Blackstone Group LP (BX:US), the world’s largest private-equity firm, has devised a way to profit from regulation: It’s helping banks meet tougher capital rules without the pain of selling assets or raising equity.
The firm last year insured Citigroup Inc. (C:US) against any initial losses on a $1.2 billion pool of shipping loans, said two people with knowledge of the transaction, who asked not to be identified because the matter is private. The regulatory capital trade, Blackstone’s first, will let Citigroup cut how much it sets aside to cover defaults by as much as 96 percent, while keeping the loans on its balance sheet, the people said.
For banks, the transactions offer a way to redeploy capital more profitably while meeting the stiffer requirements of the latest round of Basel rules. Critics say the practice doesn’t make the lenders any safer and pushes the lending risk into the unregulated shadow-banking industry.
“It’s a form of financial engineering,” said Philippe Bodereau, London-based head of European credit research at Pacific Investment Management Co., the world’s largest bond investor. “It was dead but it seems to be coming back as investors scramble for yield. If you saw this on a massive scale, you would certainly question whether this was the best way for regulators to de-risk the system.”
Under the Basel Committee on Banking Supervision’s rules, banks are required to set aside a set amount of capital based on the likelihood a borrower will default. The latest round of rules, due to come into force in 2018, will force the largest banks to increase the amount of capital they hold to 9.5 percent of the value of their risk-weighted assets.
Regulators have criticized banks for trying to meet the target by adjusting the models they use to calculate risk- weighted assets rather than raising capital. The Basel Committee, which brings together regulators from 27 nations, said in a January report that there are “substantial variations” in how banks determine the riskiness of assets.
Blackstone closed the transaction at the end of last year “very quietly,” said Jasvinder Khaira, a principal in the firm’s Tactical Opportunities Group, a specialist unit that invests in unusual, illiquid deals. “Why would Blackstone be interested in doing this deal? The short answer is” because of “changes to the Basel III framework and in general to how regulators are viewing loan exposures,” he told delegates at Marine Money’s 4th Annual London Ship Finance Forum, without identifying Citigroup.
The trades, also known as synthetic securitizations, work by transferring part of the credit risk on a pool of assets to a third party through derivatives such as credit-default swaps in exchange for capital relief from regulators. Deals range from simple transactions between two firms to more complex structures, where special-purpose companies are set up to provide protection to the bank and are in turn funded through the sale of notes to investors.
Blackstone has set up a separately capitalized company, which has written the credit-default swaps on the loans, one of the people said. They declined to say how much the firm has injected as collateral to cover any potential losses.
By buying credit protection on the first 10 percent or 15 percent of losses, lenders are able to reduce the amount of capital they need to hold to close to zero under Basel rules. The extent of the capital relief is based on banks’ own internal risk-weightings and approved by regulators. Unlike in traditional, or cash, securitizations, the assets stay on the balance sheet.
The Blackstone deal is one of the first examples involving a private-equity firm, which traditionally look to take a more active role in managing assets. It demonstrates the extent to which banks are prepared to pay up for capital when other sources, such as issuing shares or unsecured bonds, are closed.
“Banks are subject to more stringent regulatory capital rules and they need these transactions more than ever,” said Elizabeth Uwaifo, a partner at Sidley Austin in London who specializes in structured finance. “It’s not something that private-equity firms have traditionally got involved in but these deals are now becoming attractive because the yield is that much higher.”
Private-equity firms have struggled to achieve returns exceeding 10 percent after banks cut off credit in the aftermath of the financial crisis, starving the industry of the leverage required to match previous returns.
Blackstone’s Khaira described the Citigroup deal as an “elegant solution” for banks and investors, amid an industry- wide shipping crisis that’s extending into a fifth year.
European banks hold about 75 percent of $500 billion in global shipping loans, after a surge in lending in 2007 and 2008 fueled a fleet glut that sparked bankruptcies and loan defaults.
That’s forcing banks to reassess the likelihood of borrowers defaulting on their loans. Commerzbank AG (CBK), the world’s third-largest ship financier, this month adjusted the model it applies to its portfolio of about 2,000 vessels, causing risk- weighted assets to rise by about 7 billion euros ($9.2 billion).
Regulators are seeking to impose rules on the shadow- banking sector amid concerns about the creation of systemic risk. Shadow banking, which includes the activities of money- market funds, monoline insurers and off- balance sheet investment vehicles, stood at about $67 trillion at the end of 2011, according to the Financial Stability Board. The market grew by $41 trillion between 2002 and 2011 alone, the FSB found.
“Banks are always trying to find pain-free ways to boost capital ratios, whether that is fiddling RWAs or outsourcing risk,” said Bodereau.“Some deals are legitimate but it is ultimately regulatory arbitrage. We are supposed to be moving to a world where bank balance sheets are more transparent and less complex and this goes backwards.”
Still, Michael Parker, London-based global head of shipping at Citigroup, said the deal with Blackstone isn’t a “speculative investment.” The “trades will be appropriate only for the better quality assets” with a lower risk loss, he said.
Michel Bourgery, London-based managing director at MB Finance Ltd., a ship-financing consultant, agrees.
“Blackstone is providing the parachute,” he said in a telephone interview. “It’s protecting against the wind and the rain, and it’s only if you have Star Wars or something coming from the outer universe that the bank will be hit.”
Formal approval isn’t required for every individual regulatory capital trade, although lenders are likely to consult their regulator to make sure deals qualify for capital relief, according to Jonathan Walsh, global head of securitization at Baker & McKenzie LLP in London.
Blackstone spent five months to develop a structure that the Financial Services Authority, the U.K.’s financial regulator, would accept, one of the people said. The FSA was involved because the trade affected Citigroup’s U.K. unit.
FSA rules allow banks to transfer the credit risk of an underlying loan without the asset changing hands. Liam Parker, a spokesman for the Financial Services Authority in London, declined to comment on the deal.
Banks have used similar transactions previously to meet their capital targets. In 2011, Barclays Plc bought protection on the first 300 million euros of losses on 6 billion euros of loans to an undisclosed counter-party. Standard Chartered Plc (STAN) the same year sold the credit risk on $3 billion of trade- finance loans to Asian companies.
Selling the risk of default also allows lenders to meet politicians’ demands to maintain lending as the sovereign debt crisis stymies economic growth in Europe.
“The government is jumping up and down asking banks to lend more to small and medium-sized businesses at the same time as stricter capital rules come in,” Walsh said. “The banks can either say: ’I’m sorry, we’ll have to wait until people pay off their loans,’ or the regulators could look at sensible ways of releasing those assets from their banks’ balance sheets so as to free-up capital to allow them to lend to more businesses.”
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