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Mourn For The Derivative On Its Derivatives That Credit Suisse Wrote To Itself

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You may not believe this, but a few weeks ago I spoke to a business school class about the financial industry, and a student asked me "what would you say to someone who's considering a career at an investment bank?" Somehow it did not occur to me to congratulate her on her humanitarian impulses. Instead, I suggested that there are two possible futures for the big banks. In one, the various efforts to "make banking boring" - more onerous capital and liquidity regulation, clearing and futurization of derivatives, bans on prop trading, calls to break up big banks, and so forth - would create amazing opportunities for people with the intelligence, motivation, and shall we say aesthetic sensibilities to find new ways to accomplish their non-boring goals within a shifting framework. Just like changes in the tax code create work for smart tax lawyers, so changes in banking regulation and structure create opportunities for smart bankers to steal a march on their competitors.1

In the other possible future, banking would be boring.2 Today is a dark day:

Credit Suisse may be forced to scrap or, at the very least, radically restructure a multi-billion dollar employee bonus scheme that represents an important part of its efforts to boost capital by slashing risk-weighted assets in the investment bank. ...

Credit Suisse purchased protection from a third party investor – named as Guggenheim Partners by one market source – through a credit default swap accounted for at fair value, according to the bank’s fourth-quarter results.

The problematic part of the hedge is as follows: Credit Suisse has extended a multi-billion dollar credit facility to the un-named investor, which requires the bank to “fund payments or costs related to amounts due by the entity under the CDS”.

In other words, the investor can borrow money from Credit Suisse to make CDS payments to the bank if the senior tranche loses money - hardly a genuine risk transfer.

“There’s no question that Credit Suisse will have to restructure PAF2,” said one bank capital expert. “The latest Basel III guidelines all but cite Credit Suisse as an example of what not to do.”

This Credit Suisse PAF2 deal is among my favorite things in recent financial history. Was. What I like, and what the BIS hates, is not so much the actual employee bonus scheme, PAF2, which is the mezzanine tranche of a $12bn pool of Credit Suisse CVA exposure (CS keeps the equity tranche). Rather it's the $11bn senior tranche, which was hedged through an amazing CDS contract and credit facility where:

  • Under the CDS contract, Guggenheim agreed to insure Credit Suisse against defaults by CS's derivatives counterparties, and
  • Under the credit facility, if Guggenheim had to make any payments on the CDS, Credit Suisse agreed to give them the money (which they would then give back to Credit Suisse).3

If you ask "why didn't Credit Suisse just agree to give itself the money if anyone defaulted on its derivatives," you understand nothing. But I will tell you anyway: the answer is that the CDS was accounted for on a mark-to-market basis, offset CS's mark-to-market CVA losses, and reduced the amount of capital CS was required to hold against its derivatives portfolio for its CVA exposure.4 Whereas the credit facility was just a credit facility, accounted for on an accrual basis, and only showed a loss if there were actual defaults. If, as everyone expected, there were not enough defaults to reach the senior tranche, the CDS would perfectly hedge CS's mark-to-market CVA exposure (going up in value as spreads widened), while the credit facility would never experience a loss.5

Or that was the theory. The BIS disagreed:

If the bank remains effectively exposed to a tranche of the underlying default risk by providing any form of credit enhancement to the protection provider, then the CDS is not an eligible CVA hedge because, in economic substance, the transaction becomes a tranched CDS protection, regardless of whether the credit enhancement is on accrual accounting. All kinds of engagement between the bank and the protection provider need to be taken into account in order to determine whether the protection is effectively tranched.

Oh "economic substance," the bane of financial engineers everywhere. What I said about this trade last year was:

the counterparty [Guggenheim] wrote CDS to CS, and CS wrote a credit support facility where it would fund counterparty’s CDS obligations under certain circumstances. Call those certain circumstances {X}. ... The game is having {X} be large enough that the counterparty feels like it’s not writing an economic contract, but small enough that auditors and capital regulators think it is an economic contract. The name of that game is “regulatory arbitrage.”

That was the game Credit Suisse was playing, and: it lost this round. The capital regulators decided that their trade was not an economic contract, so it won't have the capital effect they wanted, so it would appear to be back to the drawing board.

Delightfully they do seem to be going back to the drawing board, rather than conceding defeat; IFR quotes someone in the bank as saying that "continued evolution of the Basel III rules is likely to require some modifications to the hedge. These changes are already well advanced." This may work out yet. My faith in Credit Suisse is diminished, but not destroyed. You can come back from this, Credit Suisse. You have to. For all of us.

CS to overhaul flawed US$12bn bonus structure [IFR]
Earlier: Marvel At The Derivative On Its Derivatives That Credit Suisse Wrote To Itself

1.Simplistically: if you don't like the Volcker Rule, you can just get rid of all your prop trading, prop investing, private equity and hedge fund businesses. Or you can make your PE business a merchant bank. Or you can hold your prop trading book longer than 60 days. There are more sophisticated approaches too obviously.

2.Btw! If you believe that, it doesn't necessarily mean you shouldn't go into banking! The nice thing about the 3-6-3 rule is: lotta golf.

3.Obviously "lend," not "give," though according to CS's disclosure "any funded amount may be settled by the assignment of the rights and obligations of the CDS to us," which sounds a whole lot like "give." Anyway it doesn't matter; the point was less payoff economics (no one thought, or thinks, that there'd actually be any claims on the CDS, which is after all pretty credit enhanced) than capital regulation.

4.Yeah I said "hold capital." I'm distraught, leave me alone.

5.More detail here or here or in the IFR article.


Layoffs Watch '15: Credit Suisse Wants You! (To Help It Cut Costs By 3.5 Billion Francs)

This is not so much a request as a requirement you're unlikely to get around, unless anyone is considering chaining themselves to their desks.