FleetBoston Financial is considering entering two novel structured credit transactions to hedge risk. The firm is in talks with commercial banks about exchanging some of the risk in its corporate credit portfolio with another firm in a direct swap without the intermediation of a broker. This would be a low cost way of hedging risk and diversifying the book, noted Robin Lenna, managing director in credit capital management in Boston. If it goes ahead the transaction will likely have a notional size of USD500 million-USD1 billion, she said.
In the appropriately named risk exchange, Fleet would buy protection on names in its portfolio and sell protection on names in its counterparty's portfolio, while trying to make the risks on both legs equal, Lenna explained. Typically no dealer sits in the middle of the exchange and no fees are exchanged, she said.
The risk exchange benefits both parties by diversifying their respective exposures for a lower cost than entering an OTC transaction, although firms need to be careful about their new exposures, Lenna said. For example, if Fleet were to make an agreement to exchange portfolios with a European counterparty it would need to be comfortable taking on European risk, which is outside of its geographic footprint. For this reason the firm would more likely choose a U.S. partner.
Alex Reyfman, credit derivatives strategist at Goldman Sachs in New York, said risk exchanges have all the pros and cons of bartering. The main drawback is the difficulty in finding the right partner. The strategy is a useful complement to the OTC credit derivatives market but firms will continue to have residual risk that will need to be shifted through more traditional trades, he added.
Fleet is also exploring taking out second-loss credit protection for the first time. This would be on its sector specific portfolios, such as commercial real estate, Lenna said. Under this hedge Fleet would take the first hit, and absorb losses on individual names, but would be protected against widespread defaults. These portfolios are strategically important and such a strategy would be prudent risk management, said Lenna, noting that the process is still in the early stages. Lenna declined to give the size of such portfolios but noted they are in excess of several billion dollars.
