Breezing into a sunlit conference room near London’s Hyde Park Corner wearing an open-collared white shirt that frames his square jaw, Loic Fery exudes the confidence of a soccer club owner who’s enjoyed success on the pitch and with the team’s account ledgers.
FC Lorient, the French soccer club Fery and his family rescued from the brink of bankruptcy in 2009, has under his ownership had some of the best seasons in its 87-year history; for the past four years, it has been the only profitable team in Ligue 1, France’s top league.
In addition, Fery, co-founder of London-based hedge fund Chenavari Investment Managers, has established a formidable reputation as an investor, Bloomberg Markets magazine will report in its October issue.
Now, some regulators and academics are concerned that a strategy he and other money managers are using may undermine new rules designed to strengthen the global financial system.
Chenavari is one of a handful of firms that invest in capital relief trades, or CRTs. A bank pays a third party, such as a hedge fund or pension fund, to take on some of the risk associated with its loans. That makes it easier for the bank to meet regulators’ capital-to-risk requirements.
CRTs often involve complex structures in which special-purpose companies are set up to provide protection to the bank through a credit-default swap, a derivatives contract that pays the buyer if a designated bond or loan portfolio defaults, and are in turn funded through the sale of notes to investors.
Launched in May 2011 with an initial investment of $75 million, Fery’s Toro II strategy, part of the firm’s Chenavari Credit Fund, is built on CRTs. Since then, Chenavari, with $4 billion under management across two funds, has invested about $1 billion in about 20 CRT deals, Fery says. The Toro II strategy earned 43 percent from its inception through the end of July.
While it’s impossible to know how many CRTs exist in total because most of the deals are private, regulatory filings indicate that European banks have engaged in at least $30 billion of these trades since 2009. CRTs use the same instruments, such as collateralized loan obligations and CDSs, that precipitated the 2008 financial crisis.
These mechanisms helped Bear Stearns Cos. and Lehman Brothers Holdings Inc. disguise the amount of toxic debt on their balance sheets and led to the near collapse of American International Group Inc., one of the main providers of credit insurance to banks.
Regulators are wary of the banking industry’s renewed interest in risk shifting. The Basel Committee on Banking Supervision announced in December that it was considering new rules that would make CRTs more expensive for banks, potentially stemming the flow of deals. The new rules, which were expected to be announced in September, would have to be adopted by national regulators.
Christine Lang, a Swiss banking regulator who sits on one of the committee’s work groups, says it has warned banks against gaming new capital requirements.
“Now, we may have to come down very heavy on the industry,” she says.
As in the run-up to the financial crisis, today’s widespread use of CRTs could mask banks’ true financial condition and make it difficult to spot systemic risks, says Anat Admati, a finance professor at Stanford University in Stanford, California, and co-author of The Bankers’ New Clothes: What’s Wrong With Banking and What to Do About It (Princeton University Press, 2013).
“This is precisely what happened with AIG,” she says.
AIG used CDSs to insure pools of subprime mortgages in transactions that were structurally similar to many CRTs. As those portfolios ran into trouble, AIG’s credit was downgraded, forcing the insurer to post collateral it didn’t have.
“The idea that if risk is transferred it can be ignored was an illusion,” Admati says.
It took an $85 billion U.S. government bailout in September 2008 to save AIG. AIG paid the government back in December and this year declared its first dividend since 2008.
In an ironic twist, it’s the prospect of tougher rules to prevent a repeat of the 2008 crisis that’s attracting banks and investors alike to CRTs, which are also known in the financial industry as credit risk mitigation transactions, or CRMs.
Under Basel III, a set of rules that started to come into effect this year, banks are required to have enough capital to cover 8 percent of their risk-weighted assets, with an increasing share consisting of equity and retained earnings.
Before Basel III, banks had to hold only 2 percent in this so-called core tier 1 capital; by 2019, that will rise to 4.5 percent and total capital ratios will have to be as high as 13 percent.
The Basel Committee estimates that 75 of the world’s biggest banks collectively will need to find an additional $300 billion in core capital to meet the new requirements.
The growing need for capital has made banks enthusiastic partners in CRTs. Citigroup Inc., Commerzbank AG, Credit Suisse Group AG, Deutsche Bank AG, Lloyds Banking Group Plc, Standard Chartered Plc and UBS AG are among the dozens of banks that have engaged in the capital-saving deals during the past four years, according to their regulatory filings.
One advantage to CRT deals, advocates say, is that hedge funds rarely threaten the overall financial system. These funds generally weathered the 2008 financial crisis better than banks; none required a government bailout.
In return for absorbing part of the banks’ default, counterparty or correlation risk, investors such as Fery’s Chenavari can make annual returns as high as 15 to 20 percent on each deal.
Basel III requires banks to raise the ratio of their capital to their assets, which are weighted according to their risk. The rules reduce the types of capital that banks can count toward the ratio while increasing the amount of assets they must offset.
CRTs help banks by lowering the risk weight assigned to their assets, allowing the institutions to reach the capital target without raising additional funds.
For example, a portfolio of loans to small and medium-sized companies might have a risk weight of 6 percent, based on historical losses. That means the bank would have to hold in reserve capital equal to 6 percent of the portfolio to cover potential losses.
By transferring the risk of default to a hedge fund through a CRT, the bank can reduce the risk weight of the portfolio to well below 1 percent.
Bankers and investors involved in CRTs say comparisons to AIG and the toxic-debt era are tendentious.
“If these transactions are properly structured, there is no counterparty risk,” says Remy Kawkabani, a former Credit Suisse banker and co-founder of London-based World Trade Capital Partners LLP.
