Lehman Brothers Collateralized debt obligations (CDO) Derivatives

BANK STRATEGIES John H. Hunt Michael J. Baek Michael F. Szymanski 212-526-6210 February 1, 1999 COLLATERALIZED LOAN OBLIGATIONS AND CREDIT DERIVATIVES EVALUATING STRUCTURED FINANCE ALTERNATIVES FOR CREDIT RISK TRANSFER Responding to volatile market forces and competition in the financial services industry, commercial banks continue to evaluate collateralized loan obligations (CLOs) and credit derivative vehicles as tools to reduce risk-based capital (RBC) and transfer credit risk to the capital markets. Not every bank has the same objective. Given balance sheet pressures caused by deteriorating Asian economies, Japanese banks have executed CLO transactions primarily to achieve RBC relief. Facing competition from securities firms for their best customers, U.S. banks are migrating toward a business strategy that relies on distribution of credit risk (including securities underwriting in Section 20 subsidiaries) rather than full retention of all loans. Against this backdrop, commercial banks are increasingly measured by the investment community on their ability to enhance shareholder value by de-emphasizing low margin businesses and allocating “economic” capital to higher return activities. In response to these objectives, innovation in credit risk transfer vehicles continues. As a result, commercial banks now have several structured finance alternatives from which to choose, ranging from CLOs to synthetic credit derivative structures. To facilitate the evaluation process, we will compare these alternatives on an economic and regulatory basis. Our goal is to explain the alternatives that banks have in credit risk transfer vehicles and the advantages and drawbacks of each. This report focuses on the structural alternatives for credit risk transfer from the issuer’s perspective. Commercial banks should also obtain two previous Lehman Brothers research reports that address CLOs and credit derivatives: Bank Strategies—Credit Derivatives, May 1998, discussed the pricing methodologies, relative value considerations, and regulatory treatment of over-the-counter credit derivative contracts; Collateralized Debt Obligations: Market, Structure, and Value, June 1998, described the evolution of the CLO market and the structural characteristics of CLOs, explained the credit rating agencies’ methodology for assessing the risks of these securities, and explored the value within the CLO market and relative value opportunities. CONTENTS New Approaches to Traditional Hurdles ............................................................... 3 A Few Words on Economic Capital ...................................................................... 3 Strategic Alternatives ............................................................................................ 4 Traditional Cash Flow CLO ................................................................................... 6 Summary ............................................................................................................ 13 Appendix A: Collateralized SYCLONE ............................................................... 15 Appendix B: Indirect Credit Derivative ............................................................... 18 Appendix C: Non-Collateralized SYCLONE ....................................................... 20 Appendix D: Financial Reporting and RBC Treatment for the Traditional Cash Flow CLO ....................................... 22 Appendix E: Financial Reporting and RBC Treatment of Reverse CLO ............. 25 Appendix F: Financial Reporting and RBC Treatment of Collateralized SYCLONE .......................................................... 26 Appendix G: Financial Reporting and RBC Treatment of Indirect Credit Derivative .................................................. 29 Appendix H: Financial Reporting and RBC Treatment of SYCLONE ........................................................................ 30 Many thanks to James J. Chen (Asset Backed Securities), Jawahar L. Chirimar (Structured Credit Trading), Jin S. Chang (Bank Strategies Group), and Pradip K. Ghosh (Bank Strategies Group) for their assistance in preparing this report. Publications: M. Parker, A. DiTizio, C. Triggiani, B. Davenport This document is for information purposes only. No part of this document may be reproduced in any manner without the written permission of Lehman Brothers Inc. Under no circumstances should it be used or considered as an offer to sell or a solicitation of any offer to buy the securities or other instruments mentioned in it. We do not represent that this information is accurate or complete and it should not be relied upon as such. Opinions expressed herein are subject to change without notice. The products mentioned in this document may not be eligible for sale in some states or countries, nor suitable for all types of investors; their value and the income they produce may fluctuate and/or be adversely affected by exchange rates, interest rates or other factors. Lehman Brothers Inc. and/or its affiliated companies may make a market or deal as principal in the securities mentioned in this document or in options or other derivative instruments based thereon. In addition, Lehman Brothers Inc., its affiliated companies, shareholders, directors, officers and/or employees, may from time to time have long or short positions in such securities or in options, futures or other derivative instruments based thereon. One or more directors, officers and/or employees of Lehman Brothers Inc. or its affiliated companies may be a director of the issuer of the securities mentioned in this document. Lehman Brothers Inc. or its predecessors and/or its affiliated companies may have managed or co-managed a public offering of or acted as initial purchaser or placement agent for a private placement of any of the securities of any issuer mentioned in this document within the last three years, or may, from time to time perform investment banking or other services for, or solicit investment banking or other business from any company mentioned in this document. This document has also been prepared on behalf of Lehman Brothers International (Europe), which is regulated by the SFA. ©1999 Lehman Brothers Inc. All rights reserved. Member SIPC. Lehman Brothers 2 February 1, 1999 NEW APPROACHES TO TRADITIONAL HURDLES In the past, commercial banks have faced numerous regulatory, rating agency, accounting, and systems hurdles to commercial loan securitization. Commercial bankers often question why they should issue a CLO at a positive spread to LIBOR when many commercial banks can fund with deposits at sub-LIBOR levels. Furthermore, the bank regulatory agencies had been reluctant to provide extensive guidance on the RBC treatment of credit derivatives purchased to hedge credit risk.1 In addition, credit rating agencies required comprehensive due diligence in establishing credit ratings for non-homogeneous commercial loan pools. As the CLO and credit derivatives markets have matured, solutions and alternative structures have emerged to address many of these concerns. Commercial banks, cognizant of the equity analyst community’s increasing focus on shareholder value measures such as Economic Value Added (EVA™), are beginning to re-evaluate the cost of funds targets set for CLOs. At the same time, the Federal Reserve (Fed) and Office of the Comptroller of the Currency (OCC) have provided more guidance on the RBC treatment of credit derivatives and residuals under the market risk rules. Finally, in an important structural breakthrough, credit rating agencies began to rely on the sponsoring bank’s internal credit scoring system and the CLO’s cash flow structure to rate CLO securities, instead of requiring “shadow ratings” on each borrower obligation in the CLO. As we will demonstrate, banks face increasing complexity in choosing the right credit risk transfer vehicle. Since the advent of the CLO market in 1996, bankers and regulators have gone through a learning process. These deliberations have resulted in new structures that optimize the RBC treatment for commercial loan portfolios and unfunded loan commitments. The result of this period of innovation is that commercial banks looking at the new issue CLO and credit derivative markets have choices to make. Some structures, such as unsecured credit-linked notes, have proven to be less desirable than the other alternatives, as evidenced by secondary market trading levels. As banks face the need to transfer credit risk and optimize capital structures, we believe that comparisons can be drawn between the remaining viable alternatives. A FEW WORDS ON ECONOMIC CAPITAL Many bankers question whether securitizing commercial loans makes sense, especially given the transaction costs and pricing compared to core funding alternatives. Certainly, CLOs and credit derivatives can provide substantial RBC reduction, as we will demonstrate. But whether the bank can maximize shareholder value through a CLO or credit derivative can be addressed only from an economic capital perspective. Though risk-based capital rules are prescribed by the banking agencies for all domestic banking institutions, internal economic capital requirements are not. It is clear that banks should manage their risks with a “rational” method for allocation of capital to different businesses, incorporating regulatory capital requirements as a minimum capital constraint. Indeed, some banks find their internal economic capital requirements to be higher than their regulatory requirements for certain lines of business. As a result, we believe that certain CLO and credit derivative structures can provide substantial economic capital relief, freeing capital for higher margin businesses, new product lines, or share repurchase plans. To make our point, we need a measurement of economic capital relief and shareholder value. In recent years, equity analysts and consultants have criticized the inadequacy of traditional accounting measures of performance such as return on equity (ROE) and return on assets (ROA). Stern Stewart & Co., a New York-based consulting firm, has developed a measure of performance called Economic Value Added (EVA) to be implemented in performance-based compensation plans. Simply put, EVA extends the measure of ROE by incorporating an explicit cost of equity capital. Recognizing its growing acceptance among equity analysts, we selected an EVA-based approach to demonstrate the potential impact that CLOs and credit derivatives can have on economic capital and shareholder value. 3 February 1, 1999 1 Though this paper references the regulatory capital requirements as applied by the U.S. banking agencies, we believe that these requirements are generally consistent across other international regulatory regimes. ™ EVA is a registered trademark of Stern Stewart & Co. Lehman Brothers EVA is net operating profit after tax less a charge for the cost of capital employed, including all debt and equity. In other words, EVA represents economic profit or the total economic return to the shareholders beyond all economic costs, including the cost of equity capital. EVA results in a dollar value that can be positive (wealth creation) or negative (wealth destruction). For our purposes, EVA2 allows us to demonstrate that banks should not merely compare CLO execution against their LIBOR funding targets. Instead, banks should consider the cost of equity capital in judging the overall cost of funds. Several banks have implemented risk-adjusted return on capital (RAROC) systems for allocating capital to business lines and activities. RAROC is computed by dividing net income (including funds transfer pricing and overhead allocations) by the total amount of economic capital assigned based on a risk calculation. As a result, RAROC is a way of expressing EVA as a percentage, rather than as a dollar value. However, an exclusive focus on RAROC is likely to lead to underinvestment in value-adding projects that bring down the overall RAROC.3 STRATEGIC ALTERNATIVES In our view, commercial banks have the following strategic alternatives with respect to their commercial loan portfolios: • Base Case—Keep the loans on the balance sheet funded with deposits, subordinated debt, and equity. Cash Flow Collateralized Loan Obligation (CLO) Structures — Traditional Cash Flow CLO—The originating bank sells its loans to a special purpose entity (SPE), retains subordinated classes and residual interests, and reinvests the cash proceeds in loan origination, share repurchases, or higher margin activities. (Examples: NationsBank Commercial Loan Master Trust and BankBoston Commercial Loan Master LLC). — Reverse Cash Flow CLO—The originating bank sells the loans to SPE, retains the senior class and residual interest, and sells the subordinated classes to achieve credit risk transfer. (Examples: Sumitomo Bank Limited Aurora Funding). Credit Derivative CLO Structures In 1997, Lehman Brothers acted as financial advisor • 2 For purposes of this paper we have utilized the pre-tax net operating profit. 