* Punitive capital weightings spur banks to sell correlation
* Some determined to hold complex assets to maturity
* Hedge funds want portfolios, but deals hard to close
By Christopher Whittall
LONDON, Feb 22 (IFR) - Several major banks are desperately
trying to free up billions of dollars in capital by finally
selling what is left of the complex credit portfolios that
brought Wall Street to its knees in the 2008 crisis.
It will be a bitter pill to swallow for the banks, which are
having to sell them off now at a loss just as the positions are
finally in the black and they can glimpse the finish line - most
of the exposures are expected to roll off in the next two years.
But banks need to conjure up capital to meet new
requirements enacted after a crisis brought about by those very
same holdings. Many have concluded that shedding the
risk-weighted assets is a better play than attempting to issue
costly equity, as they race to get above the 8.5% Core Tier 1
capital threshold of Basel III.
And even those banks on a firm capital footing are finding
it difficult to justify tying up funds against arcane assets,
instead of re-distributing cash to shareholders.
"Everyone is looking at selling correlation books," said the
head of credit at one US bank. "There is a dramatic difference
between the economic capital represented by these transactions
and the huge amount of regulatory capital they attract, which
creates a very big incentive to sell to someone where that is
not the case."
These books typically consist of credit default swaps used
to create exposure to banks and companies, often as synthetic
collateralised debt obligations.
Unfortunately for the banks that want out, these complex
derivatives are very tricky positions to unwind. Attracted by
returns on capital in the mid to high teens, specialist credit
hedge funds such as BlueMountain Capital and Renshaw Bay are now
keen to relieve banks of these much-maligned portfolios, and can
easily hire the expertise.
CDOs epitomised the excessive financial engineering that
helped to lead to the financial crisis, and it may seem
surprising that banks still hold billions of dollars worth of
them. But as correlation soared in 2008, bank credit desks began
haemorrhaging money and many institutions opted to hold on to
their positions and hope for improvement, rather than conduct a
Regulators, however, decided that banks would be better off
without exposure to such innovations - and hit correlation books
with eye watering capital charges under Basel 2.5.
So even as the total outstanding volume of synthetic CDOs
has shrunk to USD25bn from USD105bn in 2007, those still lurking
on balance sheets are continuing to wreak havoc - even though
correlation has fallen, and most are now in the black.
At Deutsche Bank, for instance, the correlation book equated
to EUR18.3bn of risk-weighted assets at the end of September
2012 for what amounted to only EUR2.4bn of assets under
international accounting standards.
Under pressure to shore up its capital position, the German
bank is seeking regulatory approval to sell the remainder of its
portfolio, even if it means doing so at a loss to carrying value
And it's not the only one: hedge funds say a number of banks
are seeking to sell correlation books either to boost capital or
so that they can deploy deadweight money to better effect by
"Banks are in the last lap now. For well-capitalised banks
it's highly accretive for them to free up capital and buy back
equity now. For other banks that are struggling to show they're
viable and are reducing RWA aggressively, it's an obvious sell,"
said one head fund manager.
Paul Wilson, a portfolio manager at BlueMountain Capital,
estimates that there are around 10 bank correlation books of
varying size in existence. But such large-scale divestments are
complex, time-consuming, attract a huge amount of regulatory
scrutiny - and do not even eliminate risk completely.
Synthetic CDOs, in which a bank has bought protection from a
SPV that then issued notes to investors, are tricky. It is
difficult for an institution to step in to face a SPV set up by
another bank, Wilson said. Instead, the bank must do a series of
back-to-back trades with another counterparty, which mirrors its
trades with the SPV and thereby offsets the risk.
"The problem is you're effectively exchanging market risk
for counterparty risk," Wilson said. "If your counterparty
defaults, the bank will still be left with open market risk. It
is therefore important that the counterparty is secure and
Credit Agricole has provided the only publicly documented
such deal, when it offloaded its correlation book to Wilson's
BlueMountain in February 2012. The benefits were clear: the
French bank managed to shed EUR14bn and boost its Core Tier 1
capital ratio by 49bp in the process. Meanwhile Credit Suisse
bit the bullet in 2011, paying up to halve the RWA in its credit
All banks have reduced correlation exposures through
bilateral unwinds and hedging risks when possible. For example,
Deutsche Bank shrank its portfolio by 74% between 2010 and 2013,
reducing it to EUR53bn from EUR200bn.
With the risks greatly reduced, some are happy to hold
portfolios to maturity. A source close to BNP Paribas, for
instance, said the French bank was comfortable keeping the
remainder of its book given the short-dated nature of the
exposures and the work it had done on optimising capital
Other banks with deeper holes from which to extricate
themselves may have no choice, and many bankers point a finger
at Morgan Stanley, which bought the Natixis portfolio in 2010.
The bank, which is rumoured to have sold some of its book last
year, declined to comment.
For some, it's a case of cherry-picking assets for sale.
Hubert Le Liepvre, global head of financial engineering,
cross-asset solutions at Societe Generale, said CDO squared and
leveraged super senior CDOs were the prime candidates to
offload, either by unwinding them or by selling them to
non-regulated third parties.
"These products are highly penalised under Basel 2.5;
there's no way you'd keep them on your books," he said.
That said, Le Liepvre noted there was some investor demand
for lightly structured products such as small first-to-default
baskets or index-related products, and that some banks had
therefore decided to maintain correlation books, although much
simpler and smaller than legacy exposures.
"The first step in reducing exposure is by far the most
significant from a risk/return perspective," said Le Liepvre.
But the difficulty of closing large deals was underlined
when UBS's CFO Tom Naratil recently told IFR that unless he saw
attractive prices for the bank's correlation book, he would hold
it to maturity.
Some banks may seek to shed assets in a more piecemeal
fashion given the difficulty of executing large-scale deals.
Either way, CDOs may continue to be a thorn in banks' sides for
a couple more years to come.