In the past, AIG could sell uncollateralized credit-default protection. Under Basel III regulations adopted so far, U.S. and European regulators will no longer grant banks significant capital relief for a CRT unless the CRT investor posts enough collateral, in the form of cash or low-risk securities such as U.S. Treasuries, to cover all possible defaults in the slice of the portfolio they’re insuring.
Richard Robb, co-founder of New York-based Christofferson Robb & Co., which has all of its $1.8 billion under management invested in CRTs, defends the trades as a way to strengthen the financial system. He says his firm’s investors -- pension funds, university endowments and sovereign wealth funds -- are the kind of institutions that regulators should want to hold risk rather than banks.
“All of our investors have 50-year time horizons, no leverage and gobs of money,” Robb says.
At the end of March, Credit Suisse entered a trade that shows how one CRT works.
Clock Finance 2013-1 BV, a private company registered by Credit Suisse in the Netherlands, provides Switzerland’s second-largest bank with protection from default on a 5 billion Swiss franc ($5.42 billion) portfolio of loans to small and medium-sized Swiss companies.
Via a CDS, Clock takes on the risk of any unexpected losses in excess of 1 percent and up to 6 percent, or 250 million Swiss francs, of the loan portfolio for eight years. Credit Suisse retains the risk of any initial defaults up to 1 percent as well as any that exceed 6 percent.
In exchange for Clock’s taking on this risk, Credit Suisse pays Clock what is essentially an insurance premium. Clock passes this money on to its own investors in the form of coupon payments on their notes. The coupon is set to the three-month Swiss franc London interbank offered rate plus 9 percentage points, or 9.02 percent as of July 31.
Credit Suisse declined to disclose the amount of capital relief it got from Clock. Fery, Robb and other money managers say most CRTs reduce the capital a bank has to hold against a particular pool of loans by 65 to 85 percent. That means Credit Suisse probably avoided having to hold hundreds of millions of francs in reserve on its balance sheet.
Wilson Ervin, vice chairman of Credit Suisse’s group executive office, says the bank enters into transactions such as Clock primarily to hedge its credit exposure. Any capital savings are an ancillary benefit, he says.
Something about Clock is unusual: that we know about it at all. Credit Suisse chose to market the deal publicly rather than placing it privately with one or two investors, as is more typical. Public distribution helped Credit Suisse get a lower rate on the notes, Ervin says.
The lack of transparency makes analyzing bank balance sheets much more difficult, says Bridget Gandy, managing director for financial institutions at credit-rating company Fitch Ratings in London.
Although some large CRTs are disclosed to investors and credit-rating firms, many deals aren’t, Gandy says. In recent years, banks have also used CRTs for businesses they were getting out of or portfolios that were already in trouble. Gandy says it would be better if banks simply sold off or wrote down such assets.
“Cleaner is always better,” she says.
Enrique Schroth, who’s on the finance faculty at Cass Business School in London, says CRTs could blind regulators to systemic risks. These might include a single hedge fund acting as an insurer for a large number of important banks or investors borrowing collateral to use in CRTs, which could exacerbate a future financial crisis.
At the end of last year, Citigroup completed a CRT with New York-based private-equity firm Blackstone Group LP. First reported by Bloomberg News in February, the deal enabled Citigroup to reduce by as much as 90 percent the amount of capital it had to hold against a $1 billion portfolio of shipping loans.
In return for insuring the bank against some potential losses on the loans, Blackstone is earning returns of about 15 percent annually, according to people familiar with the transaction.
Jeffrey French, a spokesman for Citi, says the purpose of the deal was to mitigate credit risk in the bank’s loan book and increase its ability to lend to the shipping sector. He says details of the transaction were disclosed to the U.S. Federal Reserve and U.S. Treasury’s Office of the Comptroller of the Currency. Blackstone declined to comment.
Citi is currently seeking default protection on another $500 million portfolio of shipping loans through a publicly marketed transaction, according to people with knowledge of the deal.
CRTs with large capital savings and high payments to investors are often tantamount to gaming the rules, says Lang, the Basel regulator.
“It is sad that some banks have done high-cost transactions, which the Citi deal is reported to be,” she says.
In March, the Basel Committee issued supplementary proposals to crack down on abuses, including forcing banks to immediately deduct from capital the value of future credit-protection payments.
The Bank of England’s Prudential Regulation Authority has also questioned whether some banks have used CRTs to avoid writedowns.
The PRA cited the example of an unnamed bank whose total payment for credit protection over the life of a CRT was greater than the value of the asset it was insuring. Instead of writing off the asset -- with an immediate charge against capital and earnings -- the bank amortized the loss over several years in the form of payments to the CRT investor.
One way to prevent banks from playing these sorts of games is for regulators to move away from measures of capital based on banks’ internal risk weights, Stanford’s Admati says. The imposition of significantly higher mandatory leverage ratios, which measure the proportion of capital to total assets, would make credit relief trading less attractive for banks, she says.
In July, U.S. regulators set a 5 percent minimum leverage ratio for eight bank holding companies it considers “systemically important,” including Goldman Sachs Group Inc., JPMorgan Chase & Co. and Citigroup.
The PRA announced on June 30 that it would order banks to meet a 3 percent leverage ratio by mid-2014, forcing Barclays Plc to announce plans to raise 7.8 billion pounds ($12.1 billion) in new equity capital.
At Chenavari’s London offices, Fery says he’s unperturbed about the impact of new regulation.
“I am not worried,” he says with a Gallic shrug.
Indeed, he thinks the new regulations may create even more opportunities for CRTs.
“Remember, the regulators and the banks have the same objective: At the end of the day, they want the bank to have a stronger capital base,” he says.
The question for regulators is whether CRTs provide banks - - and the entire financial system -- with a real safety net or merely a false sense of security.