3 Edward Zaik, John Walter, Gabriela Kelling and Christopher James, “RAROC at Bank of America: From Theory to Practice,” Journal of Applied Corporate Finance, 9 (1996), 83-93. • Figure 1. Strategic Alternatives CLO Structure Cashflow CLO Structures Derivative CLO Structures Modified Participation e.g., BankBoston, NationsBank, Sanwa-NY (Excelsior) Reverse CLO e.g., Sumitomo-London (Aurora) Credit Linked Notes e.g., Swiss Bank (Glacier) Direct Credit Derivatives Indirect Credit Derivatives e.g., JP Morgan (BISTRO) SYCLONE* Structure e.g., UBS (Eisberg) Collateralized SYCLONE* Structure e.g., CFSB (Triangle II) *SYCLONEs are Synthetic Collateralized Loan Obligations NotEs. Lehman Brothers 4 February 1, 1999 v v v v v v v v v to Swiss Bank Corporation in establishing the Glacier Credit-Linked Vehicle Program. The credit derivative technology pioneered in Glacier led to bank portfolio management trades, collateralized by Treasury securities. The most recent structure, described as Synthetic Collateralized Loan Obligation Notes (SYCLONE), represents the latest evolution of credit-linked note technology. — Credit-linked Note Structure—The originating bank issues senior unsecured notes, the principal of which is linked to the credit risk of a specified customer or counterparty. The notes are issued to a master trust, which in turn issues credit-linked notes. (Example: SBC Glacier Finance Ltd.). — Direct Credit Derivative - Collateralized SYCLONE4 —The originating bank enters into a credit default swap with the issuing trust, which is obligated to pay the originating bank any losses on a reference portfolio of obligors corresponding to the obligors on the originating bank’s funded or unfunded loan facility. In exchange for the credit default swap, the bank pays a predetermined periodic fee (swap fee). The issuing trust’s assets consist of Treasuries/high grade securities acquired with the proceeds from the issuance of notes, in addition to the right to the periodic fee. (Example: CFSB Triangle II structure) The Collateralized SYCLONE requires the originating bank to transfer its underlying loan portfolio into the trading account to optimize risk-based capital treatment under the market risk rules. However, GAAP does not allow banks to transfer the loans into the trading account unless the bank demonstrates an ability to quote bid-offer spreads and provide trading liquidity in the loan portfolio. As a result, two structures have emerged as alternatives to the Collateralized SYCLONE that allow banks to take advantage of the market risk rules without having to transfer the underlying loan portfolio into the trading account. 4 Alternatives to Collateralized SYCLONE 1) Indirect Credit Derivative—The originating bank enters into a credit default swap under which the counterparty (an OECD bank) is obligated to pay the originating bank any losses on a reference portfolio of obligors corresponding to the obligors on the originating bank’s funded or unfunded loan facilities. The counterparty enters into an offsetting credit default swap with an issuing trust (refer to Collateralized SYCLONE above). The originating bank may retain a 1%-2% residual interest in the underlying exposure. [Example: J.P. Morgan Broad Index Secured Trust (BISTRO ™) structure] 2) SYCLONE—This structure improves on the RBC treatment of the Collateralized SYCLONE structure by combining features of the Collateralized SYCLONE with the Indirect Credit Derivative. The originating bank enters into a subordinated (leveraged) credit default swap (approximately 10% of loan portfolio) with the issuing trust, which is obligated to pay the originating bank any losses on a reference portfolio of obligors corresponding to the obligors on the originating bank’s funded or unfunded loan facility. The originating bank then enters into a second senior credit default swap with an OECD bank on the remaining credit risk in the loan portfolio (which approximates a AA or AAA rating). In this fashion, the originating bank reduces the remaining 89% of the loan portfolio to a 20% risk weighting (assuming that the originating bank retains a 1% residual interest in the underlying exposure) (Example: UBS Eisberg structure). In addition, the bank can also swap the credit risk back from the OECD bank (which then acts as intermediary) into its trading portfolio and then apply the market risk capital rules. The bank would still be required to hold capital against the initial swap with the 20% risk weighted counterparty but would avoid paying the full default swap premium on the senior risk. ™ SYCLONEs are synthetic collateralized loan obligation notes. BISTRO is a registered trademark of J.P. Morgan & Co. Lehman Brothers 5 February 1, 1999 — Third-Party Credit Default Swap—Hedge the credit risk with an over-the-counter credit derivative provided by a dealer. For a complete analysis of this alternative, see the Lehman Brothers report, Bank Strategies—Credit Derivatives, May 1998. As a result, our economic analysis, which is built upon current market conventions, is biased toward the reverse cash-flow CLO. An issuer can choose to include the same structural features (including early amortization) into credit derivative CLO transactions to eliminate this bias. Additionally, the discussion and analysis in this report deal solely with cash-flow and credit derivative CLO structures associated with funded loan assets. Although many of the structural considerations can be applied to structures that accommodate unfunded commitments, the resulting economic analysis may vary significantly from the findings in this report. The objective of this report is to propose a conceptual framework to evaluate the benefits that these structures may provide to banking organizations. Economic analysis is presented to facilitate this discussion. The reader should keep in mind that certain assumptions have been made with respect to the reference loan collateral. The resulting economic analysis is highly dependent on these assumptions. As the paper explains, each alternative transaction has its unique costs and benefits, and the most appropriate structure will depend on the issuer’s funding needs, underlying collateral, desire for credit risk transference, and structural features (including early amortization features) of the transaction. A WORD OF CAUTION ON CHOOSING THE OPTIMAL STRUCTURE In the following sections, we focus on structures that we think make sense for commercial banks. First, we examine the strategy of issuing a “traditional” cash flow CLO, discussing the bank’s balance sheet economics before and after the transaction. Then, in Appendices A, B, and C, we describe each alternative in detail, including structural features, financial reporting treatment, RBC treatment, pricing, and economic capital efficiencies. We hope this analysis will serve as a tool for commercial bankers as they evaluate their options. As a word of caution, our economic analyses comparing credit derivative CLO structures to the reverse cash flow CLO structure (appearing in Figure A-5, B-5, and C-4) incorporate several key assumptions that are subject to change. To date, most (if not all) credit derivative CLO structures in the marketplace do not have the same early amortization features as cash flow CLOs (as explained in Appendix A on page 15). Though the mere presence of early amortization triggers does not prohibit regulatory or economic capital relief, the tenor of the risk transfer (and thus capital relief) may vary. While a cash-flow CLO can amortize earlier than expected, most credit derivative CLOs existing today cannot. In effect, these credit derivative CLOs provide similar amounts of protection but for a longer period of time. Assuming that all else is equal, this difference will have the effect of increasing the subordination levels (i.e., cost of funds) of a credit derivative CLO as compared to a reverse cash-flow CLO. Because of the impact that these early amortization triggers have on the subordination levels required by the rating agencies, credit derivative CLOs in the market today generally reference credits that are of a higher quality than the credit quality of the typical loan asset in a cash-flow CLO. 5 TRADITIONAL CASH FLOW CLO Until recently, regional banks have been reluctant to issue CLOs because 1) core deposit funding is less expensive than CLO cost of funds; 2) prior transfer mechanisms did not preserve client confidentiality; 3) negative perceptions surrounded banks’ selling customer exposures; and 4) there was no need for RBC relief. However, recent transactions demonstrate the benefits of CLO issuance. • CLO transactions can reduce the balance sheet, enhance the return on risk-adjusted assets, and help manage credit risk exposure. Securitization provides another source of funding liquidity, as well as recurring servicing fee income and yield from retained interests. Because banks can avoid borrower notification in a CLO transaction, banks can avoid significant operational burdens and improve relationship February 1, 1999 • 5 Even without the early amortization triggers, subordination levels required for a structure holding single-A quality credits may be lower than the subordination levels required for a structure holding double-B quality credits with early amortization triggers. • Lehman Brothers 6 management with borrowers (by freeing credit lines for new transactions). CLO transactions allow banks to manage risk-based capital requirements to “economic” levels because pricing in the ABS markets reflects a more accurate cost of capital for credit risk. Through CLO issuance, banks can develop empirical market evidence that much of their commercial and industrial (C&I) loan portfolio is not priced by the market at a cost of capital equating to 100% risk weighting under the Basle Accord on Risk-Based Capital. • • Structural Features • Under the cash flow structure (Figure 2), the originating bank would create a wholly owned special purpose Delaware Business Trust (the funding trust), which would purchase a 100% participation interest in the bank’s eligible loan portfolio (the firsttier participation). The intermediate funding trust is necessary to obtain “true sale treatment” for the participating loans and is not treated as a separate entity for U.S. tax purposes. Pursuant to a second-tier participation, the funding trust would contribute its 100% interest in the loan portfolio to a common law master issuance trust (the master issuance trust). Transaction Diagram Originating Bank v • • • • The master issuance trust would issue investment grade rated notes and/or certificates (investor securities) backed by its interest in the participating loans as well as a single seller’s interest that would be retained by the funding trust. The face amount of the investor securities and the seller’s interest would equal, in aggregate, the face amount of the funded loan portfolio transferred to the master issuance trust. A separate cash collateral account would be created and held for the benefit of the holders of the investor securities. The cash collateral account would be funded by the bank and would be used to cover shortfalls on the investor securities. The amount required in the cash collateral account could be reduced to the extent the bank retains the junior most investor securities. A swap agreement could be entered into to cover any basis risk or currency risks associated with the loan portfolio. The swap counterparty may be an originating bank affiliate or a third party provider. The originating bank’s rating may be acceptable to the rating agencies, depending on the ultimate outcome of any rating action, to act as swap counterparty with respect to interest rate swaps without a third party intermediary and without having an adverse effect on sale treatment. Figure 2. 100% Participation Interest in Eligible Loans w $ $ w First Tier Entity v v Cash Collateral Account 100% Participation Interest in Eligible Loans w $ Seller Certificate Cash Collateral Guaranty Swap Provider Basis & Currency Swap Second Tier Entity (Common Law Master Trust) v v w w Notes & Certificates w ABS Investors v $ $ Note w ABCP Conduit Liquidity Provider w Lehman Brothers 7 February 1, 1999 • • The use of a master trust structure would permit the future or concurrent issuances of additional series of investor securities as well as asset-backed commercial paper. For rating agency purposes, an intermediate entity is not necessary for delinked ratings. Due to uncertainty in the interpretation of SFAS 125 for regulated entities (see Appendix E), the intermediate entity provides GAAP sale treatment through a true sale. Figure 3 illustrates the isolated loan portfolio prior to securitization. For illustration purposes, we omit the seller’s interest from this analysis. We assume that the portfolio of loans is funded with a combination of debt (92%) and equity capital (8%). Assuming the cost of debt financing to be equal to LIBOR,12 we calculate the one-year net income to be equal to $19.2 million.13 We now consider a cash flow CLO securitization of this loan collateral with the resulting bond classes in Figure 4 for a five-year maturity. Figure 5 illustrates a simplified balance sheet for the issuing trust. The C&I loans are transferred from the bank’s balance sheet into the issuing master trust. The master trust issues five classes of securities, Classes A through E, which appear as trust capitalization. Class E is the unrated (first loss) class, often referred to as the “equity” piece. To simplify our analysis, we have not incorporated a separate cash collateral account (CCA) into the securitization structure (presumably Class E would include the CCA). Financial Reporting and RBC Treatment The financial reporting and RBC treatment of this structure is detailed in Appendix D. Balance Sheet Perspective Consider a loan portfolio with the following characteristics: Portfolio Notional Amount Weighted Average Margin on Loans Moody’s Diversity Score6 Moody’s Average Rating Score 7 Maximum Industry Group8 Maximum Obligor Concentration9 Maximum Loan Maturity10 Fixed Rate Loan Percentage11 = $ 1 billion = 1.50% = 75 = 1850 (“ratings”) = 8.0% = 2.0% = 5 years = No Restriction 12 13 6 The Moody’s Diversity Score is a measure of the diversification of the portfolio by obligor and industry. Generally, this score will increase as the size of the master trust portfolio grows. SBC Glacier Finance was sized with a diversity score of 40; NationsBank CLO had a diversity score of 80. For diversity scores greater than 40, additional increases in score do not yield significant decreases in subordination levels. 