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Credit Suisse Bonus Bonds Lead Embrace of Relief Deals

Credit Suisse Group AG. CEO Brady Dougan
Brady Dougan, chief executive officer of Credit Suisse Group AG, said the bonds are linked to a “portfolio of derivative counterparty risks.” Photographer: Gianluca Colla/Bloomberg

April 24 (Bloomberg) -- When Credit Suisse Group AG handed out $750 million of bonuses this year in the form of bonds, generosity wasn’t the only motive.

The securities also shielded the Zurich-based bank from potential losses on $16 billion of derivatives trades -- and reduced its capital needs -- by shifting some of the risk onto employees, people with knowledge of the matter said. Instead of the company bearing the full brunt of any trades where customers failed to pay up, bonus recipients will share the cost.

The bonds are part of a resurgence in “regulatory capital relief transactions,” created by bankers looking to cut risk and build cushions against losses without diluting shareholders, selling assets or scaling back trades and loans. Some of Europe’s biggest banks including Barclays Plc, Standard Chartered Plc and Commerzbank AG are paying investors and employees interest rates as high as 15 percent in return for agreeing to share losses on at least $30 billion of assets.

“If somebody’s out there and willing to accept that risk, that’s beneficial, as long as it’s being used properly,” said Christopher Culp, a former Federal Reserve Bank of Chicago examiner who’s now managing director of Risk Management Consulting Services Inc. in Chicago. “Some regulatory transactions are designed to exploit inefficient regulations.”

Capital Savers

Using techniques similar to the ones that packaged mortgages into bonds, lenders are turning holdings of corporate loans, export-import credit or derivatives-trading gains into triple-A securities. The transformation -- usually requiring a cash infusion from investors, or in Credit Suisse’s case, a commitment from employees -- makes the assets look safer so banks can hold less capital as a loss reserve.

The practice has drawn scrutiny from regulators in the U.K. who say it could leave firms with too little capital to withstand a financial crisis or help them defer loan losses. Another pitfall according to Culp is that instead of diffusing risk, securitization ends up concentrating it elsewhere.

While financial innovation can be helpful, “I would be just as pleased to see a lot of these banks raise new equity capital,” said Darrell Duffie, a Stanford University business-school professor who joined the Moody’s Corp. board in October 2008. “It’s a cleaner way for us all to see that systemic risk is going down.”

Regulators are pressing banks to trim holdings of risky assets and bolster capital -- the buffer between assets and liabilities that helps protect depositors from losses and prevent the need for government bailouts.

Default Swaps

In response, some banks have turned to “synthetic transactions,” built from credit-default swaps that work like insurance to reimburse the lender whenever a borrower defaults or a customer fails to pay up on a trading contract.

The credit-default swap is used to insure a pool of assets. The company then sells bonds backed by the swap that are divided into classes or “tranches” with varying degrees of risk and payoff. That’s similar to the collateralized debt obligations, or CDOs, used in the years before the 2008 financial crisis to turn subprime mortgages into triple-A securities.

Terms call for the junior or “mezzanine” tranches of the new securities to absorb a preset amount of any losses that arise in the pool of assets. This protects the more senior tranches from principal losses. In return for bearing the added risk, the junior investors get paid a higher interest rate.

Genuine Risk Reduction

While the terms may sound complex, lenders are genuinely reducing risks, said Richard Robb, chief executive officer of Christofferson, Robb & Co. The New York-based firm, with $1.5 billion in net assets, specializes in transactions that transfer credit risk from banks to investors, according to its website.

“It’s not really for amateurs,” Robb said. The firm is working on about 25 transactions, and will “end up doing between 10 and 50 percent of them,” he said.

For investors, the success of the deals is linked to the financial strength of banks’ regular corporate customers whose debts are being insured. In theory, there’s less risk of default because those companies have an ongoing relationship with the bank. By contrast, many pre-crisis CDOs were packaged from home loans made by small, independent lenders to consumers with subprime credit scores.

“The banks tend to do this not with their bad assets, but actually with their good assets,” said Ron D’Vari, CEO of NewOak Capital in New York, which advises financial firms and investors on asset-backed securities.

Who Loses

In the Credit Suisse deal, known as the Partner Asset Facility 2 notes, Switzerland’s second-biggest bank gave 5,500 employees bonds maturing in four years that pay a 6.5 percent interest rate. The bonds are linked to a “portfolio of derivative counterparty risks,” according to a Jan. 23 memo sent to the staff by CEO Brady Dougan.

That means the bonds may lose money if a certain percentage of customers fail to pay up on a $16 billion pool of derivatives trades that have gone in the bank’s favor, people briefed on the matter said. They asked not to be named because the matter is private. The company agreed to take the first $500 million of losses on the portfolio, according to its annual report.

