BNI and Mandiri boldly go....

Setting a new global precedent for the banking sector, Bank Mandiri set off on roadshows in Jakarta on Wednesday for a $150 million to $175 million lower tier 2 debt issue via UBS Warburg and Mandiri Sekuritas. Pending the success of the 10 non-call five offering, which has already garnered strong onshore support, BNI aims to follow as early as September with a $100 million to $150 million issue via JPMorgan.

Both banks are seeking to emulate the success of the Koreans in early 2000, when Hanvit Bank showed, for the first time, that a non-investment grade bank could raise subordinated debt in size from international investors. Similar to Hanvit, Mandiri and BNI will market themselves as leveraged sovereign plays in the hope of attracting investors at a time when the macro picture in Indonesia is starting to look a lot more positive. In their favour, the underlying interest rate environment is much lower than when Hanvit created a new sector with its $850 million deal and investor interest in Asian high yield debt considerably higher.

Against them, however, is the fact that investors are going to have to take a huge step down the credit curve in order to replicate the kind of returns that Hanvit's then B1/B rated lower tier 2 issue has generated since launch. Priced to yield 11.893% in February 2000, the deal is now trading at a 5.3% level.

Bank Mandiri, on the other hand, currently has a B-/B3 rating. And in line with Standard & Poor's policy to rate a non-investment grade bank's subordinated debt two rather than one notch lower, it has received a CCC issue rating. Similarly BNI, now has the same rating following its two-notch upgrade by the agency yesterday to B-. Moody's also rates it B3.

But both deals have a huge advantage over the Koreans since there is likely to be considerably more onshore interest to balance the higher pricing demands of offshore investors. Key has been the central bank's attitude and Mandiri's deal was given a huge boost after Bank Indonesia released a letter on Wednesday outlining new guidelines on the treatment of subordinated debt.

These state that domestic banks can assign the same 20% risk weighting to subordinated as senior debt so long as it is held on their trading books, which has to be marked-to-market. However, the central bank still reserves the right to limit the amount of subordinated debt any one bank can purchase off another and if a bank decides to warehouse subordinated debt in its investment portfolio then it has to be 100% risk weighted.

Analysts comment that the guidelines make a good compromise. They are supportive of both issues, but should negate some concerns that domestic banks will simply be able cross-capitalize each other. For were a bank allowed to buy the subordinated debt off another and then hold it unweighted in an investment portfolio, there would have been no net capital improvement across the domestic banking system.

Without the letter, observers say Mandiri was contemplating a $100 million issue since it would have lost its bedrock support from the domestic banking sector. But already demand is said to top the $100 million mark, with roadshows moving to Singapore Thursday, Hong Kong today (Friday) and then Europe next week, with the deal scheduled to price towards the end of the week.

Mandiri now has to decide what importance it places on the creation of a truly diversified and international investor base. From the outset, the bank has always made it clear that it views the subordinated debt issue as a dry run for its scheduled IPO later in the year and has been making progressively greater efforts to increase its visibility with international investors.

As such, it seems likely that it may be willing to pay up slightly in order to secure a truly global order book. Observers report that domestic investors are happy to accept a yield inside the current trading level of PT Indofood, because of the bank's high domestic profile and strong sovereign support. International investors, by contrast, have indicated that they are not willing to accept a yield inside Indofood, which is currently trading at 102.06% to yield 10.6% or 687bp over Treasuries.

In Libor terms, this puts Indofood at 620bp over and should Mandiri price at this level, it will be 220bp wider than the current trading level of its FRN due 2006 (call and put 2004), which is currently bid around the 400bp level over Libor. This represents the outer end of where banks originally pitched for the deal in May.

Some observers have questioned why Mandiri and BNI want to raise subordinated debt in the first place since both have relatively high capital adequacy ratios by BIS standards. These high ratios (see table below) result from the fact that their asset bases have extremely high levels of government re-capitalization bonds, which carry a 0% risk weighting.

However, while loan growth in Indonesia remains anemic, both banks are trying to move as aggressively as they can to expand their commercial portfolios. As the proportion of zero risk weighted government bonds to commercial loans drops, this will progressively pressure capital adequacy, albeit over a reasonably lengthy timeframe. So too, the government re-capitalization bonds start to mature from 2004 onwards, potentially threatening the banks with a sharp drop in capital should the government decide to replace them at a lower value.

Prior to BNI's upgrade, many commentators had questioned whether differential between Mandiri and BNI was justified since they share very similar credit characteristics (see table below).

Other analysts say investors are unlikely to make much of a differentiation between the two banks, particularly since Mandiri is 100% government-owned and BNI about 98% government-owned. As CSFB analyst Jae Ahn puts it, "When you get to the lower end of the credit spectrum it's quite hard to distinguish between credits. The asset quality and internal operations of the Indonesian banks are very weak and like all emerging market credits, it really comes down to the likelihood of support in the event of a collapse. Mandiri clearly has a slight edge because of its size."

Investors say that in its research UBS Warburg is marketing Mandiri on the basis that its profitability, asset quality and capital ratios are broadly in line with a weak BB credit and comparable banks in Thailand and Korea . Sovereign and FIG analyst, Scott Wilson, says in the report, "The government's policy towards Mandiri is similar to the Korean government's strategy with Woori Bank (formerly Hanvit Bank) and the Thai government's strategy with Krung Thai Bank. In those cases, balance sheets were cleaned up and recapitalized (on several occasions), aggressive performance targets were set and re-privatization plans announced."

He concludes, "The government's goal of creating strong financial institutions has been driven not only be a desire to boost the recovery rate on the injection of public equity into the bank, but also by a desire to establish a leading domestic financial institution to cope with an increasingly complex and competitive banking landscape both domestically and regionally."