7 The Moody’s Average Rating Score is a weighted average of the ratings on the loan portfolio using Moody’s supplied weighting factors (e.g., Aaa = 1, Baa3 = 610, Ba1 = 940, B2 = 2720). The SBC Glacier Finance was sized with an average rating of 610; NationsBank has an average rating of 900. For diversified CLO transactions, the average rating becomes the dominant factor in determining subordination levels. 8 Because S&P does not utilize a diversity score concept in reviewing loan pools, We assume 3-month LIBOR = 5.25%. For illustrative purposes, we aggregate all borrowings into a single “debt” item. Figure 3. Bank Balance Sheet (pre-CLO), $ million Income/ (Expense) 67.5 67.5 (48.3) (48.3) 19.2 Assets C&I Loans Total Liabilities & Equity Debt Equity Total Net Amount 1,000.0 1,000.0 920.0 80.0 1,000.0 Rate 6.75% 5.25 maximum concentration limits for the amount of obligors in the same industry are required. S&P is comfortable with an 8% concentration limit on each industry as a general parameter. Larger concentration limits can be established within certain limits; however, S&P will assume a downward adjustment for all loans to such industry. SBC Glacier Finance imposed an 8% limit for any S&P industry group; NationsBank incorporated a 5% limit. 9 To reduce the exposure to a single obligor, limits on the size of the loans to a single obligor must be imposed for both rating agencies. SBC Glacier Finance utilized a 2% concentration limit; NationsBank utilized a 3% concentration limit. 10 Figure 4. Bond Classes Class A Class B Class C Class D Class E L = LIBOR. Bond Classes of CLO Amount ($ million) 875.7 38.6 40.2 19.8 25.7 Rating Aaa A2 Baa2 Ba2 NR Pricing L+40 L+110 L+200 L+650 Because the collateral must support the principal due on the offered securities, the loan maturities must be managed with respect to the latest maturing security. In addition, specific percentages of maturity concentrations as well as required payment performance may be necessary for shorter securities. Limitations on the amount of fixed rate loans are necessary to reduce the interest rate mismatch between fixed rate loans and the floating rate securities issued. Although the risk can be addressed through the use of a swap, a fixed/ floating swap, unlike a basis swap, will require a counterparty rating comparable to the highest rated securities offered. 11 Lehman Brothers 8 February 1, 1999 Figure 5. Assets C&I Loans Total Trust Balance Sheet (post-CLO), $ million Amount 1,000.0 1,000.0 Rate 6.75% Income/ (Expense) 67.5 67.5 Liabilities & Equity Aaa A2 Baa2 Ba2 First Loss Total 875.7 38.6 40.2 19.8 25.7 1,000.0 5.65 6.35 7.25 11.75 (49.5) (2.5) (2.9) (2.3) (10.3) (67.5) Bank A: Allocates capital based on the regulatory capital requirements. Bank A also uses a trading account and applies the market risk capital rules to determine its regulatory capital requirements. Bank A’s internal model utilizes a value at risk technique that is very similar to Bank B’s economic capital model but is only applied to its trading account assets. Bank B: Allocates capital based on economic risk. Bank B is undergoing a review of its businesses and is considering various financing alternatives. Bank B allocates economic capital to its businesses through its treasury group, which houses its risk management and funds transfer pricing effort. The bank has developed an internal risk model that is used to determine the appropriate amount of capital for each business unit and charges a pre-tax rate of 23%15 as the cost of capital. This capital charge is typically sufficient to absorb 99.9% of the possible losses.16 On a consolidated basis, the bank satisfies its regulatory capital requirements. However, the bank considers its regulatory capital to be fungible and allocates it according to the amount of economic value at risk. Any capital not explicitly allocated is managed by the treasury group as part of the bank’s overall risk management program. Banks A and B both have $100 million of equity capital to invest. Both banks originate C&I and mortgage loans until all capital is deployed. Neither bank allows its leverage ratio to go below 6.7%. Figure 7 illustrates the pre-securitization balance sheets for each bank. Under our assumptions, Bank A is required to hold capital of 8.0% and 4.0% against the C&I and mortgage loan portfolios, respectively. Bank B establishes economic capital requirements of 7.4% and 5.5%, which have been determined by the bank’s internal model.17 Bank B’s capital allocation implies that the C&I loan portfolio is less risky than risk-based capital requirements suggest, while the opposite is true for the mortgage loan portfolio. On a consolidated basis, however, Bank B holds more capital than regulatory requirements warrant ($100.0 million versus $98.9 million). Following the securitization, and the sale of the Aaa through Ba2 classes, the bank would typically retain the first loss piece 14 with the net proceeds distributed to the bank. As a result, the bank is left with $974.3 million in cash and $25.7 million in the form of first loss. Figure 6 illustrates the bank’s balance sheet immediately following the securitization. As this example illustrates, the sale of the loans and generation of cash provides significant opportunities to restructure the resulting balance sheet. We will review some of these opportunities and their economic impact. Economic Capital Efficiencies There are several motivating factors for a bank to execute a CLO, including balance sheet reduction, economic value added, regulatory and economic capital relief. We will discuss the economics that may result from a CLO securitization including comparisons of Economic Value Added (EVA), Risk-Adjusted Return On Capital (RAROC) and Return On Regulatory Capital (RORC) for two hypothetical banks. 14 The bank would also retain the seller’s interest. Figure 6. Bank Balance Sheet (post-CLO), $ million Amount 974.3 25.7 1,000.0 Assets Cash Proceeds First Loss Class (CCA & NR) Total Liabilities & Equity Debt Equity Total 15 Targets an after tax charge of 15% assuming a tax rate of 35%. a 3σ one-tail confidence interval. 920.0 80.0 1,000.0 16 Represents 17 The bank’s internal model incorporates a variety of factors including liquidity and credit. We assume an average credit score equivalent to that of a Ba3 rating for the C & I loans. Lehman Brothers 9 February 1, 1999 Figure 7. Bank A Balance Sheet (pre-CLO), $ million Figure 8. Economic Value Added Pre-CLO, $ million Bank B 24.8 23.0 1.8 24.8% Assets Amount C&I Loans 1,000.0 Mrtg. Loans 500.0 Total 1,500.0 Liabilities & Equity Debt 1,400.0 Equity 100.0 Total 1,500.0 Net Bank B Assets Amount C&I Loans 1,000.0 Mrtg. Loans 472.5 1,472.5 Total Liabilities & Equity Debt 1,372.5 Equity 100.0 Total 1,472.5 Net Rate 6.75% 6.20 Inc/ (Exp) RBC Captl. RORC EVA 67.5 8.00% 80.0 24.0% 0.8 31.0 4.00 20.0 29.0 1.2 98.5 RBC Ratio 8.0% Bank A Net Operating Profit 25.0 Less: Cost of Equity Capital (@23%) 23.0 Economic Value Added 2.0 Return on Equity 25.0% Lvrge.* 5.25% (73.5) Ratio 6.7% (73.5) 25.0 Rate 6.75% 6.20% Inc/ (Exp) VAR Captl. RAROC EVA 67.5 7.40% 74.0 25.5% 1.9 29.3 5.50% 26.0 22.5% (0.1) 96.8 Lvrge. Ratio 6.8% RBC Ratio 8.1% 5.25% (72.0) (72.0) 24.8 Because Bank B allocates capital based on economic risk (which incorporates liquidity and credit risk), the overall economic capital charge for this loan portfolio would likely vary depending on the form of loan exposure the bank has retained. In other words, Bank B’s economic capital charge would not necessarily be the same if it retained the C&I portfolio in securitized form. Figure 9, which summarizes the economic capital charge for the C&I loan portfolio retained in securitized form, underscores this point: the resulting economic capital requirement improves to 2.5%, down from 7.4% (see Figure 9). In fact, the practice of securitizing receivables to achieve liquidity and capital benefits is commonplace among financial institutions. *Equity capital as a percentage of total assets (Equity/Assets). The Impact of a CLO This explains why Bank B has a smaller balance sheet and a higher leverage ratio than Bank A. Bank A’s ROE (expressed as RORC) is 25.0% while Bank B’s ROE (expressed as RAROC) is 24.8%. To measure the actual amount of economic benefit earned by each bank’s loan portfolios, we should consider the Economic Value Added for each bank (see Figure 8). The EVA measure provides insight into the efficiency of a specific line of business. As we can see, the economics of each loan portfolio varies for Banks A and B. Positive EVA for a business implies that the income generated from this business justifies the amount of capital needed to support it (i.e., the business generates positive economic carry). Bank A computes an EVA of $0.8 million for its C&I loan portfolio and $1.2 million for its mortgage loans. Bank B, however, computes EVAs of $1.9 million and negative $0.1 million, respectively (summarized in Figure 7). This difference in observed EVA results from the two different approaches the banks have toward allocating capital to different business lines. One should not necessarily draw the conclusion that Bank A’s performance is superior. As noted, Bank B’s ability to leverage its balance sheet is currently constrained first by its economic capital requirements. Lehman Brothers 10 Now we consider the impact of a $1 billion CLO securitization on Banks A and B. The resulting set of securities consists of four different bond classes as well as a first loss piece. Although several strategies are possible, the preferred strategy will ultimately depend on the bank’s objectives. Strategy 1: Raise cash. Retain the equity (first loss) as part of the investment portfolio. Sell the remaining classes (traditional CLO). Strategy 2: Transfer credit risk. Retain the AAA class and the first loss in the investment portfolio. Sell all other classes (Reverse CLO). Figure 9. Certificate Aaa A2 Baa2 Ba2 First Loss Total Bank B Capital Calculation Amount ($ mill.) 875.7 38.6 40.2 19.8 25.7 1,000.0 Economic Capital Factors* 0.7% 1.0 1.6 7.4 64.3 2.5 Capital Charge 6.1 0.4 0.6 1.5 16.6 25.2 *These factors are generated by Bank B’s internal model, which utilizes a value at risk approach to determine its expected losses. February 1, 1999 Strategy 3: Same as Strategy 2 but hold the retained classes in the trading account and utilize the market risk capital rule to determine regulatory capital requirements. Retain the first loss in the investment portfolio. Figure 10 summarizes the resulting balance sheet and capital impact of the three strategies.18 The motivations behind Strategy 1 versus Strategies 2 and 3 are quite different. Whereas Strategy 1 addresses issues related to funding and liquidity, Strategies 2 and 3 primarily address credit risk and economic capital. Under all three strategies, we assume that the first loss piece is subject to a 100% (dollar for dollar) regulatory capital charge,19 while economic capital requirements are 64.3% (see Figure 9). In Strategy 1 (traditional CLO), all the classes are sold except for the first loss piece, which is retained in each bank’s investment portfolio. As a result of the securitization, the banks raise $974.3 million in cash. Additionally, Bank A releases $54.3 million in regulatory capital while Bank B releases $57.5 million in economic capital. However, for Bank B, regulatory capital requirements 18 now exceed economic capital requirements, whereas the opposite was true pre-securitization (see Figure 7). Since Bank B must ultimately satisfy regulatory requirements, total capital relief amounts to $55.4 million, which is slightly less than the economic capital relief determined by the bank’s internal model. Under Strategy 2 (Reverse CLO), the banks sell the A2, Baa2, and Ba2 classes and retain the Aaa and first loss classes in the investment portfolio. Bank A allocates the maximum amount of regulatory capital of $80 million or 8% of the original C&I loan amount. Bank B allocates $22.7 million in the form of economic capital ($16.6 million for the first loss and $6.1 million for the Aaa class). Both banks raise $98.6 million in cash proceeds, as a result of the sale, and transfer the mezzanine (A2 through Ba2 class) credit risk. Though Bank B does recognize a significant amount of economic capital relief ($51.3 million),20 it is constrained by regulatory capital requirements. The result is a nominal amount of total capital relief ($1.1 million) for Bank B and no capital relief for Bank A. This $1.1 million capital relief for Bank B results from the fact that the bank is now constrained by regulatory capital instead of economic capital. In Strategy 2, the banks sell the mezzanine classes (A2 through Ba2) and retain the Aaa and first loss classes in their investment portfolios. We assume the same sales in Strategy 3, but each bank retains the Aaa class in its trading account. Because Bank B allocates capital based on economic risk, it allocates the same amount of economic capital regardless of where the retained classes are held. However, because both banks apply the market risk capital rule for trading account assets, they can realize significant regulatory capital relief by retaining the Aaa class in their trading accounts. As shown in Figure 10, total capital relief amounts to $48.1 million and $49.2 million for Banks A and B, respectively. As we have shown, these strategies may result in a significant generation of cash proceeds and a reduction in capital requirements. For practical purposes, we do not explicitly illustrate the banks’ performance sensitivity to varying loss or interest rate scenarios. Additionally, the performance measures (including EVA) chosen, though 20 We have not yet made any assumptions on the use of the proceeds that are generated. Resulting economics incorporate assumptions on structure costs and expenses. 