FT Alphaville has outlined how securitisation is getting back to its roots lately, allowing banks to reduce capital holdings at a time when fresh capital is hard to come by.
Basically, they buy protection on slices of their own assets, paying out handsome coupons to hedge funds and other investors to take on the assets’ risk. Ergo, less capital needs to be held by the bank to back this risk.
Regulators, however, have been sceptical that such deals are actually anything more than fancy financial over-engineering. They are concerned that there hasn’t actually been sufficient risk transfer from banks to the hedge funds, and other shadow entities, where the risk is meant to be going. The overall effect has been to kick losses down the road while reaping the benefits of lower capital requirements.
The UK’s Financial Services Authority has examined these deals and is pointing the finger at custom-built (internal-ratings based) models by banks that have been producing overly rosy estimates of how good these deals are at shifting risk. To solve the problem, the FSA has recommended that external ratings agencies step into the breach and apply their models — at the invitation and expense of banks, of course.
Thanks to that last twist of events, it’s now actually possible to see what these deals look like (the ratings are also required to be public). So here’s one of them — a deal called Papillon which Barclays Bank recently did. In diagrammatic form:
In short, Barclays has taken a pool of loans and securitised them, but retained all but the riskiest piece. On that riskiest €300m, Barclays has bought protection from an outside investor, e.g. hedge fund. That investor will get paid coupons over time for their trouble, but will also be hit with any losses on the loans, up to the total amount of their investment. To ensure that the investor can actually absorb these losses, collateral is posted with Barclays.
This point about collateral means that, at least in theory, Barclays is not exposed to the counterparty risk of the hedge fund. This is especially important because the hedge fund is outside the normal sphere of regulation, i.e. they aren’t required to hold capital against risk-weighted assets in the way banks are.
On that point though, that’s also what makes these deals work — risk is being transferred beyond the realm of regulation.
But if you wish to view these deals in a positive light, you can point to the risk mitigation techniques (100 per cent collateralisation) that the industry is coming up with seemingly on their own, cough, after the AIG debacle, cough. And then note that the market is matching entities that don’t want the risk (banks) with entities that do (hedge funds).
If you wish to view this in a negative light, point to the fact that there is little disclosure around these deals. We have no idea how many are being done in aggregate, hedge funds are unregulated, and just because a few banks are seemingly doing this with reasonable quality assets with well-managed funds, that doesn’t mean that everyone is.
And then there is the over-engineering element whereby some deals were, and maybe still are, done where the premiums paid over time to the hedge fund are actually equal to or above the expected loss of the transaction. That the Fed and Basel Committee were concerned enough to issue guidance on this is noteworthy. It’ll be down to individual national regulators to prevent “over-engineering”, and some regulators are more hands-on than others.
To get back to Papillon though, here’s the description of the portfolio from Moody’s:
The portfolio has a weighted average life of approximately 2.9 years and contains both senior secured and senior unsecured loan. The closing portfolio is made up of 667 loans to 541 corporate groups and is predominately composed of loans to the US (53%) and European (46%) companies.
How does Moody’s think these loans will do?
In its base case Moody’s analyzed the performing portfolio to have a 4.8% expected default rate (…) and a mean recovery rate of 43.8%.
Without knowing the size of the loans, it’s impossible to determine whether that default rate and recovery rate means that the first loss tranche will almost certainly get wiped out. Seems like there’s a reasonable chance of it though.
If the prediction were for the tranche to get wiped out, then Barclays is basically paying for a hedge fund to help kick out its losses over time while getting a nice reduction in regulatory capital.
Moody’s assigns (sf) ratings to Barclays Bank PLC “Papillon 2011-5” unfunded credit default swaps (pdf) – Moody’s
Public scrutiny beats regulatory caution – Euroweek
Back to the BISTRO for today’s securitisations, Part 1 – FT Alphaville
Back to the BISTRO for today’s securitisations, Part 2 – FT Alphaville