Squeezing the bank balance sheet from both sides

Ever on the look-out for new and lucrative corners of the capital markets, many firms have identified what is often called capital management as a promising niche. At its most respectable, this business consists of advising banks and other companies on how to measure and manage the true economic risks of their activities. More often than not, however, it is about cold-calling bank treasurers and trying to sell them ideas for complex deals. Michael Peterson reports

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Lately, European bank treasurers have been receiving a lot of suggestions for deals designed to improve their return on capital.

They should be receptive to these ideas - even if they balk at the fees being asked - because they are under growing pressure to improve return on equity.Of course, banks can do this by cutting costs or improving their lending practices, but a bit of financial jiggery-pokery helps as well. With a collaterallized loan obligation here and a hybrid tier-one deal there, banks have found that they can squeeze an overweight business into a slim-line balance sheet.
Pressure to improve returns is coming from equity investors that have grown tired of accepting single-digit returns on their investments - especially if they now have a whole eurozone full of alternative assets they can buy. "Investors are forcing European banks to improve returns on equity just at the time their cost of funding is rising because they are starting to lose cheap deposits," points out Oldrich Masek, head of financial institutions structured finance at JP Morgan in London. "The banks can do one of two things. They can reprice their loans - which they are doing as far as they can - or they can use securitization to make the asset side more efficient."

Since the first bank balance sheet collateralized loan obligation was completed for NatWest in 1997, awareness of these tools has spread rapidly. "You would be hard pressed to find a bank treasurer who was not aware of techniques such as CLOs," says Tamara Adler, head of securitization at Deutsche Bank in London. "Whether they use them is a function of, first, their capital pressure, both economic and regulatory; second, their return on equity targets and the returns they are currently achieving; and third, whether or not the regulatory environment makes securitization easy or efficient to accomplish."
Regulators have become much more accommodating of CLOs in recent years, largely because banks have been pushing them to recognize the latest innovations. "They don't necessarily issue regulations before we're ready to bring a transaction to market," says one banker, "They are cautious by nature. But they are clearly moving in coordination with the development of the market."
Rapid evolution
The CLO may be only three years old, but the structure used for the original NatWest Rose transaction has evolved almost beyond recognition. The number of institutions that have issued CLOs is growing steadily, with regional players such as HypoVereinsbank, Rabobank, KBC and Banca Commerciale Italiana joining the global institutions such as JP Morgan and SBC that issued the first deals. The most significant recent trend in this market has been the rise of synthetic securitization. "Cash [non-synthetic] deals have now become few and far between," says one banker. In synthetic CLOs, risk is transferred from a bank's balance sheet to end investors through credit derivatives, with the corporate loans remaining on the bank's books. JP Morgan's Bistro structure, first used in December 1997, remains the archetype, but recent deals such as HypoVereinsbank's Geldilux and Deutsche Bank's Cast (see box) have added new bells and whistles to this basic structure.
Synthetic securitization introduces a new class of investor for corporate loans. In a synthetic CLO the issuer transfers the bulk of the credit exposure - the least risky part - through a "super senior" default swap that can cost as little as 10 basis points. The originating bank is effectively buying insurance against a catastrophic credit deterioration and this type of exposure - which is statistically less risky than triple-A - has proved very attractive to large reinsurance companies such as Swiss Re and Pacific Life. In a typical synthetic CLO the other tranches of risk are then transferred to fixed-income investors through a series of bond issues with the very riskiest first-loss position retained by the originating bank. The next obvious progression is for banks to securitize assets without issuing any securities at all. "Completely unfunded risk transfer transactions are simply taking securitization to the next step," says Masek at JP Morgan. "They draw from securitization tools in terms of taking a portfolio and being able to value different layers of risk. Using the same concept you can transfer elements of risk without necessarily financing the assets." Masek says JP Morgan has arranged deals of this sort with a total notional value of some $100 billion in the past two and a half years.
Such deals simply comprise a series of two or three default swaps each of which transfers a certain level of risk off a bank's balance sheet. Some of these deals are done more or less publicly. In February, for example, Royal Bank of Scotland completed a CLO called Braveheart which consisted entirely of over-the-counter default swaps.
One great advantage of these deals is that they cut down on paperwork. "Most of these transactions are consumed by one, two or three counterparties," say Masek. "You don't need to go through the exercise of issuing a prospectus, setting up a vehicle or getting it rated. So not only are they a cheaper form of risk transfer or of synthetic capital, they can also be cheaper from an execution and documentation perspective as well."
Secret deals
But even if no securities are issued, the bank still needs to find end investors that will take the risk. Historically, one of the barriers to the growth of the credit default swaps market has been the shortage of investors willing to take exposure to higher-risk credits. However, several market participants report a growing appetite for junior default-swap tranches. "We've been doing this sort of transaction for the past two and a half years and over that time we have seen the investor base for this sort of product develop," says Masek. The other big advantage of a swaps-only CLO is that it can be done in complete secrecy. None of the bank's clients need even suspect that it wants to offload the risk of lending to valued customers. Semi-public swaps-only deals may now account for perhaps 25% of all CLOs. But no-one is sure how many additional deals are done as entirely private transactions between two banks. What is clear is that this type of structure has become much more important in the past year.
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