19 Refer to the FDIC and OCC Risk-based Capital Requirements—Low Level Recourse. Figure 10. Impact of Strategies on Balance Sheet and Capital Charge, Excluding cash proceeds Invest. Portf.* Do Nothing Bank A 1500.0 Bank B 1472.5 Strategy 1 Bank A 525.7 Bank B 498.2 Strategy 2 Bank A 1401.5 Bank B 1374.0 Strategy 3 Bank A 525.7 Bank B 498.2 Balance Sheet Trading Acct. Total 0.0 0.0 1500.0 1472.5 Invest. Portf. 100.0 100.0 Capital Charge Trading Acct. Total 0.0 0.0 100.0 100.0 0.0 0.0 525.7 498.2 45.7 44.6 0.0 0.0 45.7 44.6 0.0 0.0 1401.5 1374.0 100.0 98.9 0.0 0.0 100.0 98.9 875.7 875.7 1401.5 1374.0 45.7 44.6 6.1 6.1 51.9 50.8 *Includes the mortgage loans and remaining C&I loans. Strategy 2 economic capital equals $48.7 million. This is composed of $26.0 million for the mortgage loans and $22.7 million for the retained AAA ($6.1 million) and first loss ($16.6 million) classes. Lehman Brothers 11 February 1, 1999 based on current trends in the industry, may not be uniformly relevant to all readers. Despite these limitations, it is important to illustrate the resulting benefits when we incorporate the use of the proceeds generated from the CLO securitization.21 For illustrative purposes, we choose Strategy 1 (traditional CLO) as a “base case” and consider the following scenarios: • Scenario I—Utilize cash proceeds to repurchase stock equal to the amount of freed equity capital. The remaining proceeds will pay down liabilities and purchase investment securities22 so that target leverage and RBC ratios of 6.7% and 8.0%, respectively, are achieved. Scenario II—All freed equity capital will be utilized to originate new loans. The cash proceeds will fund the new loans. Cash not used to originate new loans will purchase investment securities until a target leverage ratio of 6.7% is achieved. The composition of each bank’s new loan originations will depend on the economic analysis presented in Figure 7. For instance, Bank A believes mortgage loans are more profitable than C&I loans, as evidenced by their higher ROE and EVA statistics. Therefore, Bank A will bias new loan originations more toward mortgages. Bank B, however, believes that C&I loans are more profitable. In fact, Bank B has determined that mortgage loans have negative EVA. As a result, Bank B decides to exit the mortgage loan business and dedicate all equity capital to originate new C&I loans. Figures 11 and 12 illustrate the resulting balance sheets for each bank under both scenarios. The increase/(decrease) in asset amounts is listed in the net change column. Figure 13 provides a comparative summary of the preand post-securitization economics for each bank. The current economics of the pre-securitization portfolios vary for Banks A and B. In our base case strategy, 21 Figure 11. Scenario I (Repurchase Stock), $ million Net Income/ Economic Chng. (Expense) Capital RBC Amount Bank A Balance Sheet Assets First Loss Class 25.7 C&I Loans Mortgage Loans 500.0 GNMA Securities 159.0 Total 684.7 Liabilities & Equity Debt 639.0 Equity 45.7 Total 684.7 Net Bank B Balance Sheet Assets First Loss Class 25.7 C&I Loans Mortgage Loans 472.5 171.0 GNMA Securities Total 669.2 Liabilities & Equity Debt 624.6 Equity 44.6 Total 669.2 Net 25.7 (1,000.0) 159.0 9.2 31.0 9.5 49.7 NA* NA NA NA 25.7 20.0 45.7 (761.0) (33.5) (54.3) (33.5) 16.2 • 25.7 (1,000.0) 171.0 9.2 29.3 10.3 48.8 16.6 26.0 0.8 43.4 25.7 18.9 44.6 (747.9) (32.8) (55.4) (32.8) 16.0 *Bank A does not calculate economic capital requirements. Figure 12. Scenario II (New Origination), $ million Net Income/ Economic Amount Change (Expense) Capital RBC Bank A Balance Sheet Assets First Loss Piece 25.7 C&I Loans 383.3 Mortgage Loans 1,091.0 GNMA Securities Total 1,500.0 Liabilities & Equity Debt 1,400.0 Equity 100.0 Total 1,500.0 Net Bank B Balance Sheet Assets First Loss Piece 25.7 C&I Loans 928.5 Mortgage Loans 545.8 GNMA Securities Total 1,500.0 Liabilities & Equity Debt 1,400.0 Equity 100.0 Total 1,500.0 Net 25.7 (616.7) 591.0 - 9.2 25.9 67.6 102.7 NA NA NA NA 25.7 30.7 43.6 100.0 - (73.5) (73.5) 29.2 25.7 (71.5) (472.5) 545.8 9.2 62.7 32.8 104.7 (73.5) (73.5) 31.2 16.6 68.7 2.7 88.0 25.7 74.3 100.0 In this analysis, we assume the original $100 million of invested capital can decrease in size but not increase. CLO expenses are assumed to equal $1.1 million (11 bp of the portfolio notional amount). 22 Assumed to be GNMA securities with a 6.0% yield and regulatory and economic capital charges of 0.0% and 0.5%, respectively. - Lehman Brothers 12 February 1, 1999 Figure 13. Comparative Summary Pre- and Post-Securitization Economics, $ million Net Cost Operating of Capital Income Capital 100.0 100.0 25.0 24.8 23.0 23.0 Asset Size Do Nothing Bank A 1500.0 Bank B 1472.5 Strategy 1 Scenario I: Repurchase Stock Bank A 684.7 Bank B 669.2 ROE 25.0% 24.8 EVA 2.0 1.7 the higher RORC (and EVA) while Bank B exited this business and dedicated all loan origination efforts to C&I loans. Under each bank’s investment guidelines (i.e., allocate capital to the most profitable businesses), the correct investment decision was made (i.e., increase incremental investment in higher ROE business). However, the results reveal how different capital allocation processes can affect a bank’s total profitability. This analysis highlights a few observations worth noting: 45.7 44.6 16.2 16.0 10.5 10.3 35.5 35.9 5.7 5.7 Scenario II: New Origination Bank A 1500.0 Bank B 1500.0 100.0 100.0 29.2 31.2 23.0 23.0 29.2 31.2 6.2 8.2 ROE = Return on equity. EVA = Economic value added. we assume that all the classes except the first loss are sold, resulting in generation of $974.3 million in cash proceeds and a significant reduction in capital requirements. Regulatory requirements demand dollar-for-dollar capital on the retained first loss class (low-level recourse) while our calculated economic capital requirements require 64.3 cents to the dollar (see Figure 9). Because Bank B follows an economic capital approach, it is afforded greater capital relief from a CLO securitization. As a result, we see a change in Bank B’s limiting constraint (i.e., from economic capital to regulatory capital). Under Scenario I (Repurchase Stock), we observe a greater EVA increase relative to presecuritization (Do Nothing) for Bank B than for Bank A. Note that EVA increased for both banks as a result of the transaction, even though the C&I loans, prior to securitization, had positive EVA. This implies that the capital relief benefits from a CLO securitization outweighed the lost economic profit caused by the balance sheet removal of the C&I loan portfolio. Scenario II (New Origination) also results in EVA increases for both banks compared to pre-securitization. As in Scenario I, Bank B observes a higher EVA increase than Bank A, but the difference now is much larger. This can be attributed to the use of economic risk (versus RBC requirements) for allocating capital. As previously mentioned, Banks A and B followed different strategies in Scenario II. Bank A favored mortgage loans because of Lehman Brothers 1. Though both banks achieve increased profitability, the amount achieved may vary depending on the bank’s decision-making policy (manifested through its capital allocation process). 2. By optimally leveraging economic capital, a bank can further increase its profitability. As illustrated by Bank B under both scenarios (Repurchase Stock and New Origination), the bank no longer becomes constrained by economic capital but finds regulatory capital to be the binding constraint. As a result, Bank B is in a position of having excess economic capital, which it allocates toward a zero risk-weighted investment, further leveraging its balance sheet, but not to a greater level than Bank A. 3. These results also illustrate a potential shortfall in decision-making based on ROE. Comparing the economics of Scenario I, Repurchase Stock versus Scenario II, New Origination, we see that Scenario I results in a higher ROE. However, we can see that the resulting profitability is greater in Scenario II. Though we do not attempt to encourage or discourage the use of EVA as a performance measure, many industry participants, as well as industry analysts, view these discrepancies as one of the benefits EVA analysis provides over ROE. SUMMARY We have summarized the potential benefits and drawbacks of several alternative structures in a comparative fashion, incorporating traditional measures of profitability (ROE), return on risk-based capital (RORC), and economic value added (EVA). The appendices provide detailed information on alternative structure for credit risk transfer. Commercial loan securitization and structured credit derivatives can serve various functions in a bank’s corporate finance strategy. Collateralized loan obligations 13 February 1, 1999 provide an off-balance sheet exit strategy with respect to a loan portfolio, resulting in RBC relief and substantial cash proceeds for reinvestment. However, some traditional CLO strategies in which the bank retains subordinated tranches may not translate into substantial credit risk transference or economic capital relief. At the other end of the spectrum, structured credit derivative transactions can provide substantial credit risk transference, economic capital relief, and RBC reduction but do not provide the bank with cash proceeds for funding new projects. As a result, in the world of CLOs and credit derivatives, one size does not fit all. Banks should choose the optimal structure based on their specific funding objectives, economic capital hurdle rates, risk-based capital positions, and strategic view regarding the commercial loan business. Based on the structure chosen by the bank, a CLO can increase the profitability of the bank whether it allocates capital based on economic risk or regulatory capital rules. Figure 14. Comparison of Strategic Alternatives Credit Derivative Structure Direct Credit Derivative— Collateralized SYCLONE (App. A) Indirect Credit Derivative— (App. B) Medium to high degree* Impact on Bank Credit Risk Transfer Cash Flow Colltrlzd. Loan Obligations Traditional CLO Reverse CLO Direct Credit Derivative— SYCLONE (App. C) Medium to high degree* Varies*—Generally the bank Medium to high degree*— Medium to high degree* retains residual interest and While retaining a first loss subordinate classes. residual, the bank sells the subordinate classes. $ 974 million Not required Yes** High—Processing of monthly CLO cashflows. Sale accounting for loan portfolio (i.e., off-balance sheet treatment). $ 98 million Not required Yes** High—Processing of monthly CLO cashflows. Partial sale accounting for loan portfolio (limited to the amount of proceeds raised from selling the subordinate class). $0 Not required No Cash Proceeds Borrower Notification Early Amortization Ongoing Operation. Require./Costs Financial Reporting $0 Not required No $0 Not required No Low—Limited to tracking defaults. Loan portfolio remains on balance sheet and credit default swap qualifies for hedge accounting. Low—Limited to tracking Low—Limited to tracking defaults. defaults. Loan portfolio remains on balance sheet and credit default swap qualifies for hedge accounting. Loan portfolio remains on balance sheet and credit default swap qualifies for hedge accounting. RBC Treatment - Similar to Indirect credit - Full RBC reduction related - Full RBC reduction on - If the bank transfers the - Given OECD bank derivative. to classes sold. underlying loan expointermediary on credit subordin. classes sold. - However, the bank no - Dollar-for-dollar capital default swap, the bank - Lower market risk charge sure to trading, it can longer pays the full default against retained first loss apply the market risk need not transfer loan on retained senior swap premium on the residual (low-level recourse classes . rule to loans. exposure to trading. senior risk. rule). - Dollar-for-dollar capital - Credit default swap - Reduced RBC on the - Substantial RBC reduction against retained first loss provides a substantial underlying loan exposure - Bank places the back-toback swap (with the on subordinated classes residual. offset to the loan expo(i.e., risk weighting from OECD bank) into the retained in the trading sure in trading account. 