* CVA securitisation falls foul of latest regulatory guidelines
* Bonus structure had provided sizeable regulatory capital relief
* Credit Suisse expected to change flawed transaction
By Christopher Whittall
LONDON, Feb 27 (IFR) - Credit Suisse may be forced to scrap or, at the very least, radically restructure a multi-billion dollar employee bonus scheme that represents an important part of its efforts to boost capital by slashing risk-weighted assets in the investment bank.
The Swiss bank’s Partner Asset Facility (PAF) 2 scheme was introduced in 2012 as part of its annual compensation pool awarded to over 6,000 senior staff. It consists of a series of structured notes that reference an underlying pool of counterparty credit risk exposures stemming from the bank’s derivatives operations.
Credit Suisse never revealed the regulatory capital relief afforded by PAF2 - only referring to “material risk reductions” - but it is likely to be sizeable: at inception, the structure covered 18% of the credit exposure in the bank’s derivatives business.
These billions of dollars worth of capital savings look set to disappear, though, as the bank’s year-end financial statements reveal the PAF2 transaction involves a hedging structure that falls well short of the latest regulatory guidelines.
The PAF2 structure - which covers approximately USD12bn notional of expected exposures from the bank’s derivatives counterparties - is sliced into three tranches: a technique since prohibited by the Basel Committee for counterparty risk hedges. Credit Suisse retained a USD500m first loss tranche, while senior employees receive coupons of 5% to 6.5% per year from a USD800m mezzanine tranche.
But perhaps more significant is the flawed structure used to hedge the senior tranche of the PAF2 deal, which at USD11bn is by far the largest slice of risk in the portfolio.
Credit Suisse purchased protection from a third party investor - named as Guggenheim Partners by one market source - through a credit default swap accounted for at fair value, according to the bank’s fourth quarter results.
The problematic part of the hedge is as follows: Credit Suisse has extended a multi-billion dollar credit facility to the un-named investor, which requires the bank to “fund payments or costs related to amounts due by the entity under the CDS”.
In other words, the investor can borrow money from Credit Suisse to make CDS payments to the bank if the senior tranche loses money - hardly a genuine risk transfer.
“There’s no question that Credit Suisse will have to restructure PAF2,” said one bank capital expert. “The latest Basel III guidelines all but cite Credit Suisse as an example of what not to do.”
Credit Suisse declined to comment. However, sources within the bank said: “While PAF2 is working as a true economic hedge that transfers risk to employees, the continued evolution of the Basel III rules is likely to require some modifications to the hedge. These changes are already well advanced.”
PAF2 was an important plank in Credit Suisse’s plan to transition to Basel III by 2013 - five years ahead of most of its peers - by aggressively cutting risk-weighted assets from CHF370bn in September 2011 to CHF293bn currently.
Basel III lumps a hefty capital charge on the credit value adjustments (CVA) associated with derivatives exposures, incentivising banks to try and repackage this risk and sell it on to investors.
Credit Suisse’s PAF2 scheme represented the first publicly-detailed securitisation of CVA since the financial crisis. UBS and Deutsche Bank have also executed privately placed deals, while it emerged last week that Societe Generale is lining up a CVA securitisation to sell to third-party investors.
But Credit Suisse has shown the risk of executing a deal prior to the regulations being finalised. The Basel Committee has since stated that tranched securitisations would not constitute eligible hedges for CVA exposures, seemingly because this may open the door to leveraged structures.
A set of “Frequently Asked Questions” from the Basel Committee last November goes a step further, specifically outlawing structures similar to PAF2.
In one section, the Committee states that if a bank remains exposed to a tranche of underlying default risk by providing “any form of credit enhancement to the protection provider, then the CDS is not an eligible CVA hedge.” The Committee further clarifies this to be the case even if the credit facility is subject to accrual accounting - as in the case of Credit Suisse.
The Credit Suisse guarantee facility is four-years in maturity and can be extended to nine years, although the bank has the right to terminate the transaction for certain reasons “including certain regulatory developments”. Analysis of Credit Suisse accounts indicates the facility could be as large as CHF5.8bn.
Guggenheim Partners is well known for its connections with Credit Suisse. Two members of the firm’s executive committee - its president, Todd Boehly, and chief investment officer, Scott Minerd - worked for Credit Suisse First Boston prior to joining. Guggenheim Partners did not return a request for comment.
FINMA - the Swiss bank’s regulator - declined to comment on whether Credit Suisse would be forced to restructure the PAF2 bonus scheme, saying it did not comment on individual cases. (Reporting By Christopher Whittall, editing by Helen Bartholomew and John Mastrini)