No-one doubts the success of the fixed-income department at Salomon Smith Barney. Since the merger first of Salomon Brothers with Travelers’ brokerage house Smith Barney in 1997, and then Travelers itself with Citibank in 1998, the fixed-income group has risen up the bond league tables and made a lot of money in the process.
A greater focus on client relationships at the expense of proprietary trading after the first merger, and a wider base of clients around the world and a balance sheet to boot, after the second, have been two major contributing factors.
But Salomon has also played a deft hand in innovation, as last year’s mini-Trups (pronounced troops) structure proves. Trups stands for tier one-qualifying capital securities (the acronym is a bit of a stretch), a collateralized debt obligation, and in itself is nothing new; banks have been launching CDOs and CLOs (collateralized loan obligations) since 1996. But these securities are only economically beneficial to larger banks. Smaller banks find it much more difficult, whether because of legal costs, other set-up costs such as securing a separate credit rating for the securities, or simply because of the premium demanded by investors when investing in small and therefore illiquid securities.
That’s where the “mini” comes in, as Salomon devised a way to structure a deal to allow several smaller banks to bundle the amounts they would like to issue into one security.
In charge of the structure was Joshua Siegel, vice-president in Salomon’s structured products group. “The structure grew out of an idea we had back in 1997 to repackage secondary paper from banks, but we faced a couple of problems. First, the secondary paper in the market didn’t work for the deal and second the rating agencies had no system for rating 30-year CDO.”
Thus began the long process of preparation. First Siegel and his team collated data on bank default rates going back to 1934. Once they’d done that, they did what Siegel calls “a Moody’s type analysis of the data, which indicated a rating of high Baa to A-. We presented our work to Moody’s and they spent a year or so looking at it and came up with the same general conclusions.”
The next stage was to come up with a pool of banks diversified enough to mitigate the risk of all defaulting within a short space of time. “We decided to see if we could do that by dividing the US into a number of geographical regions,” says Siegel. “We came up with five which were as correlated as any five randomly selected Moody’s industries. No two regions had peak defaults within two years of each other.”
After that the team had to make the structure usable for a 30-year time frame. “We started with Moody’s one-year transition methodology and applied it to a 30-year time frame, running thousands of simulations,” says Siegel. Moody’s agreed with the concept and with that had the 30-year duration, the default-rate analysis and the diversification needed to market the deal.
All that was needed now was interest from the issuers’ side. Siegel took the idea to the firm’s banking group and the new products group, who both liked the idea. They expressed an interest, but there was another problem.
“Our investment bank doesn’t cover all of the smaller community banks,” says Siegel. “So instead we went through our financial consultants in the retail brokerage group and other distribution channels. The feedback was that there was a great deal of interest in tapping tier-one capital, as long as there was a ceiling on the rate.” That was set at 10.875%, or 460 basis points over treasuries, for the underlying securities, which translated to 9.25% (323bp) for the issue itself.
In all, 29 banks took part in last March’s deal, divided roughly equally between public and private banks. Each contributed between $3.5 million and $10.75 million each.
