Synthetic Funding Structures
Investment banks are increasingly turning to offshore synthetic structured solutions for their funding, regulatory capital and accounting treatment requirements. We saw earlier how total return swaps could be used to obtain off-balance sheet funding of assets at close to LIBOR and how synthetic conduit structures can be used to access the asset-backed commercial market at LIBOR or close to Libor. In this section we discuss synthetic structures that issue in both the CP and medium-term note (MTN) market and are set up to provide funding for investment bank portfolios or reference portfolios of their clients. There are several ways to structure these deals, some using multiple SPVs, and new variations are being introduced all the time.
We illustrate the approach taken when setting up these structures by describing two different hypothetical funding vehicles
Offshore Synthetic Funding Vehicle
A commercial bank or investment bank can set up an offshore SPV that issues both CP and MTNs to fund underlying assets that are acquired synthetically. We describe this here, as Long-term Funding Ltd.
Assume an investment bank wishes to access the CP and MTN markets and borrow funds at close to LIBOR. It sets up an offshore SPV, called Long-term Funding Limited, which has the freedom to issue the following liabilities as required:
* commercial paper;
* medium-term notes;
* guaranteed investment contracts (GICs); these are deposit contracts that pay either a fixed coupon to lenders or a fixed spread over LIBOR;
* repo agreements.
These liabilities are used to fund the purchase of assets held by the investment bank. These assets are purchased synthetically via TRS contracts or sometimes in cash form as a reverse repo trade. The vehicle is illustrated at Figure 3.
The vehicle is structured in such a way that the liabilities it issues are rated at A-1/F-1 and Aaa/AAA. It enables the originating bank to access the money and capital markets at lower rates than it would otherwise obtain in the interbank (unsecured) market. The originator invests its own capital in the structure in the form of an equity piece. At the same time, a liquidity facility is also put in place, to be used in the event the vehicle is not able to pay maturing CP and MTNs. The liquidity facility provides additional comfort to the rating agencies.
The types of assets and liabilities that can be held are described below.
Underlying Reference Assets
The vehicle's asset structure is composed of mainly synthetic securities, accessed using funded TRS contracts. However to retain flexibility the vehicle is also able to bring in assets in cash form through reverse repo transactions.
Possible types of assets that can be acquired by Long-Term Funding Ltd include:
* short-term money market instruments rated AAA;
* bullet corporate bonds rated from AAA to BB;
* structured finance securities including ABS, RMBS and CMBS securities rated from AAA to BB;
* government agency securities, such as those issued by Ginnie Mae, Fannie Mae and Freddie Mac, as well as Pfandbriefe securities;
* secondary market bank loans and syndicated loans rated AAA to BBB.
Reference assets can be denominated in any currency and currency swaps are entered to hedge currency mismatches because the vehicle only issues liabilities in dollars and euros.
As well as the quality of the underlying reference assets, the credit rating of the TRS and repo counterparties is also taken into consideration when the liabilities are rated.
Long-Term Funding Ltd finances the purchase of TRS and reverse repos by issuing CP, MTNs and GICs. The interest-rate risk that arises from issuing GICs is hedged using interest-rate swaps.
The ability of Long-Term Funding Ltd to issue different types of liabilities means the originating bank can access funding at any maturity from one-month to long-term and across a variety of sources. For instance, CP may be bought by banks, corporates, money market funds and super-national institutions such as the World Bank; GIC contracts are frequently purchased by insurance companies.
Multi-SPV Synthetic Conduit Funding Structure
One of the main drivers behind the growth of synthetic funding structures has been the need for banks to reduce regulatory capital charges. While this has been achieved by setting up an offshore SPV that issues liabilities and references assets synthetically, recent proposals, such as FIN46R in the U.S. which changes accounting treatment for SPVs, means this approach may not be sufficient for some institutions. The structure we describe here can reference an entire existing SPV synthetically, in effect a synthetic transfer of assets that have already been synthetically transferred. The vehicle would be used by banks or fund managers to obtain funding and capital relief for an entire existing portfolio without having to move any of the assets themselves.
The key to the synthetic multi-SPV conduit is the CP and MTN issuance vehicle, which is a standalone vehicle established by a commercial or investment bank. This provides funding to an existing SPV or SPVs and acquires the assets synthetically. The assets are deemed as being held within the structure and as such attract a 0% risk-weighting under Basel I.
This structure has the following features:
* an offshore SPV that issues CP into the U.S. and euro markets;
* a synthetic purchase of the entire balance sheet of an existing SPV; the funds issued in the CP market are used to provide a funded TRS contract to the SPV whose assets are being funded;
* the customer realizes funds and also retains the return on the assets; however it benefits from reduced capital charge and no more necessity to mark the assets to market;
* the investment bank originator and CP investors (in that order) offer to wear any losses on the reference portfolio due to credit events or default and the bank earns a fee income for setting up this facility;
* assets and additional SPVs can be added at any time;
* a liquidity facility is in place in the event CP cannot be issued.
