Banks are struggling to deal with the hefty capital requirements associated with their derivatives businesses under Basel III, causing many institutions to resort to the kind of structured credit transactions at the heart of the 2007-08 credit bubble in order to shift these risks off their books.
To avert a repeat of the financial crisis, regulators have forced banks to hold substantially more capital in general, particularly against the activities that they judge to be most dangerous, such as derivatives trading. This has caused banks to shed risk-weighted assets by every means possible. Much of this has involved selling capital-intensive legacy assets that have gone the way of the dodo, such as synthetic CDOs and the remnants of their correlation exposures.
But it's also focused their minds on risk-weighted assets generated by more mainstream, vanilla business lines that banks are keen to continue. Credit value adjustments - used by banks to measure and reserve against potential credit losses from derivatives counterparty risk - have come under particular scrutiny from regulators after it emerged that two-thirds of losses from counterparty credit risk in the 2008 financial crisis emanated from CVA losses and only a third from actual defaults.
Regulators have duly lumped the value-at-risk of CVA exposures with a hefty capital treatment, which banks on efficiency drives have been keen to ease. However, regulators are mindful of banks dodging the capital requirements, making it hard to develop acceptable hedges, while the sheer size and complexity of these exposures is a stumbling block to finding investors willing to take on the risks. "CVA deals get a lot of internal and external scrutiny and you need a big incentive to get one of these things finalised. The long-dated nature of these exposures also makes it challenging. That said, the economics certainly will motivate people to find a way to get it done," said one head of credit at a US bank.
Many firms have tried, with varying success. UBS sold a privately placed securitisation of CVA, for example, while Societe Generale is understood to be lining up a transaction currently. Part of the problem is that supervisors have not made up their minds what kind of hedges for VaR of CVA will receive regulatory capital relief. It seems that Credit Suisse's US $12bn CVA securitisation - part of which had been used in its employee bonus scheme - now falls foul of Basel's latest guidelines from last November and will have to be restructured: an outcome that the bank warned might happen when it launched the deal more than a year ago.
One general sticking point is that regulators don't want banks to tranche the underlying risk of the portfolio, but instead require the entire portfolio of underlying risk to be transferred to third-party investors. "A bank typically has billions of dollars worth of exposure in these books. If it can't buy first-loss protection to get capital relief, it has to buy protection on the entire stack of risk. There aren't many institutions that can sell billions of dollars worth of protection, so you have to come up with interesting ways to reduce the amount of capital your protection seller provides. And on top of being huge, the exposure is dynamic and can move around," said Doug Warren, a portfolio manager at BlueMountain Capital.
BlueMountain is working with several banks to develop a structure that would provide regulatory capital relief. "The idea is that we create an entity with enough capital that the banks and their regulators get comfortable it provides sufficient protection," said Warren.
And it's not the only one. One buyside veteran of capital relief trades lamented that the low rates environment had attracted "any firm with a fixed income fund" to look at the enticing yields of about 15% that CVA securitisation structures offered. He blamed this fierce competition for the comparatively low yields of 11% the SG structure is said to offer. However, one head of CVA trading at a major bank cast doubt on the likelihood of deals making it out of the door due to the meagre returns on offer compared with the size of the risk investors have to take down.
What to do with the super-senior tranche of risk is particularly troublesome. Witness the US $11bn super-senior tranche on which Credit Suisse bought protection from Guggenheim Partners. This was seemingly to shield against the mark-to-market volatility of the colossal super-senior tranche, which credit experts say is a far more significant risk in capital treatment terms than the default risk of the lower tranches.
"The difficulty with any structure is you need someone to take the super-senior tranche, which is very large, illiquid and offers very little pick-up for the investor," said the CVA trading head. "The traditional sellers of this protection - the monolines - are no longer around, and for normal investors it'd be like picking up pennies in front of steamrollers: it's a very large risk for a very low return, yet these are the risks banks want to get rid of."
That is not to say banks won't try their best. Warren at BlueMountain points out that banks will want to lower their capital on derivatives exposures to offer better credit pricing for counterparties and give themselves a competitive edge. But with such a high barrier to entry on these deals, many institutions are looking at simpler capital mitigation exercises in the meantime.
"People always talk about CVA reg cap trades as a Holy Grail, but banks are looking at a whole range of options. Regulators wanted banks to focus on their exposures to other institutions, so doing things like collapsing trades, assigning them elsewhere and generally cleaning up exposures to one another can be enough to reduce capital requirements," said one credit banker.