Royal Bank of Scotland Group Plc pulled a $207 million sale of bonds backed by its own derivative trades after investors scarred by losses on exotic debt balked at the complexity, three people briefed on the matter said.
The deal, called Score, was canceled in February, said the people, who asked to remain anonymous because the plan wasn’t public. Money put up by bondholders would have been used to reimburse RBS if customers failed to pay up on a 2 billion-pound ($3.2 billion) book of derivatives trades, according to a November presentation. If no customers defaulted, bondholders would get their money back plus interest topping 15 percent.
The cancellation shows RBS misjudged the appetite for securities constructed like those that led to the 2008 financial crisis. While RBS described deals such as Score as a “key tool” to build capital after its government bailout, investors burned by about $420 billion of losses on subprime-backed collateralized debt obligations remain wary of intricate vehicles that promise outsized returns, the people said.
“I don’t know who would actually go out and purchase these,” said Dan Rosen, chief executive officer of Toronto- based consultant R2 Financial Technologies Inc., which advises banks and investors on risk management. “You have thousands of derivatives, hundreds of risk factors.”
The bank abandoned the idea after a rally this year in corporate bonds reduced pressure on RBS, a person with knowledge of the decision said. An RBS spokeswoman, Rebecca Nelson, declined to comment. The Edinburgh-based firm, the U.K.’s largest government-owned lender, received a 46 billion-pound U.K. rescue and has posted annual losses for four straight years, including 2011’s 2 billion-pound deficit.
“RBS is going to be under continued pressure to raise capital for the foreseeable future,” said Glenn Blasius, CEO of Ovid Capital Advisors LLC in New York, formed last month to manage and invest in structured deals that help banks free up capital. Blasius said he couldn’t imagine why the bank backed off “just because the market rallied.”
Score -- short for Securitization of Credit Risk Exposures -- was among a breed of deals conceived by financiers over the past decade to help banks free up capital while minimizing the need for asset sales. Lenders are facing regulations adopted after the 2008 crisis requiring them to hold more capital to serve as a buffer against losses and head off future bailouts.
When Trades Fail
The Score deal also was responding to a growing awareness among bankers and regulators of the havoc unleashed when a derivatives trade goes bad. The U.S. government bailed out New York-based American International Group Inc. (AIG:US) partly on concern firms including Goldman Sachs Group Inc. might incur multibillion-dollar losses if AIG failed to make good on derivatives payments.
RBS planned to sell the Score bonds in U.K. currency totaling 130 million pounds. Here’s how the deal was supposed to work, according to the bank’s presentation:
RBS first would estimate its “credit-risk exposures” on derivatives trades with about 230 customers. Such risks arise when a lender uses a derivatives contract to bet on interest rates, commodities, currencies and stocks. If prices move in the bank’s favor, it effectively creates a debt to the bank -- and the risk that the loser might not pay. The credit exposure is the estimated potential profit on all of RBS’s trades with each customer at any point in the deal’s six-year life.
Next, RBS would put the exposures -- in this case totaling 2 billion pounds -- into a pool and agree to absorb the first 0.5 percent of losses from any customer defaults, or 10 million pounds. It then would sell investors 70 million pounds of junior notes whose principal would take a hit if customer defaults climb beyond 10 million pounds.
In return for that risk, the bonds offered an interest rate of 15.5 percent over benchmark money-market rates. Another 60 million-pound class of “mezzanine notes” paying 11.5 percent over the benchmark would get wiped out if losses reached 140 million pounds.
RBS planned to keep the remaining 1.86 billion pounds of credit exposures, or the top 93 percent. Since the firm would then have a 7 percent buffer against losses, its own position garnered an Aa3 rating from Moody’s Investors Service -- the fourth-highest among 21 grades. As a result, the bank would be deemed less likely to suffer losses than before the deal, and would be allowed to keep less capital on hand.
“Alignment of interest is achieved as RBS retains an economic interest in all the underlying names in the portfolio,” the bank said in the presentation. “This will also fulfill new regulatory requirements.”
If all the derivatives trades had gone against RBS, the credit exposures would have dropped to zero, because customers on the other side of the trade owed nothing to the bank. The upshot: Bond investors would have gotten a free pass on reimbursements, the people said.
Score offered “attractive returns” as well as the ability to invest in “names which are not readily available in the market,” according to the presentation. Some of the trading customers “may not have public ratings,” the bank said.
Still, when RBS marketed the deal to investors late last year, it couldn’t find enough takers for the junior notes at the proposed interest rate, the people briefed on the sale said. The 10 million-pound buffer against losses wasn’t enough insulation, making the bonds too risky to hold even with the coupon of more than 15 percent, one of the people said.
The bank canceled the transaction in February after a rally in corporate bonds made the deal less attractive compared with other available methods of freeing capital, one person said. Shares of RBS advanced more than 30 percent this year.
Wall Street’s practice of packaging debt into structured securities with arcane names became tainted after subprime- mortgage-backed collateralized debt obligations saddled lenders and investors with hundreds of billions of dollars of losses during the financial crisis. Losses quickly burned through junior portions of structured securities, forcing holders of the senior AAA portions to take writedowns and contributing to the collapse of some credit markets in the 2008 financial crisis.
Capital-relief deals like Score have proved more reliable, said two investors who asked not to be identified because most of the deals are negotiated privately.
That’s partly because the bonds are usually backed by the financial strength of the bank’s regular corporate customers, with whom they have continuing relationships. By contrast, subprime loans were often written by independent lenders and then bought up by firms including Citigroup Inc. (C:US) and Merrill Lynch & Co., mainly to generate fees from packaging them into new securities.
According to the November presentation, RBS and one of its predecessors, ABN Amro Bank NV, have “structured more than 15 such customized transactions with a nominal amount exceeding 180 billion pounds.” An ABN Amro deal from 2003 called Amsco valued at about 5 billion euros paid off in full.
A group of former ABN Amro executives led the Score deal, including Emaad Siddiqui, Serdar Ozdemir, Kaikobad Kakalia and Gerwin Scharmann. Siddiqui, who left the bank earlier this year, said he couldn’t comment. The others declined to comment or didn’t return calls for comment.
RBS has strengthened its financial base since its government bailout by seeking private investment and reducing holdings of corporate, real estate and project-finance loans, according to a January report by Jonathan Glionna, a Barclays Plc analyst.
While the lender has improved its capital base to about 10 percent of assets from 2 percent in 2007, “it’s their intention to continue to build capital, like it is for almost all the banks,” Glionna said in an interview.
Ann Rutledge, a former Moody’s analyst who’s now a principal at R&R Consulting in New York, said shifting risks to outside investors was a good idea in theory.
“It’s true finance,” said Rutledge, whose firm rates mortgage bonds and other asset-backed securities. “You stabilize things for the people who really want predictability and you leave more yield for the people who are willing to take a bigger risk.”
Still, elaborate financing structures don’t always work out as intended, she said.
“You’re trying to engineer more precision than may actually exist,” Rutledge said. “That kind of precision in the corporate world isn’t possible.”
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