Combined Referenced Note & Total-Return Swap Funding Structure
For several reasons, entities such as hedge funds or other investment companies, whether they are independent or part of a banking or bancassurance conglomerate, are not able to obtain funding from mainstream banks directly. Hedge funds, for example, are commonly funded via a prime brokerage facility set up with banks. Put simply, under a prime brokerage the provider of the facility holds the assets of the hedge fund in custody and these assets act as security collateral against which funds are advanced. These funds are used by the hedge fund to pay for the assets it has purchased and are lent by the primer broker at a spread over LIBOR, typically 50-70 basis points. The prime broker also lends assets to cover short positions.
Many investment companies hold positions in illiquid assets, such as hedge-fund-of-funds shares, or other difficult-to-trade assets. It is more difficult to raise funds in the wholesale markets using such assets as collateral, because of the problem associated with transferring them to the custody of the cash lender. The advent of credit derivatives and financial engineering has enabled companies to get around this problem by setting up tailor-made structures for funding purposes. Here we describe an example of a funding or liquidity structure that raises cash in the wholesale market via a note and total-return swap structure that references a basket of illiquid assets.
Assume two entities are part of a bancassurance group: a regulated broker-dealer (Smith Securities) and a hedge fund derivative investment house (Smith Investments Company). The investment house raises funds primarily from its parent banking group; however for diversity purposes it also wishes to raise funds from other sources. One such source is the wholesale markets, via a note and TRS structure, illustrated in Figure 5.
The lender is an investment bank (ABC Bank plc). It is willing to advance funds to the investment company, secured by its assets, at a rate of LIBOR plus 20 basis points. This is a considerable saving on the investment company's cost of funds with a prime broker and comparable with its parent group funding rate. Its assets, however, cannot be transferred as they are untradeable assets and so cannot act as collateral in the normal way.
Instead we structure the following in order to enable the funding to be raised:
* ABC Bank plc does not lend funds directly, instead it purchases a two-year note at a price of par. The return on this note is linked to the performance of a basket of assets held by Smith Investment Company. As Smith Investment Company is an unregulated entity, it cannot issue a note into the wholesale markets. Therefore the note is issued by its sister company, Smith Securities;
* the funds raised by the sale of the note are transferred, in the form of a loan, from Smith Securities to Smith Investment Company at LIBOR flat;
* simultaneously the two companies enter into a TRS arrangement, with start and maturity dates matching the note. Under this TRS, Smith Securities receives the performance of the basket of assets, and pays LIBOR flat;
* also, Smith Investment Company and ABC Bank plc enter into a TRS arrangement whereby the bank pays the performance of the basket of assets and receives LIBOR plus 20 basis points.
The net cashflow of this structure is Smith Investment Company pays ABC Bank plc LIBOR plus 20 basis points and raises funds via the proceeds of the note issue by Smith Securities. The economic effect is that of a two-year loan from ABC Bank to Smith Investment Company, but because of legal, regulatory, operational and administrative restrictions we need to have the structure described above to affect this.
Note that under some jurisdictions, it is not possible for group companies to make inter-company loans, particularly if the two companies are incorporated in different countries, without attracting withholding tax on the loan. For example, it may be inter-company loans must be of under one-year maturity. To get around this, in Figure 1 we have shown the loan from Smith Securities to be a one-year loan, which is then rolled over for another year on maturity.
The market in credit derivatives has seen significant progression since its inception as, essentially, a hedging tool for banks. The development of synthetic structured products has enabled a wider range of participants to enter the market and access wider opportunities for disintermediation.
We have shown how, by structuring a vehicle using synthetic securitization technology, Treasury desks--not hitherto large users of credit derivatives--have been able to access the money markets in a way that would not have been possible previously. The vehicles we have described here enable financial institutions to conduct asset-liability and liquidity management on a more flexible basis. They also enable other financial institutions to obtain funding for assets that are illiquid or untradeable.
The rapid expansion of the credit derivatives market has occurred during a period that has seen market corrections, large-scale market defaults and subsequent improving credit fundamentals. As more and more reference names, as well as structured finance, high-yield and other assets are traded synthetically, we can expect to see more frequent application of these products by banks and other financial institutions for balance sheet management purposes.
This week's Learning Curve was written byMoorad Choudhry, a visiting professor in the Department of Economics atLondon Metropolitan Universityand co-founder of YieldCurve.com.