Wall St bankers revive CDOs in derivatives battle

Written by Bloomberg | Updated: Jan 30 2011, 04:30am hrs
Three years after collateralised debt obligations helped trigger the worst financial crisis in 70 years, Wall Streets math wizards are exploring how to use them to deflect rules intended to prevent the next crisis.

Credit Suisse Group AG traders are testing a risk model that may help them reduce capital charges imposed by the Basel Committee on Banking Supervision on derivative products. Claudio Albanese, a quantitative economist who is advising the lender on the plan, says it could also help banks to limit one of their biggest risks by allowing them to offload through a CDO the risk that one of their trading partners, or counterparties, defaults.

Critics say such CDOs could trigger a new crisis. In theory, its a great ideajust like the CDOs of subprime debt that caused the financial crisis, said Richard Werner, professor of international banking at the University of Southampton.

Albaneses plan shows how banks are likely to try and mitigate rules that impose higher capital requirements on their operations and threaten profit, according to Charles Freeland, a former deputy secretary general of the Basel Committee. The Basel rules may cut the return on equity by more than half for some derivatives, forcing some banks to stop arranging those types of transactions, according to Kian Abouhossein, a banking analyst at JPMorgan Chase & Co. in London. The tougher the rules are, the more the incentive there is for bankers to arbitrage them, Freeland said.

In derivative trades such as interest-rate swaps, a bank agrees with a client to exchange payments, allowing one to pay a fixed interest rate and receive a floating rate and the other the reverse. Banks charge the client for the risk it might default and be unable to meet its obligations over the life of the agreement. The new capital charge, which banks must implement by 2013, may force banks to put aside at least two to three times more capital than under the earlier rules, said Jon Gregory, a partner at Solum Financial Partners LLP, a London-based financial advisory firm, based on estimates he helped to draft for banks.

Securitizations such as CDOs are one of the potential channels that could lead to products that allow banks to trade counterparty risk, Merlushkin said. Frank Iacono, a former Morgan Stanley credit derivatives banker says hes considering creating products that let banks trade their counterparty default risk. Ex-Citigroup banker Shankar Mukherjee is trying to get a credit rating that would allow his firm, Novarum Group, to sell contingent credit default swaps, a form of insurance, to lenders. His contingent credit default swaps would allow the buyer to recoup the actual loss on a derivative when a counterparty defaults.

These transactions, in their general form, will look more attractive post-Basel III, said David Murphy, London-based head of risk and reporting at the International Swaps and

Derivatives Association, which represents more than 800 organisations active in the derivatives market. Because of the higher capital charge Basel III will impose, there will be more benefit from hedging the risk and hence freeing up capital.

Regulators said they will carefully scrutinize banks attempts to remove risk from their balance sheets. The Basel rules are transforming traders interest in rules and risk, elevating the role of risk officers. One measure of risk traders are focusing on is value at risk, a gauge of the average amount the bank could lose on any given day.