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Spoilsport Banking Regulators Ruin Another Derivative That Was Too Beautiful To Live

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Soon it will be time for Congress to shout at bankers about derivatives again and that's fine, but allow me to indulge a bit in mourning for a derivative that Basel III killed today. That being of course SunTrust's postpaid bifurcated collateralized variable share forward on its Coca-Cola stake:

SunTrust Bank's third quarter is about to be a bit of a kitchen sink report, and that includes tossing out its old stash of Coca-Cola. ... Included in the asset shuffle will be the sale of 60 million shares of Coca-Cola Co. that the bank has held for nearly 100 years, a sale that will lead to a $1.9 billion pre-tax gain in the quarter.

SunTrust had in 2008 entered into two contracts to sell its Coke shares in 2014 and 2015. But after reviewing its position in light of new global capital regulations known as Basel III, SunTrust realized holding onto its Coke shares would punish its capital standing and decided to move forward the sales. The bank also said owning the shares hurt its stress-test results.

Probably nobody cares about this but me, but the derivative in question is among the works of art in the financial world so I want to share it with you.* Basically what happened is (all numbers rounded and split-adjusted):

  • In 1919 SunTrust got some Coke shares, worth $100,000, for underwriting its IPO. (This is not part of the derivative, but it happened. Nice IPO fee, as it turns out.)
  • In 2008 a dealer gave SunTrust some $19 per share for 60mm Coke shares, or about $1.1bn. ("Coke" and "dealer" are both used in the financial sense here, not the other one.)
  • Coke was trading at about $25 at the time.
  • But! SunTrust didn't have to give the dealer the shares until 2014/2015. (It was split into two tranches for reasons that don't concern us here.)
  • And! When they ultimately handed over the shares, SunTrust got to keep any value above that $19 a share, up to a maximum price of $33. The dealer got anything over $33.**

So basically SunTrust floored its risk on the shares, while keeping upside up to a cap. It's just a collar, in other words, and maybe you do this in your personal options trading. (Which: stop!) But SunTrust didn't do it because they like day-trading options and had an axe on skew; they did it because they got to basically tell some people that they'd sold the shares, and tell some other people that they weren't selling them until 2014/2015. With those people being:

  • banking regulators thought SunTrust had sold the shares, so they got to increase their regulatory capital by 44bps in 2008; but
  • the IRS thought they hadn't sold the shares, so they didn't have to pay taxes on the $19-33 per share (which was all gain, remember) until 2014/2015.

That is a good trade: capital now, taxes later. To be super super clear: this was all super super legal! There is an IRS ruling on the tax point,*** and SunTrust ran the capital treatment by the Fed when it did the deal in 2008.

But all good things must come to an end, and the end here was Basel III and other general clamping-down on bank capital stuff. (The Fed's stress tests played a role; "negative implications associated with equity securities in assumed adverse economic scenarios within future CCAR assessments were considered as part of the Company’s evaluation.") So they get $490mm of extra capital today, and also pay about $700mm of taxes, also today, and it's all straightforward and as-you'd-expect and terribly terribly boring.

I have no real point here except "this trade was beautiful and now it's dead." I think sometimes about asymmetries in the financial industry and this feels like a tiny one. I suspect that if Carl Levin's Permanent Subcommittee On Investigations has read this far, they'll be pleased to learn that this particular (rather egregious) regulatory arbitrage is no longer easily available to the banks they are haranguing. But they haven't! The people who knew and loved trades like this will mourn its passing; the people who should celebrate its demise won't even notice.

SunTrust Sells Coke Shares and Bad Loans [Deal Journal]
SunTrust Announces Actions That Improve Risk Profile and Strengthen Balance Sheet [EDGAR]

* Incidentally no conflicts; SunTrust doesn't name the bank who did it but at a minimum it wasn't me personally. Rumor is it was Deutsche Bank. Also to be clear this structure is not at all original to the bank that did it or anything; it's been around for ages and really it's just a private Feline PRIDES / mando unit. But that block of KO shares was a bit of a grail among corporate equity derivatives bankers for years so, y'know, my hat is off to the people who convinced a conservative southern bank to actually do it.

** With KO now at $38ish, that means the dealer got to keep some $300mm when SunTrust unwound the trade. SunTrust seems to have no complaints about giving up that $300mm - and it's not windfall, the dealer was hedged - which certain municipalities I could name might take note of.

*** The eleven people who care about these sorts of things may be interested to know that, while in 2008 SunTrust talked a good game about how on any early termination of the forwards:

SunTrust generally may not prepay the Notes. The interest rate of the Notes will be reset upon or after the settlement of the Agreements, either through a remarketing process or based upon dealer quotations. In the event of an unsuccessful remarketing of the Notes, SunTrust would be required to collateralize the Notes and the maturity of the Notes may accelerate to the one year anniversary of the settlement of the Agreements. However, SunTrust presently believes that it is substantially certain that the Notes will be successfully remarketed.

... of course today they're prepaying the Notes: "SunTrust also repurchased the notes from the counterparty issued in 2008 in connection with the VFPAs." My assumption is that none of those eleven people work at the IRS but, y'know, for your consideration.****

**** [Update] Imagine this note being in an even tinier font; also don't read it. Footnote *** was really for about eleven people and was written vaguely enough to get a bit misconstrued, so here's a fuller version. The "Notes" are not really part of the economics of the equity derivative described in the text, but they're the engine that makes the tax artistry work. In the text I said that the dealer - call them "DB" for argument's sake - gave STI $19 a share for the Coke shares. But actually it didn't: if DB gives STI money for its shares, that would be taxable immediately. What it did instead was promise (via the variable forward purchase agreement) to give STI $19-33 a share in 2014/15, and it bought STI notes in an amount equal to $19 a share in 2008. So STI owed DB $19 a share on the Notes, DB owed STI $19 a share on the forward, and STI had the use of the $19 starting in 2008. Good for STI, good for capital, but also not a taxable event.

But that's obviously ridiculously circular: DB gives STI $19, STI owes DB $19, and DB owes STI $19 is really just "DB gives STI $19 free and clear," which would be taxable. To make it not a taxable event the Notes and the forward have to be separate in some IRS-blessed sense; one of the incantations that you utter to make them separate is to say that when the forward unwinds the Notes are not prepayable. That's what that quoted language says, and it comes right from the IRS ruling. But then when you actually unwind the forward you realize that no one really wants to keep the Notes around - STI doesn't want to gross up its balance sheet, and DB doesn't want $1bn of STI credit risk. So they just tear up the Notes.