100% to 20%). trading portfolio. portfolio (market risk rule). - Dollar-for-dollar capital - Dollar-for-dollar capital against first loss against first loss residual. residual. Increase Increase Increase Increase Increase Decrease Increase*** Increase Decrease Increase*** Increase Decrease Increase*** Return on Eco. Capital Return on RBC (RORC) Increase EVA Increase Note: To compare the strategic alternatives, we used one reference portfolio of underlying loan collateral (described on page 7) in each structure summarized above. * The bank obtains credit risk transfer for “unexpected” losses. Expected losses are anticipated to be absorbed by the retained first loss class. ** Though early amortization does not prohibit capital relief, it does have an effect on shortening the tenor of risk transfer. *** Change in terms of economic capital. Bank A calculates its return over regulatory capital while Bank B uses economic capital (refer to page 8). Lehman Brothers 14 February 1, 1999 APPENDIX A: COLLATERALIZED SYCLONE Figure A-1. Collateralized SYCLONE, Transaction Diagram Treasuries/High Grade Securities Credit Default Swap Loss Amounts v w w As in the Reverse CLO (Strategies 2 and 3), the bank may have to retain a small amount of first loss exposure. The bank would then have recourse to the assets of the issuing trust for losses in its loan portfolio up to the amount of collateral held in the trust. The amount of notes issued by the trust should be of sufficient size to accomplish the goal of transferring risk and achieving capital relief. This can be illustrated by comparing the elements of a Collateralized SYCLONE with a Reverse CLO. Assuming the same $1.0 billion of C&I Loan collateral with the same Moody’s Average Rating score of 1850 (Ba3), we create the structure depicted in Figure A-2. Figure A-3 compares the Collateralized SYCLONE with the Reverse CLO structure. Where possible, we map the credit derivative counterpart of the Reverse CLO. Under the Reverse CLO, the bank retains the Aaa and first loss classes and sells the A2 through Ba2 classes. The classes sold are comparable to the amount of protection provided by the default swap. Though it is helpful to compare the Collateralized SYCLONE with the Reverse CLO, the resulting structures may vary considerably. In this example, though both structures have the same underlying collateral, the amount of first loss exposure retained by the bank under the Collateralized SYCLONE is larger than under the Reverse CLO, [i.e., $35.0 million (3.5%) versus $25.7 million (2.6%)]. These differences in subordination levels are a result of differences between the two structures. Though both structures accomplish the goal of transferring credit risk, the specific risk transferred may vary depending on certain early amortization “triggers” that are present in traditional CLOs. In addition, in a traditional CLO, the issuing master trust would typically hold more C&I loan collateral compared to the amount of CLO notes issued. For example, in a $1 billion CLO securitization, the bank may contribute $2 billion in C&I loans. The CLO investors would then be subject to 50% of the losses of the $2 billion Figure A-2. New Structure* Credit Risk Retain Transfer to Trust Transfer to Trust Retain Face Amt. ($ mill.) 785 120 60 35 Swap Premium NA 60 bp 670 NA Originating Bank Swap Fee w v Issuing Trust Notes v First Loss Structural Features • The originating bank enters into a credit default swap with the issuing trust, which is obligated to pay the originating bank any losses on a reference portfolio of obligors in the issuing bank’s funded or unfunded loan facilities. In exchange for the credit default swap, the originating bank pays a predetermined periodic fee (swap fee). The issuing trust’s assets consist of Treasuries/high grade securities acquired with the proceeds from the issuance of notes, in addition to the periodic fee. Depending upon the enhancement levels required by the rating agencies, the originating bank may be required to retain unrated first loss exposure. The periodic fee will be sized to cover the negative carry between the issuing trust’s investments and the weighted average coupon on the notes and to build reserve accounts as applicable over time. • • • Economics The Collateralized SYCLONE accomplishes the goal of transferring a significant amount of the credit risk of the underlying loan portfolio. This risk transference is analogous to the risk transferred in a Reverse CLO structure. However, if the deal is structured as a credit derivative, many of the operational requirements are no longer necessary. This simplification reduces many of the costs associated with a full securitization.A-1 Rating SuperSenior Aaa Aaa Ba2 First Loss A-1 In our analysis, expenses for credit derivative structures are assumed to equal $0.5 million (5 bp of the portfolio notional amount). *These subordination levels reflect in part an assumption regarding certain early amortization factors. Lehman Brothers 15 February 1, 1999 Figure A-3. Certificate Aaa A2 Baa2 Ba2 First Loss* Collateralized SYCLONE Reverse CLO Action Retain Sell Sell Sell Retain Face Amt ($ mill.) 875.7 38.6 40.2 19.8 25.7 Collateralized Rating SuperSenior Aaa Aaa A2 Baa2 Ba2 First Loss SYCLONE Equivalent Credit Risk Retain Transfer to Trust NA NA Transfer to Trust Retain Face Amt. ($ mill.) 785 120 0 0 60 35 *For illustrative purposes, we combine the CCA and first loss classes under the Reverse CLO. Note that the CCA is prefunded and equal to 1% of the total loan balance. portfolio ($1 billion divided by $2 billion). In other words, the bank would still be the beneficiary of $1 billion of credit protection (assuming all the CLO notes were sold). The amount of loan collateral in excess of the CLO issue is typically referred to as the seller’s interest and is owned by the bank. A-2 In general, a typical loan portfolio would consist of loans with various maturities. Any principal received prior to an originally scheduled CLO maturity date would be used to purchase a newly originated loan that would be put back into the trust. As stated above, the CLO may be structured to amortize early under certain trigger events, such as default rates that become greater than 3%. Under an early amortization event, the pro rata amount of any principal repaid on the entire $2 billion loan portfolio could be directed toward the early repayment of the CLO notes and would not be used to purchase new loans, thus affecting the premature amortization.A-3 An early amortization event does not reduce the amount of credit protection or capital relief the bank would achieve, though it does reduce the tenor of such relief provided. The bank would realize any benefits associated with the amount of CLO notes still outstanding. From a rating agency perspective, this early amortization feature provides an additional level of protection to investors that results in lower levels of required subordination. Though the Collateralized SYCLONE can be structured to mimic the early amortization feature, other structural differences will likely lead to differences in required subordination levels. Once again we revisit hypothetical Banks A and B. However, now the analysis will focus solely on the C&I loan portfolio in isolation. Figure A-4 lists each bank’s resulting capital allocation. From a regulatory capital perspective, neither Bank A nor Bank B would benefit from this transference of credit risk in its loan portfolio unless the loans were transferred into its trading account—a highly formidable task for most banks.A-4 On the other hand, Bank B is afforded significant economic capital relief. Figure A-5 summarizes the resulting economics of a Collateralized SYCLONE compared to a Reverse CLO. As one can see from the results, the economic value added measure for Bank A decreased under a Collateralized SYCLONE. Primarily, this effect is attributable to the lack of regulatory capital relief and the fact that the A-4 The issue of synthetically transferring the loan portfolio into the trading account is addressed in Appendix C. Figure A-4. Resulting Capital Allocations, $ million Capital Requirements Bank A Bank B C&I Loans Retained First Loss Default Swapa Required Capital Do Nothing Freed Capital 785 35 180 45.0 35.0 0.0 80.0b 80.0 0.0 5.5 22.5 0.0 28.0 74.0 46.0 A-2 The seller’s interest does not provide additional subordination and should be treated as an on-balance sheet loan asset. A-3 The proportion of principal directed to amortize the CLO notes may increase over the life of the CLO. aThere are no regulatory capital requirements because the default swap is collateralized by U.S. Treasuries. bRequired capital equals the maximum of the pre-CLO regulatory capital requirement of $80.0 million and the post-CLO capital calculation (dollar-for-dollar capital on the first loss piece and 8.0% of the retained AAA class). Total regulatory capital cannot exceed the original allocation toward C&I loans and, in this case, is equal to $80.0 million. Lehman Brothers 16 February 1, 1999 loans must continue to be funded on the balance sheet. Basically, the bank reduces its income by recognizing swap premium expense while maintaining its current capital structure (i.e., including the associated costs of capital). Intuitively, the fact that a significant amount of the credit risk has been transferred to the capital markets would suggest that the amount of economic capital allocated to the portfolio should decrease. This effect is illustrated by the result associated with Bank B. Bank B realizes a significant amount of economic capital relief but, due to the current regulatory capital framework, does not recognize any regulatory capital relief. However, on an “economic basis,” Bank B can utilize the Collateralized SYCLONE as an efficient tool to manage portfolio credit risk. Though it appears that the Reverse CLO structure (Strategy 3) provides greater capital efficiency compared to the Collateralized SYCLONE, there may be other factors not incorporated into this analysis that would make the Reverse CLO less attractive. Among these factors are the “internal” costs associated with a CLO transaction. Nevertheless, banks whose primary goal is to reduce credit risk (i.e., reduce economic capital) should consider this structure as an alternative risk/capital management tool. Figure A-5. Economics of the Transaction, $ million Capital Do Nothing Bank A Bank B Collateralized SYCLONE Bank A Bank B Reverse CLO* Bank A Bank B 80.0 74.0 Net Op. Income 19.2 18.9 Cost of Capital 18.4 17.0 ROE 24.0% 25.5 EVA 0.8 1.9 80.0 28.0 31.9 22.7 14.0 11.2 13.1 12.6 18.4 6.4 7.4 5.2 17.5 40.1 41.0 55.5 (4.4) 4.8 5.7 7.4 *Represents Strategy 3. ROE = Return on equity. EVA = Economic value added. Refer to “A Word of Caution on Choosing the Optimal Structure” on page 6. Lehman Brothers 17 February 1, 1999 APPENDIX B: INDIRECT CREDIT DERIVATIVE Figure B-1. Indirect Credit Derivative, Transaction Diagram Treasuries/ High Grade Securities Credit Default Swap $ w w Credit Default Swap counterparty.B-1 Like the traditional cashflow CLO (Strategy 1), this structure transfers the risk on the full loan portfolio subject to the retained first loss exposure (Figure B-2). However, unlike a CLO, the loans remain on-balance sheet with no cash proceeds generated. Additionally, the all-in costs associated with this transaction can be significantly lower than the costs of a CLO securitization. Figure B-3 summarizes the comparison between an Indirect Credit Derivative and a traditional cashflow CLO. Though the two structures are conceptually similar, there are some differences worth noting. In the case of a traditional CLO, any losses that exceed the amount absorbed by the first loss piece are borne directly by the CLO investors. In essence, the bank has been collateralized by the cash proceeds that were generated during the sale of the CLO classes. In the case of the Indirect Credit Derivative, the bank would have recourse (and credit exposure) to the counterparty for any losses that exceed the retained first loss amount. Under the unlikely scenario that a simultaneous credit event occurs with respect to the loans and the counterparty, the bank can find itself without credit protection on the underlying portfolio.B-2 However, these differences will be reflected in the pricing levels offered by the protection selling counterparty, which will take into account the related costs associated with the risks retained and sold. Generally speaking, the counterparty to this structure would offset much of the default protection sold through a Collateralized SYCLONE structure (i.e., the protection selling counterparty would enter into its own protection buying transaction). The Indirect Credit Derivative would be more economically feasible only for protection selling counterparties who allocate capital based on internal B-1 v v Loss Amt. Counterparty Loss Amt. Origin. Bank Swap Fee (OECD Bank/ Securities Dealers) Periodic Fee Issuing Trust Notes v v v Structural Features • The originating bank enters into a credit default swap under which the counterparty is obligated to pay the issuing bank any losses on a reference portfolio of obligors in the issuing bank’s funded or unfunded loan facilities. In exchange for the credit default swap, the originating bank pays a predetermined periodic fee (swap fee). The counterparty enters into a back-to-back credit default swap with the issuing trust that obligates the issuing trust to pay the counterparty the same amount of losses the counterparty is committed to pay to the issuing bank under the credit default swap. The counterparty pays a periodic fee to the issuing trust equal to the swap fee less the counterparty’s profit margin. The issuing trust’s assets consist of Treasuries/high grade securities acquired with the proceeds from the issuance of notes, in addition to the right to the periodic fee. Depending upon the enhancement levels required by the rating agencies, the originating bank may be required to retain unrated first loss exposure. The periodic fee will be sized to cover the negative carry between the issuing trust’s