The employees -- who had no choice about accepting the terms -- would suffer the next $750 million of any losses, two people briefed on the terms said. Still, Dougan said in his January memo that “our best estimation from actual experience is that this will pay its interest and principal in full.”

The deal was designed “to provide for additional flexibility” as new regulations “require higher minimum capital standards,” Credit Suisse said in the annual report. The plan was discussed with Swiss regulators before it was approved by the bank’s compensation committee, the firm said.

Commerzbank’s Bonds

Suzanne Fleming, a spokeswoman for Credit Suisse, declined to say how much capital was freed up by the transaction.

Commerzbank sold about 150 million euros ($198 million) of junior bonds against 2 billion euros of loans to small- and medium-size companies in Germany, the lender said in a Feb. 2 statement. The bank retained responsibility for the first 28 million euros, or 1.4 percent, of losses, said Martin Halusa, a spokesman. Next, the bondholders would suffer any losses, until they’re wiped out. The company is still on the hook for any losses on the remaining 1.8 billion of euros of loans, he said.

The bonds pay a coupon of 14.5 percent over benchmark short-term interest rates, Halusa said. The Frankfurt-based bank hasn’t released the amount of capital freed up by the deal, “but the sum met our expectation and was in line with the market,” he said.

AAA for Barclays

Barclays in January obtained a triple-A rating for the most senior 5.1 billion euros of bonds backed by a 6 billion-euro book of 667 loans to 541 large companies in the U.S. and Europe, according to a Moody’s Investors Service press release. The London-based bank, ranked second by assets in the U.K., sold part of the most junior 300 million euros of bonds, which would cover the first 5 percent of losses, a person with knowledge of the transaction said.

Standard Chartered, the London-based bank whose origins date to 19th-century British colonial rule in Africa and India, has done at least two deals in the past year to cut its credit risks on $5 billion of loans. In some cases, the bank was able to garner AAA ratings for pieces of the bonds it held onto. Owners of the junior portions receive interest payments as much as 15 percent over short-term benchmarks, according to data compiled by Bloomberg.

Paul Ewing-Chow, a Standard Chartered spokesman in Singapore, declined to comment on how much capital was freed up, citing “regulatory considerations.”

Once Burned

Investors who remember getting burned by structured finance have been wary of some new deals.

In February, Royal Bank of Scotland Plc -- which was bailed out by the government during the financial crisis -- shelved a planned sale of bonds backed by 2 billion British pounds of potential derivatives-trading claims after investors balked at the risk and complexity, three people briefed on the sale said. The junior-most RBS bonds would have paid 15.5 percent interest over benchmark rates, according to a November presentation.

Aside from about $20 billion of structured deals dubbed “Bistro” by JPMorgan Chase & Co.’s predecessor in the late 1990s, capital-relief transactions in the U.S. have been rare.

That’s because the nation’s lenders are still operating under a set of rules adopted in 1988 that make the deals less attractive than in Europe, which is under a newer regime, said Alexandre Martin-Min, head of structured credit investments at AXA Investment Managers. Some U.S. banks have started to consider whether the deals might make sense once newer rules adopted in 2010 are formalized by U.S. regulators, said Martin-Min, whose firm manages 512 billion euros.

Private Deals

Most deals never become public because they’re privately negotiated between banks and hedge funds or other financial firms, typically with investments of $50 million to $100 million, said Olivier Renault, head of structuring and advisory at StormHarbour Partners LP, a securities firm with offices in London and New York. Regulators have clamped down in recent years on transactions done in the shadows that did little more than help banks push off loan losses into future reporting periods, he said.

The Bank of International Settlements, which coordinates global rulemakers, warned in a December 2011 statement that “credit-protection transactions” may have “the potential for regulatory capital arbitrage.”

“There is a little bit of suspicion on transactions that have been done in the past that should not have been allowed,” Renault said. “The deals that were abusing the rules were always private transactions.”

‘Flawed’ Assumption

In May 2011, the U.K. Financial Services Authority told banks that any capital-relief deals would have to get public ratings to qualify. The agency said that lenders using internal mathematical models to calculate their capital requirements could erroneously assume that there was “no systematic risk” in the senior classes of securitizations that were retained.

“The performance of senior tranches of many securitizations since 2007 has shown this assumption to be flawed,” the FSA said.

Losses tied to CDOs created from 1999 to 2007 and packaged from asset-backed securities ultimately may total $420 billion, or 65 percent of their original balance, according to an August 2011 paper by the Federal Reserve Bank of Philadelphia. Junior portions of structured securities were wiped out, forcing holders of the senior AAA portions to take writedowns and contributing to the near-collapse of banks including Citigroup Inc. and Merrill Lynch & Co.

To contact the reporters on this story: Bradley Keoun in New York at

To contact the editor responsible for this story: David Scheer at

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