CDS used to help relieve bank balance sheets

CDS, once a source of contention for critics of derivatives, are now being used to help de-risk European banks’ balance sheets affected by the ongoing crisis in Europe. From the WSJ

The latest example came Monday, when a large unidentified German bank obtained protection from alternative asset manager Christofferson, Robb & Co. in a deal using credit-linked notes, or CLNs, fixed-income securities with credit derivatives tucked inside.

The deal transferred the bank’s credit risk from a 2 billion euro ($2.42 billion) portfolio of loans made to 500 unrated small- and medium-sized enterprises to investors, giving the bank space under capital-reserves regulations to make new loans.

Christofferson, Robb invested 125 million euros in the deal, its fourth such trade this year, freeing up about the same amount of capital the bank otherwise would have had to set aside to back up the loans, which it did not want to sell. The move comes at a time when regulators are pressuring banks to build capital buffers against financial-market shocks.

Richard Robb, a co-founder of Christofferson, Robb, declined to name the bank involved or the investors in the deal, because the trade was private. Christofferson, Robb set up a separate trust especially for the transaction; in turn, that trust, called a special-purpose vehicle, issues notes and holds the proceeds in reserve to compensate the bank for losses. The bank can draw down money as needed if the loans in the portfolio run into trouble. In the meantime, the bank pays investors a regular fee for the protection that allows it to release a certain amount of capital for use on new loans or other activities.

“It makes them safer,” Mr. Robb said in an interview, adding that banks can replenish their capital without having to sell more stock and dilute their equity.

The deal is the latest in a string of regulatory driven transactions using credit derivatives. Their cousins, credit-default swaps, act like insurance for bonds and loans and were blamed by regulators for deepening the financial crisis. Now regulators are increasingly sanctioning complex maneuvers involving credit derivatives as a means of transferring risk outside the banking system to institutions like pension funds and insurers, which are paid handsomely to assume it.

The trades–called “risk-sharing” transactions by the handful of firms that specialize in them because the underlying corporate loans stay on the banks’ books–come in a variety of shapes and sizes. Typically they offer banks a way to move risk off their books, while holding onto the loans and the relationships they have nurtured with customers.

Newer transactions such as the one by Christofferson, Robb stand in contrast to pre-crisis structures, which were known for their reliance on leverage, or borrowed money to magnify returns, and for their distance from the underlying borrowers, making it difficult for investors to accurately gauge the risks they were assuming.

AXA Investment Managers completed a similar deal in June, part of a planned 500 million-euro strategy, where it agreed to reimburse the bank for the first 7-8% of losses from a pool of corporate loans. In the process, it took protection on each loan and bundled it into one investment called a collateralized debt obligation, or CDO, another example of financial gearing that was lambasted in the wake of the crisis.

Alexandre Martin-Min, head of structured credit investments at AXA IM, said the collateralized debt obligations in question–dubbed “synthetic CDOs” because they are stuffed with credit-default swaps that reference debt rather than the debt securities themselves–are safer than pre-crisis CDOs.

“The problem with pre-crisis synthetic CDOs was the amount of leverage,” said Martin-Min.

The maximum payouts are funded upfront to the bank, almost like a credit card they can tap when losses occur.

Mascha Canio, head of structured credit at PGGM, a pension-fund asset manager in the Netherlands with 118 billion euros in assets under management, said the fund has been doing risk-sharing trades annually since late 2006.

“We feel it is an effective alternative to investing in banks, for example by buying shares, and offers credit risk that is otherwise not available,” she said. “We expect losses, and they do occur and that’s part of the return, but after assuming those losses we still have returns that are in the low double digits.”

Cheyne Capital, another alternative asset manager, has closed $250 million of risk-sharing transactions over the past few years, using synthetic securitization. The firm’s most recent trade was in February, with net returns in the low teens, and the portfolio was carefully selected by Cheyne from all the corporate loans on the bank’s balance sheet. The bank then takes the first loss risk, giving the two a reason to align their interests.


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