investments and the weighted average coupon on the notes and to build reserve accounts as applicable over time. • • • • • The Indirect Credit Derivative accomplishes the goal of transferring the majority of the credit risk in the bank’s loan portfolio by purchasing default protection (on the full loan balance) from a 20% risk-weighted Lehman Brothers 18 w First Loss As is the case with most default swap transactions, the bank (protection buyer) would suffer losses only if both the reference loans and the counterparty (protection seller) experience credit events. this risk. B-2 Except for collateral that may be pledged under the swap agreement to offset Figure B-2. New Structure Credit Face Amt. Swap Risk ($ mill.) Premium Transfer to Counterparty 785 15 bp Transfer to Counterparty 120 40 Transfer to Counterparty 60 650 Retain 35 NA Rating SuperSenior Aaa Aaa Ba2 First Loss February 1, 1999 Figure B-3. Indirect Credit Derivative versus Traditional CLO Traditional CLO Action Sell Sell Sell Sell Retain Indirect Credit Derivative Credit Risk Transfer to Counterparty Transfer to Counterparty NA NA Transfer to Counterparty Retain Certificate Aaa A2 Baa2 Ba2 First Loss Face Amt. ($ mill.) 875.7 38.6 40.2 19.8 25.7 Rating SuperSenior Aaa Aaa A2 Baa2 Ba2 First Loss Face Amt. ($ mill.) 785 120 0 0 60 35 models. In the case of banking entities, the capital costs associated with acting as the protection seller would be similar to the capital treatment for Bank B in Appendix A (excluding the effect of retaining the first loss exposure). Figure B-4 illustrates Bank A’s and Bank B’s resulting capital requirements for the isolated C&I loan portfolio. Unlike the Collateralized SYCLONE, the Indirect Credit Derivative affords considerable risk-based capital relief.B-3 The notable difference between the Indirect Credit Derivative and a Collateralized SYCLONE is the synthetic “sale” of the credit risk associated with the “SuperSenior Aaa class” (the SuperSenior class is equal to the portion of the original loan portfolio that constitutes Aaa risk after the effects of subordination). Though the Indirect Credit Derivative does not generate the cash proceeds of a Traditional Cash Flow CLO, it does facilitate regulatory and economic capital relief. Because the protection selling counterparty may look at the Collateralized SYCLONE to determine the structural requirements of B-3 The bank would also be required to hold regulatory capital for the counterparty Figure B-5. Economics of the Transaction, $ million Capital Net Op. Income 19.2 18.9 Cost of Capital 18.4 17.0 ROE 24.0% 25.5% EVA 0.8 1.9 Do Nothing Bank A Bank B Indirect Credit Derivative Bank A Bank B 80.0 74.0 50.4 22.6 11.6 10.1 11.6 5.2 23.0% 44.8% 0.0 4.9 Traditional CLO Bank A 25.7 Bank B 16.6 9.2 8.8 5.9 3.8 35.9% 52.9% 3.3 5.0 ROE = Return on equity. EVA = Economic value added. Refer to “A Word of Caution on Choosing the Optimal Structure” on page 6. offsetting its risk, much of the subordination requirements would likely be mirrored to the protection buying bank.B-4 However, benefits may be achieved if the protection selling counterparty can assemble a more efficient default basket structure by pooling exposures from multiple protection buyers. Figure B-5 summarizes the economics of the Indirect Credit Derivative compared to a traditional CLO. Though both banks achieve capital relief, there is substantially more economic capital reduction than regulatory capital reduction. In addition, the effect of the loan assets remaining on the bank’s balance sheet combined with the increase in expense due to the default swap premium paid results in zero EVA for Bank A. For Bank B, however, the effect of additional economic capital relief more than compensates for the increased expense resulting in an improvement in EVA. risk associated with a derivative contract. Because this capital charge is relatively small, we have omitted it from this analysis for simplicity. Figure B-4. Resulting Capital Allocations, $ million Capital Requirements Bank A Bank B C&I Loans First Loss Default Swap Required Capital Do Nothing Freed Capital 35 965 35.0 15.4 a 50.4 80.0 29.6 22.5 0.1b 22.6 74.0 51.4 a The swap has a 20% risk weight because of the OECD counterparty ($965 x 20% x 8% = $15.4). b Economic capital held against the risk that both the OECD counterparty and the loans default at the same time. B-4 The protection selling counterparty, however, would not have the same amount of first loss exposure. Lehman Brothers 19 February 1, 1999 APPENDIX C: SYCLONE Figure C-1. SYCLONE, Transaction Diagram Intermediation (back-to-back) Swap Loss Amounts Swap Fee (less intermediation cost) w Senior Credit Default Swap Counterparty (OECD Bank/ Securities Dealer) w Loss amounts on 91% of the underlying credit exposure (i.e., second loss or AAA rated credit risk) w Originating Bank w w w Subordinated Credit Default Swap Treasuries/High Grade Securities $ w w Loss amounts on 7% of the underlying credit exposure (i.e., first loss or lower rated credit risk) w Issuing Trust Notes v First Loss Structural Features • • This structure combines the Collateralized SYCLONE with the Indirect Credit Derivative. The originating bank enters into a credit default swap with the issuing trust, which is obligated to pay the originating bank any losses on a reference portfolio of obligors in the originating bank’s funded or unfunded loan facilities. In exchange for the credit default swap, the issuing bank pays a predetermined periodic fee (swap fee). The issuing trust’s assets consist of Treasuries/ high grade securities acquired with the proceeds from the issuance of notes, in addition to the right to the periodic fee. Depending upon the enhancement levels required by the rating agencies, the originating bank may be required to retain unrated first loss exposure. 20 • • • • • The periodic fee will be sized to cover the negative carry between the issuing trust’s investments and the weighted average coupon on the notes and to build reserve accounts as applicable over time. The originating bank then enters into a second credit default swap with an OECD counterparty on the remaining credit risk in the loan portfolio (which approximates a AA or AAA rating), described as the SuperSenior Aaa class in Appendix B. The counterparty enters into a back-to-back credit default swap with the originating bank, which obligates the originating bank to pay the counterparty the same amount of losses the counterparty is committed to pay to the originating bank under the second credit default swap. The originating bank pays a periodic fee to the counterparty equal to swap fee less any intermediation costs (profit) to the counterparty. February 1, 1999 Lehman Brothers The SYCLONE has the effect of synthetically “transferring” the loan portfolio into the bank’s trading account through the back-to-back default swap with the counterparty. Economically, this structure is similar to the Collateralized SYCLONE without the added expense of purchasing default protection on the SuperSenior Aaa equivalent amount. In this structure, the back-to-back swap serves to transfer this risk into the trading account within the framework of the GAAP and risk-based capital rules (Figure C-2). Figure C-3 summarizes Bank A’s and Bank B’s resulting capital requirements for the isolated C&I loan portfolio. The issuing bank would retain a first loss exposure equivalent to that of the Collateralized SYCLONE, and the bank would transfer the Aaa through Ba2 risk to the trust entity. However, the retained SuperSenior Aaa exposure would be swapped with an intermediary and then subsequently swapped back from the intermediary to the issuing bank’s trading account. From an economic perspective, this back-to-back swap does not change the risk exposure of the bank to the SuperSenior Aaa class. Additionally, in order to conform to the current regulatory capital framework, it is still necessary to hold capital against the default swap intermediary even though the risk is swapped back into the bank’s trading account where it will be subject to a market risk capital charge. (See footnote B-3 on page 19.) Similar to the Collateralized SYCLONE and the Indirect Credit Derivative, the loan collateral described on page 7 requires higher levels of subordination (first loss) when compared to its cash flow CLO counterparts. This higher level of first loss generally limits the amount of regulatory capital relief attainable. Figure C-4 illustrates the resulting economics on the isolated C&I loan portfolio. As Figure C-4 shows, even though Bank A achieves regulatory capital relief, the amount of benefit is insufficient to compensate for the incremental expense of buying credit protection on its mezzanine risk exposure. However, from an economic perspective, the amount of capital relief provides more than enough economic benefit. As a result, we see an increase in EVA for Bank B and a decrease in EVA for Bank A. Figure C-2. New Structure Credit Face Risk Amt. ($ mill.) Transfer to Counterparty* 785 Transfer to Trust 120 Transfer to Trust 60 Retain 35 Swap Premium 2 bp 60 670 NA Rating SuperSenior Aaa Aaa Ba2 First Loss Figure C-4. Economics of the Transaction, $ million Capital Do Nothing Bank A Bank B SYCLONE Bank A Bank B Collateralized SYCLONE Bank A Bank B Reverse CLO* Bank A Bank B 80.0 74.0 Net Op. Income 19.2 18.9 Cost of Capital 18.4 17.0 ROE 24.0% 25.5 EVA 0.8 1.9 *This risk would be swapped back to the bank’s trading account. The swap premium represents the intermediation fee. Figure C-3. Capital Requirements for C&I Loans, $ million Capital Requirements Bank A Bank B 53.1 28.0 12.3 11.0 12.2 6.4 23.3 39.4 0.1 4.6 C&I Loans Default Swap First Loss Back-to-Back Swap Required Capital Freed Capital 180 35 785 0.0* 35.0 18.1** 53.1 26.9 0.0 22.5 5.5 28.0 46.0 80.0 28.0 14.0 11.2 18.4 6.4 17.5 40.1 (4.4) 4.8 31.9 22.7 13.1 12.6 7.4 5.2 41.0 55.5 5.7 7.4 *There would be no regulatory capital requirements against U.S. Treasury collateral **Regulatory capital held against the initial Aaa default swap with the OECD counterparty ($12.6) and the subsequent default swap held in the trading account ($5.5, which is equal to Bank B’s economic capital charge). * Assume the Aaa class is retained in the trading account (Strategy 3). ROE = Return on equity. EVA = Economic value added. Refer to “A Word of Caution on Choosing the Optimal Structure” on page 6. Lehman Brothers 21 February 1, 1999 APPENDIX D: FINANCIAL REPORTING AND RBC TREATMENT FOR THE TRADITIONAL CASH FLOW CLO Financial Reporting Treatment Prior to last year, it was difficult to achieve off-balancesheet (or sale) treatment in commercial loan securitizations. However, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 125, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities , which results in sale accounting for commercial loan securitization (subject to criteria outlined below). Previously, securitization accounting was governed by SFAS 77, Reporting by Transferors of Transfers of Receivables with Recourse, which imposed a “risks and rewards” model for sale criteria. Under SFAS 77, the Securities and Exchange Commission (SEC) often concluded that commercial loan securitization did not result in sale accounting because the originating bank could not estimate its obligation (or risks) under recourse provisions and retention of subordinated interests with enough accuracy to satisfy the SEC. However, SFAS 125 adopted a new approach that focuses on control over financial assets (rather than on evaluation of who is subject to their risks and rewards). SFAS 125 provides for sale treatment if the bank relinquishes control of the collateral and the issuing entity is a “qualifying SPE [special purpose entity].” The transfers will be structured to meet the bankruptcy isolation tests applied to insured depository institutions (i.e., FIRREA opinions or “true sale” opinions will be obtained). Financial Components Approach For transfers that result in the recognition of a sale, SFAS 125 requires that newly created assets obtained and liabilities incurred by transferors as part of a transfer of financial assets be initially measured at fair value. Interests in transferred assets that are retained (e.g., servicing rights, beneficial interests) are to be measured by allocating the previous carrying amount of the assets between the interests sold and interests retained based on their relative fair values at the date of the transfer. The amounts initially assigned to these financial components will be a determinant of the gain or loss from a securitization transaction under SFAS 125. Assets and liabilities recognized as a result of applying SFAS 125 subsequently will be accounted for as if they had been acquired or incurred in an independent transaction, which, in some cases, will result in such amounts being stated at their fair values for financial reporting purposes. Accounting for Retained Interests in the Securitization Interest-only strips, loans, other receivables, or retained interests in securitizations that can contractually be prepaid or otherwise settled in such a way that the holder would not recover substantially all of its recorded investment must subsequently be measured like investments in debt securities classified as available for sale or trading under SFAS 115. Sale Criteria To record a sale under SFAS 125, the bank must surrender control over the loans. The following conditions must be met: • The transferred loans have been isolated from the bank—put presumptively beyond the reach of the bank and its creditors, even in bankruptcy or other receivership. The entity buying the loans must have the right to pledge or exchange the transferred loans, or the entity must be a “qualifying special purpose entity” (QSPE). The bank cannot maintain effective control over the transferred loans through a repurchase agreement or a call option on the transferred loans if the loans are not “readily obtainable.” 