What's a bank to do when regulators want it to offload risk to prevent a repeat of the last financial crisis? Why turn to a complicated derivative transaction commonly associated with that same crisis, of course.
Deutsche Bank, which has lost almost half its equity value so far this year, is planning a synthetic collateralized loan obligation to lower the capital requirements tied to a pool of billions of dollars of corporate loans.
The German lender certainly needs some help with its balance sheet. It's one of the worst-capitalized banks in Europe and is negotiating with the U.S. Justice Department over a potential $14 billion fine for mortgage-related activities. So it makes sense for Deutsche Bank to try to get creative to make its books look better.
At first glance, the idea that the bank's managers would turn to derivatives that are closely associated with some of the instruments that nearly brought down the financial system in 2008 is puzzling.
But European regulators seem to welcome these transactions. The logic is that these deals are usually fully funded, with investors posting the full amount that they're on the hook to cover should a lot of a bank's loans go bust. They're not highly leveraged wagers similar to the pre-crisis synthetic collateralized debt obligations, which were backed by who knows what and sold to whomever.
European banking regulators are even considering giving preferential regulatory treatment to the most-senior portions of these synthetic CLOs, which the originating banks hold on their balance sheets, to encourage more of them. The European Banking Authority noted in a report that these particular risk-transfer arrangements "have performed relatively well" and are purchased by the most sophisticated investors who carry out "in-depth due diligence analysis."
In other words, according to the regulators, investors who buy these securities are smart. They can parse through the loans and assess a bank's underwriting standards as well as anyone else. They'll do a good job, so let's trust them. It'll make us all safer.
Regulators are essentially paying investors to take on the job of risk assessment. They're charging banks high enough capital costs that it makes sense for the firms to arrange these deals and offer high enough interest rates to entice investors to take on first-loss pieces.
Viewed in that light, it's a little more understandable why buyers of these derivatives are so enthusiastic, especially because their yields are typically greater than 10 percent.
One such investor, Dutch fund PGGM NV, is so passionate about these synthetic transactions that it published a six-page report last year explaining its view and why it's such a big buyer of them. Many European banks have arranged these transactions. Last week, Alastair Marsh and Tom Beardsworth highlighted these transactions in a Bloomberg News article.
Just because an investment sounds scary doesn't mean it is. But there's a profound irony in the idea that a troubled bank is selling a crisis-era derivative to meet regulations aimed at preventing another crisis.
This column does not necessarily reflect the opinion of Bloomberg LP and its owners.
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Lisa Abramowicz in New York at firstname.lastname@example.org
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