CIA 1

Case Discussion

Submitted by
Imran Khan
2127815

Under the guidance of

Prof. Harshitha Moulya

School of Business and Management

CHRIST (Deemed to be) University,
Bangalore

January 2023
Case Summary
BankUS was a leading global financial services firm that had recently been placed on a credit
watch. BankUS' finance and advisory line of business included capital raising, advising on
financing and risk management issues, and making markets in fixed income, equities, foreign
exchange, commodities, and derivatives.
1. BankUS’s Credit Exposures
BankUS faced credit risk in many of its business activities, including corporate lending,
standby letters of credit, and sales, trading and derivatives. The Bank also faced credit risk by
acting as an intermediary on behalf of clients and other third parties. Averse wanted to protect
both current and potential future clients with a credit relief transaction.
BankUS's advisors agreed that a subset of its credit exposures could be transferred to other
parties by diversifying across geography and industry. Averse believed this would be possible.
Averse created a portfolio of 302 companies with $9.722 billion in credit exposures. This
portfolio reflected rating agency criteria, as well as the relative importance of BankUS clients.
Averse invested in 302 companies whose average credit quality was A2 (Moody's) and A
(Standard & Poor's), and whose minimum credit quality was A3/BBB+. The portfolio was
made up principally of well-regarded and stable companies that make up prominent indices
such as the S&P 500 or the Russell 1000.
2. Capital Adequacy Requirements
As a U.S. bank holding company, BankUS was subject to capital adequacy requirements, which
required it to maintain sufficient levels of equity capital against its assets to ensure survival
during a downturn in the credit cycle. The capital adequacy rules designated different types of
capital and different types of assets, and they were often applied in an inconsistent manner
when providing regulatory capital relief to struggling banks.
John Averse believed the regulations burdensome and reduced BankUS's profits because the
$9.722 billion package of credit exposures required the bank to carry additional capital. The
package was comprised entirely of highly rated companies, so lending rates were constrained
and margins were thin. Averse complained that BankUS needed to set aside $8 of equity for
every $100 that it lent, so it charged a high rate for internal use of equity capital.
Averse believed that the capital adequacy requirements of the package of loans far exceeded
the capital that a prudent, but unregulated, firm would need for adequate protection. However,
he could not be certain that bank regulators would grant adequate capital relief.
The Collateralized Loan Obligation Proposal
Averse had several proposals to remove credit risks from the balance sheet, including a
collateralized loan obligation (CLO).
1. Loan Securitizations
Securitization of pools of loans had grown enormously during the 1990s, with residential
mortgage lending being the largest market for securitized lending. The fastest growth had come
from securitizations of consumer lending, including credit cards, auto loans, and other personal
loans.
Securitizing commercial and industrial loans presented its own problems because the loans had
more diverse credit risks and payment characteristics than mortgages and automobile loans.
2. Alternative CLO Structures
Several versions of the CLO had been suggested to Averse, and all shared several features. The
most senior tranche would be no greater than $9.453 billion in face value and the subordinated
notes would be no greater than $237 million in size.
The SPV would sell $9.453 billion of senior notes and $237 million of subordinated notes to
the capital markets and keep $32 million. Averse noted that the regulators would grant relief
given the "true sale" of the loans to a bankruptcy-remote entity, but was concerned about cost.
BankUS would retain $8.993 billion of the top tranche of senior notes, and the capital markets
would purchase the remaining $460 million.
Averse would argue that the Bank had fully unloaded the risk from the $9.722 billion pool by
selling the riskiest $269 million of securities and $460 million of senior Aaa notes. A final
CLO alternative was discussed, but it was viewed as impractical and unlikely to succeed in
achieving regulatory capital relief. The bank would need to place approximately 1.5%14 of
capital against the $8.993 billion of Aaa securities instead of the typical 8%.
Applications of Credit Derivatives
The first credit derivative transactions were completed in 1993, and the market surged from
$20 billion to $150 billion in 1997. JP Morgan Securities suggested to BankUS a kind of
portfolio-insurance structure, coined the "Bistro" structure, that would functionally replicate
many of the features of CLO structures.
The Bistro Trust
BankUS would purchase credit protection from an off-balance sheet SPV, named the Broad
Index Secured Trust Offering ("Bistro"), and would use the proceeds to purchase five-year
Treasury securities. BankUS entered into a credit default swap with the Bistro Trust, under
which the Trust would pay a periodic fee in return for a payment equal to the actual write-off
suffered by BankUS on a senior unsecured obligation, or the original par value of a senior
unsecured obligation. The periodic fee would be used to supplement the Treasury coupons to
make interest payments on the Ba2 and Aaa notes, and to make payments into a reserve fund
to cover the first losses incurred by the portfolio.
The Treasury securities matured and provided a pool of funds out of which BankUS would
receive its credit protection payments. The five-year period was a disadvantage from Averse's
perspective, but it provided more time for a "workout value" to be established on the defaulted
debt instruments. BankUS did not actually have to "own" the credit exposure or loan at the
time of the transaction. It just had to specify the 302 reference companies for which it wanted
to buy credit protection, and a maximum amount of credit protection for each.
Averse argued that BankUS had sold off its riskiest exposures through the Bistro transaction
and had set aside enough capital to satisfy the risk capital rules and should therefore be entitled
to relief from the 8% capital requirement.
Conclusion
John Averse sat in his office and flipped through the presentation materials and follow-up
answers that his advisors had provided. He wondered what his objectives should be and which
proposals better met those objectives.
The regime of regulation described in Exhibit 6A had been modified to be more supervisory
rather than directive, and to rely on an "internal (i.e. bank) model" solution to the problem. This
model has to meet certain guidelines set up by the banking regulators.
This amendment requires banks to set aside less capital for assets that it holds in its trading
book than for assets held in the banking book, but regulators have been careful to limit what
can be placed in the trading book. If a firm is in danger of falling into financial distress, it may
want to hedge away some risks. If a firm has a convex tax schedule, hedging its earnings can
reduce its tax burden and increase value. A firm may want to hedge in order to improve its
credit position and take on more debt. This will help the firm budget and plan more effectively.
Loans owned by a bank are sold to an off-balance sheet vehicle. The funds are obtained by
issuing bonds to investors. The loans on the bank's balance sheet are sold to the SPV, which
raises money to buy the loans. The Bank sells loans to an SPV, which issues Ba2 notes yielding
T+375 basis points and Aaa notes yielding T+60 basis points. The Bank retains the remaining
$32 MM. BankUS pays a periodic fee to the SPV which issues two tranches of notes yielding
T + 375 basis points and Aaa notes yielding T + 60 basis points.