22 Subsequent Income Recognition for Residual Interest-only Strips SFAS 125 does not address the subsequent accounting treatment for residual interests. However, Emerging Issues Task Force (EITF) Issue No. 89-4, “Accounting for a Purchased Investment in a Collateralized Mortgage Obligation Instrument or in a Mortgage-Backed Interest-Only Certificate,” provides guidance by analogy. EITF 89-4 was originally intended to address how an investment in a nonequity CMO instrument or in a mortgage-backed interest-only certificate should be accounted for in subsequent periods. Specifically, it addresses how current and expected future cash flows should be allocated between February 1, 1999 • • Lehman Brothers income and return of investment in each accounting period. The approach taken in EITF 89-4 has been applied to interest-only residuals retained in CLO transactions. At the date of purchase, an effective yield is calculated based on the purchase price and anticipated future cash flows. In the initial accounting period, interest income is accrued on the investment balance using that rate. Cash received on the investment is first applied to accrued interest with any excess reducing the recorded investment balance. At each reporting date, the effective yield is recalculated based on the amortized cost of the investment and the then-current estimate of future cash flows. This recalculated yield is then used to accrue interest income on the investment balance in the subsequent accounting period. This procedure continues until all cash flows from the investment have been received. The amortized balance of the investment at the end of each period will equal the present value of the estimated future cash flows discounted at the newly calculated effective yield. such a manner are referred to as having been sold “with recourse.” For example, a bank that transfers $100 million of commercial loans to a securitization vehicle and retains a $10 million junior subordinate security must hold capital against the full $100 million of loans transferred (i.e., $8 million). The amount of capital required under this special rule, however, is limited to the maximum loss exposure retained by the bank (the low-level recourse rule). Under this rule, a bank is never required to hold capital greater than the maximum amount of recourse for which the bank is contractually liable under the recourse arrangement (i.e., the face amount of the retained subordinate piece). For example, a bank that transfers $100 million of commercial loans to a securitization vehicle and retains a $2 million junior subordinate security would hold capital against the full $100 million of loans transferred (i.e., $8 million). However, because the bank’s maximum exposure to losses on the transferred loans is less than the $8 million capital computed under the general rule, the low-level recourse rule applies, and the bank’s regulatory capital requirement is limited to $2 million—the full amount of the retained $2 million junior subordinate security. In addition to the total capital ratio and Tier 1 capital ratio, a minimum leverage ratio (Tier 1 capital to average total assets) established by federal authorities must be met. The guidelines provide for a minimum leverage ratio of 3% for banking organizations that meet certain specified criteria. Although Tier 1 capital in the leverage ratio is computed in the same manner as the Tier 1 capital ratio and total capital ratio, the denominator is based upon the average GAAP assets of the bank. As such, the assets are not risk-weighted but are held at face value. For example, a bank that retained a subordinate security in a $100 million securitization having a face amount of $2 million would include only the $2 million face amount of such security in its asset base for purposes of computing the leverage ratio. RBC Treatment Summary of RBC Rules Related to Asset Sales The Fed and OCC have adopted risk-based capital guidelines establishing minimum capital that must be held by banks. Under these guidelines, a bank is generally required to hold 8% capital against its riskadjusted GAAP assets. For example, a bank that holds $100 million of commercial loans (100% risk-weighted) is required to maintain $8 million of capital against such assets (8% x 100% x $100 million). If, instead, the bank held $100 million of first-lien residential mortgages (50% risk-weighted), the amount of capital required would be $4 million (8% x 50% x $100 million). Special rules apply to banks that retain “first dollar” loss or subordinate positions in asset securitizations. In particular, where a bank transfers assets to a securitization vehicle and provides credit enhancement by retaining a first dollar loss position, the bank is required to hold capital against the full risk-weighted amount of the assets transferred. Assets sold in Application to Traditional CLO Structure Similar to credit card securitizations, the transaction can be structured to meet the low-level recourse rule so Lehman Brothers 23 February 1, 1999 that banks obtain risk-based capital relief. However, if the bank adopts the market risk rule for its trading portfolio,D-1 the bank can transfer subordinated retained interests in the CLO transaction to the trading portfolio, apply the internal models approach, and significantly lower its risk-based capital requirements. In summary, to reduce the risk-based capital allocation against the C&I portfolio, the bank will apply the following rules: • • The low-level recourse rule limited the amount of capital that a bank must hold to the maximum contractual loss exposure retained by the bank under the recourse obligation if that amount is less than the amount of the effective capital requirement for the underlying asset. Low-level recourse—Excess spread account (or interest-only receivable) Before the advent of the low-level recourse rule, the risk-based capital guidelines had the effect of requiring a full leverage and risk-based capital charge whenever assets are sold with recourse, even if the institution’s maximum exposure under the recourse obligation is less than the capital charge on the asset sold. Market risk—Subordinated CLO beneficial interests (including the interest-only receivable) The bank could transfer the subordinated interests from the investment portfolio to the trading portfolio. The bank would apply the market risk rule to its entire trading portfolio. Trading positions covered by this rule are excluded from the credit risk capital charge (and analysis under the low-level recourse rule). The measure for market risk equals the sum of a VAR-based capital charge, the specific risk add-on (if any), and the capital charge for de minimis exposure (if any). If the bank can retain greater levels of subordinated interests, it can improve the capital markets execution on the senior CLO classes. D-1 The Market Risk Capital Amendment requires some banks to hold capital to support their exposure to general market risk and specific risk associated with certain investments. Credit derivative transactions would also be subject to capital charges due to counterparty credit risk. The Basle Committee on Banking Supervision developed two broad approaches, the Standardized Approach and the Internal Models Approach, to determine market risk capital requirements. The U.S. banking agencies mandate the Internal Models (VAR) Approach to calculate the General Market Risk Component. Branches of foreign banks located in the U.S. would be required to comply with their home country requirements. • Tier 1 leverage capital In addition, GAAP sale treatment under SFAS 125 will allow the bank to reduce its balance sheet for Tier 1 leverage capital purposes. Lehman Brothers 24 February 1, 1999 APPENDIX E: FINANCIAL REPORTING AND RBC TREATMENT OF REVERSE CLO Financial Reporting Treatment The financial reporting analysis follows the model described above for the traditional CLO. The bank should qualify for sale accounting in this structure. Because the portion of the loan portfolio sold in this structure is much lower than in the traditional CLO, the percentage of offbalance sheet funding obtained will be lower. In allocating the carrying amount of the loan portfolio to that which is sold (i.e., the subordinated classes) and that which is retained (i.e., the senior classes and the residual interest), the bank will take into account the relative fair values of each class. Because the retained senior class will be equivalent to AAA credit risk, more book value will be allocated to it and less will be allocated to the sold subordinated classes. This fair value allocation process drives up the gain (or reduces the loss) on sale of the subordinated classes, all else being equal. RBC Treatment The RBC analysis follows the model described above for the traditional CLO. Because the bank is retaining a large senior class, traditional application of the low-level recourse rule would result in no RBC relief. As a result, the bank most likely would not select this structure unless it intended to place the retained senior class into the trading account and determine the RBC charge using the market risk rule. Because SFAS 125 allows the bank to classify the retained senior class as a trading security under SFAS 115, Accounting for Certain Investments in Debt and Equity Securities, the Fed and OCC have indicated that banks could elect market risk treatment for the senior class. If the bank could develop internal models to estimate the specific risk component in the residual class, the bank could also elect market risk treatment for the residual. However, we believe that most banks will elect the low-level recourse rule for the residual class. Lehman Brothers 25 February 1, 1999 APPENDIX F: FINANCIAL REPORTING AND RBC TREATMENT OF COLLATERALIZED SYCLONE Financial Reporting Treatment In contrast to CLO structures, this alternative does not result in sale treatment for the underlying loan portfolio. Instead, the originating bank must account for the purchased credit default swap as a derivative contract. SFAS 133 appears to make a distinction between credit default products and credit spread products. Specifically, financial guarantee contracts are not subject to SFAS 133 if they provide for payments to be made only to reimburse the guaranteed party for a loss incurred (i.e., a credit default swap) because the debtor fails to pay when payment is due, which is an identifiable insurable event. In contrast, financial guarantee contracts (such as credit spread options) are subject to SFAS 133 if they provide for payments to be made in response to changes in an underlying asset (e.g., a decrease in a specified debtor’s creditworthiness). In practice, purchased financial guarantee contracts are accounted for as insurance contracts. Premiums paid (i.e., credit default swap fees) are accrued as prepaid assets on the balance sheet, and are amortized as an expense over the period of protection (i.e., the term of the credit default swap). As the underlying portfolio deteriorates, the bank must record a loan loss provision under SFAS 114, Accounting by Creditors for Impairment of a Loan, and SFAS 5, Accounting for Contingencies. However, in determining the appropriate loan loss provision, the bank should factor in the recoveries due from the financial guarantor. As a result, the loan loss provision should not include losses that will be recovered under the credit default swap. Current Practice Under current practice, a derivative contract is carried at fair value on the balance sheet with unrealized gains or losses reported in earnings (i.e., mark-to-market accounting), unless the derivative is designated as a hedge of an underlying transaction or exposure. To qualify for hedge accounting, the derivative must be effective at reducing (or modifying) the underlying exposure. If the credit default swap qualifies as a hedge of an underlying loan portfolio, then the bank would recognize payments received under the swap as an offset to credit losses experienced in the loan portfolio. The premium paid for the swap would be expensed over the period of protection on a straight-line basis. SFAS 133 In June, the FASB established new accounting rules for derivative contracts, including credit default swaps. SFAS 133, Accounting for Derivative Instruments and Hedging Activities, must be adopted by January 1, 2000. SFAS 133 requires that banks recognize all derivatives as either assets or liabilities in the balance sheet and measure those instruments at fair value. If certain conditions are met, a derivative may be specifically designated as a “fair value hedge” (i.e., a hedge of the bank’s exposure to changes in the fair value of a loan portfolio with respect to interest rates). In the case of an interest rate swap, the change in fair value of the loan portfolio (with respect to interest rate risk) would be offset by the change in fair value of the derivative. Any ineffective portion of the hedge (i.e., the amortization of an option premium paid by the bank) would be recognized in earnings as an expense. However, this treatment will not apply to credit default swaps. In the SFAS 133 definition of derivative contracts, the FASB sought to exclude “traditional” insurance