Synthetic Structure Pitched for Capital Relief
J.C. Flowers & Co. and Sandler O’Neill & Partners are pitching a program under which community banks could gain capital relief for their holdings of residential and commercial mortgages, among other assets.
Word of the push comes shortly after the Comptroller of the Currency shot down a “portfolio risk transfer” initiative in which J.P. Morgan sought to reduce its capital requirements by securitizing its mortgages while keeping large senior interests in the resulting bonds. But in a departure from the two all-cash deals conducted through that program last year, J.C. Flowers and Sandler O’Neill are eyeing the creation of synthetic securities tied to the banks’ mortgage portfolios.
While both firms are keeping tight-lipped about the inner workings of the initiative, the arrangements would at least partly resemble the synthetic credit-default swap deals that essentially went extinct in the U.S. during the 2007-2008 market crash. Rather than representing outsized short-selling opportunities, however, the idea would be to transfer the risk associated with the banks’ mortgage exposures to counterparties while keeping the referenced accounts on their balance sheets.
The upshot would be an ability to reduce the risk weightings associated with the reference pools under the Bank for International Settlements’ Basel 3 rules. An implementation plan the Comptroller began enforcing in January 2015 requires that community banks assign risk weightings of 50-100% to their residential mortgage holdings and 150% to their more-volatile commercial mortgage exposures — while setting aside Tier 1 or Tier 2 capital equal to at least 8% of their risk-weighted assets.
Under the proposed structure, the risk weightings would be zero for the first 10% of each reference pool. A 20% weighting would apply to the rest.
In J.P. Morgan’s portfolio risk transfer deals, the idea was that the bank’s retained positions would carry 20% risk weightings, versus 50% for the underlying loans, even as the large sizes of its interests and its continued work as servicer meant it still carried the collateral accounts on its books.
The problem: Under Section 3.41 of Rule 12 of the Code of Federal Regulations, banks seeking risk-based capital relief via cash securitizations must move the underlying loans off their balance sheets. Because no such “true-sale” requirement exists for synthetic deals, however, J.C. Flowers and Sandler O’Neill are pitching their approach as passing muster.
J.C. Flowers is playing a deal-structuring role in the transactions and serving as an investor, with Sandler O’Neill handling structuring and distribution. The strategy appears to be the product of more than a year of discussions with potential clients, along with regulators including the Comptroller and FDIC.
That said, it remains unclear how the New York firms plans to address separate tests under Section 3.41 that apply to swaps. “The sine qua non in these trades is achieving a true sale. For cash securitizations, you won’t get capital relief unless you past that test,” said David Moffitt, a managing director who heads asset management at J.C. Flowers. “The good news is that this determination is not a change in course for the Comptroller, and this doesn’t impact the utility of synthetic structures.”
Similar synthetic risk-transfer techniques already have been used in Europe for years, often for portfolios of corporate loans and small-business loans. While those offerings take place under more lenient interpretations of Basel 3 rules than those at work in the U.S., they could offer some insight into workable structures — including provisions for investor capital to be held in trust.
“We believe this could be another tool . . . for banks to bolster Basel 3 capital ratios and reduce loan concentration risk,” Sandler O’Neill partner Tom Killian said.
As for J.P. Morgan, the bank apparently urged peers including Bank of America and Wells Fargo to conduct deals like the ones it carried out — with the idea that the Comptroller would bend to a “strength in numbers approach.” But attorneys for the other institutions balked.
“[J.P. Morgan was] selling that hard to a bunch of my clients, but it wasn’t difficult to figure out the balance-sheet questions,” one lawyer said. “If you can get others to follow, it makes it almost impossible for the Comptroller to make that call. But in this case, no one else would pull the trigger.”
Nonetheless, a widespread desire by banks to reap the economic benefits of their loans while minimizing capital requirements is expected to lead to continued attempts at innovation. “People obviously want to do these things, and they can be accomplished,” another lawyer said. ?