Metaphorically speaking of course. Better perhaps: Her Majesty’s version of AIG.
Or, as they are calling it, the government asset protection scheme.
Details of which have just been released by statement (emphasis ours):
DISCLOSURE
All participants in the Scheme will be required to meet the highest international standards of public disclosure in relation to their asset books.
Subject to maintaining appropriate commercial confidentiality, the Treasury will publish and lay before Parliament the agreements which it enters into with participating institutions in relation to the operation of the Scheme.
ELIGIBLE ASSETS
The Scheme will provide protection for portfolios containing assets each of which must be eligible for the Scheme. The Treasury expects to provide protection for those assets on an institution’s balance sheet where there is the greatest degree of uncertainty about the future performance of those assets.
Assets may be denominated in any currency. It is intended that the following categories of assets will be eligible for the Scheme, subject to assessment by the Treasury for inclusion on a case-by-case basis:
* Portfolios of commercial and residential property loans most affected by current economic conditions;
* structured credit assets, including certain asset-backed securities;
* certain other corporate and leveraged loans; and any closely related hedges, in each case, held by the participating institution or an affiliate as at 31st December 2008.
The Treasury may consider the inclusion of other asset classes in the Scheme, subject to appropriate investigation by the Treasury and its advisers and the determination of an appropriate fee. Assets to be included in the Scheme will be subject to appropriate investigation by the Treasury and its advisers in order to assess the probability of future loss. An applicant will be required to give the Treasury and its advisers open access to all information required for this purpose.
The level of protection offered by the Treasury will be determined following detailed discussions with eligible institutions and their demand for the Scheme.
The reason we draw comparison with AIG is because the new scheme will effectively do what AIG – and other insurers, like the monolines – did for the banks back in the heady days of the Great Moderation. That is, provide regulatory capital relief.
See, Basel II Accord, Part 2, section IV, subsection D, rule 4, paragraphs 583-588: treatment of credit risk mitigation for securitisation purposes:
Credit risk mitigants include guarantees, credit derivatives, collateral and on-balance sheet netting.
…
586. Credit protection provided by the entities listed in paragraph 195 may be recognised. SPEs cannot be recognised as eligible guarantors.
587. Where guarantees or credit derivatives fulfil the minimum operational conditions as specified in paragraphs 189 to 194, banks can take account of such credit protection in calculating capital requirements for securitisation exposures.
588. Capital requirements for the guaranteed/protected portion will be calculated according to CRM for the standardised approach as specified in paragraphs 196 to 201.
Under Basel, banks hold regulatory capital as a cushion against potential losses from their assets. The amount of capital which must be set aside against each asset varies according to those assets’ “risk weightings”: which are calculated according to a host of different models prescribed by the Basel accord. Much of the recent problems for banks then, have been caused by now riskier assets requiring huge extra capital requirements. Indeed, the capital requirements increase exponentially as assets get riskier.
But, as the above pars state, risk-weightings can be offset by credit risk mitigants: insurance. Or in the lingo, wrapping. In non-Basel speak: if you own a risk weighted security, you can reduce its regulatory risk weighting by hedging against it using credit derivatives. To illustrate that in ratings terms: a bank could thus own a security rated BBB but using sufficient hedging – with, in this case, HMT, (but previously, someone like AIG) – treat the security as if it was rated AAA. The difference in risk weightings implied are huge.
Back to details of the scheme:
ASSESSMENT OF “FIRST LOSS” AMOUNT AND FEE
In setting the terms under which protection will be offered, the Treasury and its advisers will take into account their estimation of the performance of the assets of the institution to be included in the Scheme. The fee, “first loss” amount to be borne by the institution and residual exposure will be set
accordingly.
It is intended that pricing of the Scheme will be structured having regard to international practice so as to provide appropriate incentives to participating institutions to meet their commitments agreed with the Treasury to support lending to creditworthy borrowers and to ensure appropriate protection for taxpayers. Participating institutions will be entitled to cancel the protection, subject to the agreement of the Treasury and payment of an appropriate termination fee.
It is understood that the fee will not necessarily take the form of equity, but will instead involve issuance to the government of “capital instruments”.
MANAGEMENT OF THE ASSETS
Assets included in the Scheme will continue to be managed by the institution and will remain on its balance sheet but will be required to be “ring-fenced” by the institution so that actions in relation to them, including enforcement and disposal, will be subject to appropriate Treasury controls.
The Scheme may also provide for the Treasury to take over ownership and/or management of the assets in certain defined circumstances.
The Scheme will include appropriate further requirements as to the management of the assets by the institution.
The Treasury will require open access to all information it considers necessary in connection with the Scheme and will require regular reporting by the institution to the Treasury.
DURATION OF THE SCHEME
The duration of the coverage will be determined following examination of the assets to be included in the Scheme and is expected to be not less than 5 years and to be consistent with the tenor of the assets.
ADMINISTRATION OF THE SCHEME
The Scheme is expected to be administered by the Treasury or an entity to be established or designated by the Treasury. References in this summary to the Treasury include, where appropriate, an entity as described in paragraph 10.1. The cost of establishing and administering the Scheme will be borne by participating institutions.
As with AIG’s business, in principle, the scheme could be very lucrative. And indeed, it shouldn’t necessarily need a huge amount of capital – though that very much depends on the nature of the guarantee contracts which will be written. The problem is that modelling the value of most structured credit products – particularly CDOs – is extremely difficult. The Treasury intends to assess submissions on “a case-by-case basis”, which is plainly mad. The most qualified names in finance have had their fingers burned touching CDOs. There’s a danger that the Treasury’s scheme – just like AIG – could be rather a costly capital sump. Particularly so given that we’d expect a whole load of institutions to rush in and secure guarantees over structured asset classes that have not yet violently unwound (but could well do) – such as synthetic CDOs.