japanese banks.

Growing Instability

The perp market, however, has become particularly unstable in recent months. The key reason may be their “perpetuity” feature. The owner of a conventional bond, with a floating interest rate and a definite maturity date, expects to receive regular payments of interest and counts on receiving his principal back no later than the maturity--and earlier if the bond can be sold on the market.

A perp, however, has no set maturity. Thus, its owner can regain his principal only by selling the note. If the market stagnates, the principal may be lost for good.

Market professionals say that although no issuers of perps have defaulted on interest payments, investors have lost confidence that a market exists for them to regain their capital. In recent weeks, large institutional holders of the securities, thought to be Japanese banks, have dumped them on the market, seriously depressing prices.

“It’s the short-term liquidity of the market that’s at issue,” one market observer said.

First Jolt

Traders say the market suffered its first jolt in early December, when the price of the notes dropped by as much as two points--the equivalent of $20 per $1,000 face value of each note. After that rumble, traders agreed informally to change their pricing policies to keep the market open.

Early this year, the market fell again after the Bank of England, the bank regulatory authority in Britain, moved to limit the ability of commercial banks to count perps among their primary capital ratios. With Tuesday’s collapse, sources said, some perps are showing paper losses of as much as 12 points, a drop so great that traders simply ceased dealing in the instruments.

In contrast with December’s efforts to reopen the market, Jerry Goldstein, an executive of Sanwa Bank and the head of a dealers’ group in perps, was quoted Tuesday by Reuters as saying “no one’s even suggested (a reopening).”

Other sources say investment bankers are looking for ways to refashion the bonds to render them marketable again.