As the FT’s Tracy Alloway also recently reported, the sector was already back to its pre-crisis size at the end of 2010 at a healthy $60,000bn of assets.
There are a lot of diverse entities and activities getting lumped into that figure though.
The activity that FT Alphaville is especially interested in is the resurgence of a particular breed of securitisations where banks buy protection on their own assets from shadow banks, allowing them to carry less regulatory capital (and also avoid having to recognise losses on those assets).
Such deals may also lead to nosebleeds (boo!), excessive footnotes (yay! we mean, boo!), as well as carrying a mild risk of heart-attack or insolvency where your counterparty exhibits symptoms of ratings downgrades.
In any case, these deals actually hark back to the roots of securitisation by means of credit derivatives as done by the JP Morgan Dream Team with the original BISTRO deal in 1997. However, they have gotten substantially more ridiculous in the last couple of years.
Deals like the first BISTRO weren’t about the reckless subprime mortgage pipeline of securitisation, whereby banks encouraged bad quality lending so that they could package the mortgages and spit them out while earning a handsome fee. That’s not what we mean here.
Old-style synthetic deals were classic risk transfer with significant regulatory benefits that made them economical over all. Since a number of new deals appear to be all about the regulatory benefits and a lot less about risk transfer (to the shadow banking sector), regulators are getting a bit twitchy. More on that later.
First, let’s look at what motivates BISTRO-style deals:
– Bank has a pool of loans and is holding regulatory and economic (i.e. voluntary) capital reserves in case the loans are not repaid when due.
– Bank would like the regulatory capital to be lower because the loans aren’t that profitable, so it isn’t a good use of funds.
– Could sell loans to a third party, but that would make clients think that we don’t love
the more profitable advisory and capital markets business they could give the bankthem.
– Bundle a bunch of the loans together, and buy protection (via a highly customised credit default swap) from outside “investors”, either shadow banks, widows and orphans, or German Landesbanken.
– Convince regulators that this means regulatory capital held should be substantially lower.
– Win the argument, deploy capital in more profitable business areas, e.g. prop trading.
With the European Banking Authority’s June deadline for bank recapitalisations fast approaching, not to mention tougher Basel 2.5 regulations coming online, banks are taking to more BISTRO-like synthetic deals.
The financial engineering going into them in order to get the maximum regulatory capital relief is pretty hardcore. As FT Alphaville has pointed out, both the Fed and more recently the Basel Committee have issued warnings to would-be arbitrageurs about deals involving “high cost credit protection”.
In a nutshell, banks are buying protection on a slice (or slices) of a portfolio of their assets, typically an equity or a mezzanine position.
On the other side, selling the protection, are shadow banks like hedge funds. In case you are wondering which ones, Mark Pengelly at Risk has some names for you:
A number of credit hedge funds have been actively touting such trades, including Channel Capital, London-based Chenavari, New York-based Christofferson Robb & Company and Illinois-based Magnetar Capital, say market participants. “Deleveraging by European banks is and will be significant, so trades designed to reduce risk-weighted assets and outright portfolio sales are where the opportunity is right now. The bank capital shortfall is massive,” says Loïc Fery, London-based managing partner at Chenavari.
(Ha, Magnetar! Ha… ‘nough said.)
This brings up the other handy point about such deals — since there is no sale of assets, the assets don’t have to be written down, triggering a nasty loss.
The “high-cost” bit of at least some of these deals, that the Basel and Fed letters speak to, refers to the fact that the coupon paid by the buyer (the bank) to the seller (hedge fund) may over time be equal to the loss experienced, i.e. where the loss is covered by payouts from the seller (hedge fund) to the buyer (the bank).
Do you think we’re talking crazy and that there is no arb here? We sympathise. After all banks are meant to hold one for one capital for expected losses, right? Regulatory capital relief should surely be more about capital held against unexpected losses. Which is why it’s so damn intriguing that the Basel Committee thinks there “may” still be an arb to be had:
For example, consider a bank that purchases credit protection on a first-loss retained securitisation position where the cost of protection is equal to the recorded value of the securitisation tranche on which protection is being purchased or where the terms and conditions of the contract ensure that the premiums paid throughout the life of the contract will equal the amount of the realised losses. Regulatory capital arbitrage may exist where the immediate capital relief recognised for credit protection purchased ultimately will be offset by the premiums paid and recognised in earnings over the life of the contract.
And hence they state:
Rather than contributing to a prudent risk management strategy, the primary effect of these high-cost credit protection transactions may be to structure the premiums and fees so to receive favourable risk-based capital treatment in the short term and defer recognition of losses over an extended period, without meaningful risk mitigation or transfer of risk.
The article by Risk outlines the typical shape of these deals and what assets they involve:
A typical trade could involve the securitisation of a leveraged loan portfolio. The bank would sell the first-loss tranche to outside investors and retain the senior tranche, reaping a capital benefit. Because the capital relief is significant, banks can afford to pay investors an appropriate premium to take the risk off their balance sheet, says Fery. The size of the deals can vary, but recent transactions have ranged in size from €50 million–100 million notional invested, he says. According to market participants, underlying assets that have been used in these securitised deals include leveraged loans, loans to small and medium-sized enterprises and even books of derivatives counterparty risk.
Banks do not appear to know that every time counterparty risk is transferred, a fairy dies.
Armed with the Basel Committee’s note, it’s over to individual regulators to determine whether such deals should get regulatory capital relief for transferring risk to the shadow banking sector. In Part 2, we look at what the UK Financial Services Authority’s response has been and how banks’ own internal models have an important role to play.
More Angry Birds, less regulatory arbitrage, please – FT Alphaville
Risks emerging from shadows look worryingly like 2008 – FT
Basel 2.5 prompts flurry of asset sales and risk transfer deals – Risk
Gillian Tett on the Genesis of the debt disaster – FT (2009)