products, such as financial guarantee contracts. As a result, Lehman Brothers 26 Trading Book Treatment An alternative to hedge accounting is to transfer the underlying loan portfolio and the purchased credit default swap into the trading account. In this fashion, the bank would mark each position to market, and presumably, the change in fair value related to credit risk would be offset in trading profit and loss (trading P&L). However, in practice, transfers to the trading account from the banking book are subject to certain restrictions. First, such transfers should be rare. Second, in order to transfer loans to the trading account, the bank should be in the position to make an active market in the individual loans. With respect to loan assets, the trading account designation has traditionally been limited to loans that the bank acquires principally for the purpose of selling in the near term to profit from short-term price movements. Many accountants would object to classifying loan portfolios as trading assets unless the bank actively quotes a bid-offer spread on the individual loans. February 1, 1999 Consolidation Issues Regarding the Issuing Trust Questions may arise about whether the originating bank, as sponsor of the issuing trust (an SPE), should consolidate the issuing trust and record its notes (or certificates) as debt liabilities on its balance sheet. Based on our reading of existing authoritative literature, we do not believe so. The originating bank should record the credit default swap as if the credit default swap were directly purchased from the market. The authoritative accounting literature does not specifically address consolidation of SPEs in the context of this transaction. Some sponsors would follow the guidance under SFAS No. 94, Consolidation of All Majority-Owned Subsidiaries. Under SFAS 94, a sponsor would consolidate all SPEs that it “controls,” unless control of the SPE is temporary or control rests with the majority owners of the SPE. Because the originating bank does not control the activities of the SPE (which are passive in nature), the bank could conclude that it should not consolidate the SPE. Others might analogize to the guidance under EITF Abstracts, Appendix D, Topic D-14, “Transactions Involving Special-Purpose Entities.” Under Topic D-14, the SEC staff stated its belief that nonconsolidation and sales recognition by a sponsor or transferor of an SPE is appropriate when the majority owner (owners) of the SPE is an independent third-party that has made a substantive capital investment in the SPE (i.e., greater than 3% of the total assets of the SPE), has control of the SPE, and has substantive risks and rewards of ownership of the SPE (including residuals). If the SPE issues beneficial interests in the form of certificates to independent third parties that bear the substantive risks and rewards of ownership of the SPE’s assets (i.e., a written credit default swap collateralized by securities), the SPE should not be consolidated by the originating bank. In this case, certificates representing undivided beneficial ownership interests constitute “equity” from an accounting perspective. In addition, the certificate holders bear all the risks and rewards of ownership of the credit default swap and securities, and retain all elements of “control” (if any elements can be identified, given that the SPE is a bankruptcy-remote passive entity). If the originating bank retains a residual interest in the issuing trust, some accountants may seek to apply Topic D-14 and argue that the residual interests constitute “equity” in violation of the 3% asset test detailed above. Given the lack of authoritative FASB guidance on SPE consolidation, the outcome of this debate is uncertain. The FASB is currently addressing these issues in its Consolidation Project. The originating bank would recognize interest income on the residual interest under EITF 89-4 (Appendix D) if the originating bank does not consolidate the SPE. RBC Treatment This alternative does not result in sale treatment for the underlying loan portfolio. Instead, the originating bank should evaluate the purchased credit default swap as a financial guarantee of the underlying loan portfolio. The ultimate degree of RBC relief on the underlying loan portfolio (that itself carries a risk weight of 100%) depends on whether the loan portfolio and the credit default swap reside in the banking book or the trading book. If the loan portfolio remains in the banking book, the originating bank obtains RBC reduction only to the extent of the notional amount of the credit default swap. If the loan portfolio is transferred to the trading book along with the credit default swap, then the originating bank obtains RBC relief under the market risk rule. However, regulatory accounting principles (RAP) conform to GAAP. As a result, unless the originating bank can overcome the hurdles discussed in the accounting section above regarding transferring loans to the trading account, the Fed and the OCC will not allow the originating bank to apply the market risk rule to the underlying loan portfolio. As a result, various structures have been developed for “synthetically” transferring the underlying loan portfolio to the trading account. We explore these structures in Appendix C. Lehman Brothers 27 February 1, 1999 Figure F-1. Regulatory Treatment, Originating Bank (Protection Buyer) Risk-based Capital Banking Book Treatment: • If certain criteria are met, the bank can assign the unamortized portion of the underlying asset being hedged to risk category appropriate to the guarantor. - Because the guarantor is an SPE, it does not fall into the definition of OECD bank. - If the SPE’s obligation under the credit default swap is collateralized by U.S. Government or agency securities, the portion of the loan portfolio equal to the SPE’s collateral is assigned to the 0% risk category under the collateralized transactions rule. - If the SPE’s obligation is collateralized by high grade (AAA) asset-backed securities, no RBC relief is obtained. • Criteria for lower weighting—Whether the credit derivative is considered an eligible guarantee for RBC purposes depends upon the degree of credit protection actually provided. Factors include, - protection over the remaining term of the underlying loan portfolio, - restrictive definitions of default or materiality thresholds in the credit derivative, and - risk weight of the guarantor. - Calculate “general market risk” charge using VAR (similar to cash instruments). - Calculate “specific risk” charge (which differs for open, matched, and offsetting positions) unless the internal VAR model incorporates this risk.* - Calculate “counterparty risk” charge by summing the market value of the contract and an add-on factor representing potential future credit exposure. - The matched nature of the combined position eliminates “general market risk” and “specific risk.” Credit Exposure (i.e., Concentration of Credit Risk Reporting) • A nongovernment guarantee does not reduce a bank’s asset concentration to a borrower because the underlying concentration still exists. • However, examiners will consider how the bank manages the concentration, including the use of nongovernmental guarantees. Classification (i.e., OEAM, Substandard, Doubtful, or Loss) • The protection may be sufficient to preclude classification of the underlying asset or reduce the severity of classification. • Sufficiency depends upon the extent of credit protection that is provided. Factors include - financial capacity and willingness of the guarantor, - legal enforceability of the credit derivative contract, and - protection over the remaining term of the underlying asset. Trading Book Treatment: • The originating bank transfers both the underlying loan portfolio and the credit default swap to the trading book. • The originating bank would evaluate the credit default swap and the underlying loan portfolio under the market risk rule for risk-based capital: *In current practice, several banks calculate the “specific risk” charge under a credit ratings-based internal models approach that is not based on VAR methodology. Rather, these banks employ a statistically based approach that is similar to the credit rating agency methodology establishing the operating guidelines for many derivatives product companies (DPCs). Under these operating guidelines, required DPC capitalization levels are driven by credit rating migration analysis. Relevant default histories may not be available for individual counterparties (such as Latin American companies) in DPCs. However, a credit rating agency can still assign a rating to the company based on fundamental analysis. The DPC will use the credit rating (and the loss migration statistics associated with that rating category) to calculate required capitalization under its operating guidelines. This approach appeals to several banks that are attempting to meet the market risk capital amendment requirements. Lehman Brothers 28 February 1, 1999 APPENDIX G: FINANCIAL REPORTING AND RBC TREATMENT OF INDIRECT CREDIT DERIVATIVE Financial Reporting Treatment The same financial reporting issues (excluding consolidation concerns) that arise in the Collateralized SYCLONE structure apply to this structure (see Appendix F). If the originating bank retains a residual interest in the issuing trust, the Fed and OCC would treat the residual as a recourse arrangement and would apply the lowlevel recourse rule. Under this rule, the originating bank is required to hold capital dollar-for-dollar against the face amount of the retained subordinate exposure. In this structure, the counterparty enters into offsetting derivative contracts that can be placed into the counterparty’s trading account for financial reporting purposes. As a result, the counterparty can apply the market risk rule to the combined position. The application of the market risk rule could substantially reduce the counterparty’s RBC charge for this transaction, resulting in more favorable credit default swap pricing levels for the originating bank. RBC Treatment The same RBC issues that arise in the Collateralized SYCLONE structure apply to this structure (Appendix F). In addition, the bank would be required to hold capital for credit risk arising from derivative transactions. (See the Lehman Brothers report, Credit Derivatives, May 1998). Lehman Brothers 29 February 1, 1999 APPENDIX H: FINANCIAL REPORTING AND RBC TREATMENT OF SYCLONE Financial Reporting Treatment The same financial reporting issues that arise in the Collateralized SYCLONE and Indirect Credit Derivative structures apply to this structure (see Appendix F). From the originating bank’s perspective, the two purchased credit default swaps are treated as financial guarantee contracts. Because the intermediation (backto-back) credit default swap would not qualify as a hedging instrument, the originating bank should classify it as a trading account liability. portfolio, which remains in the banking book. The loan portfolio being hedged is assigned to a risk category appropriate to the guarantor. • • RBC Treatment In the Collateralized SYCLONE structure, the originating bank cannot optimize its RBC treatment unless it applies the market risk rule to the underlying loan portfolio and the purchased credit default swap. However, as discussed in Appendix F, the originating bank must meet the GAAP requirements for transferring loans to the trading account in order to apply the market risk rule to the underlying loan portfolio. The SYCLONE structure has been developed to achieve RBC relief by “synthetically” transferring the underlying loan portfolio to the trading account. From an RBC perspective, by purchasing the two credit default swaps, the originating bank has purchased credit default protection on the entire face amount of the underlying loan portfolio (assuming no retention of residuals). The originating bank designates each swap as a hedge of the unamortized portion of the underlying loan • Credit default swap with the issuing trust—Because the guarantor is an SPE, it does not fall into the definition of OECD bank. If the SPE’s obligation under the credit default swap is collateralized by U.S. Government or agency securities, the portion of the loan portfolio equal to the SPE’s collateral is assigned to the 0% risk category under the collateralized transactions rule. Credit default swap with OECD bank—Because the swap counterparty is an OECD bank, the portion of the loan portfolio equal to the notional contract of the swap is assigned to the 20% risk category. If the originating bank retains a residual interest in the issuing trust, the Fed and OCC would treat the residual as a recourse arrangement and would apply the low-level recourse rule (See Appendix D). Under the low-level recourse rule, the originating bank is required to hold capital dollarfor-dollar against the face amount of the retained subordinate piece. The intermediation (back-to-back) credit default swap is a newly created trading position from a RBC perspective. Because this swap resides in the trading portfolio, the originating bank should apply the market risk rule to this exposure in determining the appropriate RBC charge. In addition, the bank would be required to hold capital against the initial swap contract with the 20% risk weighted counterparty. However, the bank would avoid paying the full default swap premium on the senior risk, given the fact that the counterparty hedges its specific risk in the backto-back swap with the bank. Lehman Brothers 30 February 1, 1999