Yesterday, Bloomberg reported that Blackstone – the behemoth private-equity firm – has created a nifty way for big banks to skirt their risk-based capital requirements by as much as 96 percent. That’s a lot, so the structure had better make sense if the Basel III rules are to have any meaning. But, as I understand the transaction, it’s a pure arbitrage play better characterized by creativity than capital at risk. If regulators let it go on as is, they’ve only themselves to blame if Congress scuttles U.S. rules to implement Basel III in favor of a simple, high and counter-productive leverage standard.
The transaction is reportedly built by a Blackstone entity called the “Tactical Opportunities Group,” a name to me all too reminiscent of special-operations units deployed by the military to take out counter-insurgents. In this case, the target is the Basel III rules and the weapon is a cannon designed by very clever financial engineers: a structured company offering synthetic asset transfers into a specialty company without apparent capital that converts the risk into credit derivatives with yield-seeking investors then taking off its hands. Cool….
What does this high-flying “tactical opportunity” do? Essentially, it permits Citi to shed the top layer of risk – ten or fifteen percent – on a billion-plus in shipping loans housed in the U.K. Shipping loans have been heading for the bottom since the 2008 financial crash, making them particularly costly if properly scored for their credit risk. So, what to do?
Blackstone’s Navy Seals structured a freestanding company that on paper agrees to take this risk, parsing it then out through a series of structured derivatives, even though the actual shipping loans stay on the bank’s books – the “synthetic securitization” famed in song and story.
This deal might make sense from both a business and capital perspective if risk of loss for these loans was, in fact, meaningfully transferred. Was it? Again, one can’t tell for sure – all there is to go on is the aforesaid Bloomberg story. It, though, says it doesn’t know if the Blackstone structured-credit vehicle – my term, not theirs – has collateral backing its risk. Nor, from what one can tell, is there any permanent capital in the structure, let alone loss reserves or a counter-cyclical buffer. Are there contractual restrictions barring the structured-credit vehicle from returning funds to Blackstone at the first sign of a scare, leaving the bank to fend for itself? Again, no word.
Based on the Bloomberg story, the deal was blessed not by the OCC or Federal Reserve, but rather by the U.K.’s seemingly-ferocious FSA. For all the talk coming out of England of late, one would think the FSA would forefend such fancy doings. But, either befuddled or becalmed, Bloomberg says the FSA explicitly bought off on this structure. However, the capital position of the bank involved – Citi – is consolidated up to the U.S. parent. Thus, even if the FSA agreed to this feat of financial derring-do, the U.S. can and should bring it back to earth.
The fault here isn’t in the capital rules per se. Basel I, II and III rightly allowed for reduced risk-based capital when banks purchased credit-risk mitigation (CRM). If the CRM comes from a capitalized, regulated counterparty – a bank or insurer that is forced in fact to back its bets – then reduced capital makes sense not only because risk is lower, but also because sharing it makes capital go farther around the financial system and diversified concentrations to boot. The problem is that the Basel II and III rules, seduced by models and financial engineering, don’t in fact limit CRM credit to capitalized providers. Indeed, it creates incentives for CRM offered by shadow entities because – duh – it’s cheaper to make promises that satisfy regulators if one doesn’t actually have to keep them.
Worrisomely, the financial crisis hasn’t chastened market interest in these structures. Not only is Blackstone busily building them, but the “Bipartisan Policy Commission” report recommending GSE reform this week urged Congress to rely on them instead of hard dollars put up front before the taxpayer. Cool indeed again.
What this transaction is, at its heart, is an arbitrage deal in which a PE and its customers take nominal credit risk without having to post collateral or capital against it in exchange for a nifty fee. The fee comes from a regulated bank desperate to get out of a capital hole for which meaningful ways to mitigate risk – asset sales, capitalized CRM – are too expensive for its taste. Too bad, – from a prudential perspective, a bank that pays a fee to pay CRM that isn’t worth the paper it’s printed on except to a befuddled regulator is not only not reducing its risk, but in fact increasing it. The more these deals go forward, the greater the drain of their fees on weak banks, the more highly leveraged the bank becomes and the less transparent its risk position because nominal capital disclosures show seemingly resilient risk-based capital. A thin reed indeed.