Monday, April 25, 2016

Rogue Bonds

We received a couple of calls late last week about the securitization structure (or catastrophe or "cat" bond) deal that Credit Suisse is preparing.

We haven't seen the deal docs, but from what we understand and have read, the concept is interesting:

Credit Suisse would free up some capital by insuring itself (by way of the bond sale) against certain operational risks, like fraudulent transactions, trade processing errors, regulatory or compliance shortcomings ... or the all-important concern of rogue trading, which caused JPMorgan and SocGen a pretty penny (just look up London Whale or Jérôme Kerviel).

We understand that CS would issue a two-tranche securitization, reportedly backed by a 700 million franc policy from Zurich Insurance Group.  Zurich would retain the first 10% of the risk, with the senior notes being sold off by way of a Bermuda vehicle.  From the reports we've seen, the senior notes would attach at losses of $3.6 billion and detach at losses of $4.3 bn. It's not immediately clear to us whether Credit Suisse would stomach losses above $4.3 billion, but that would seem unlikely ... we assume there's more to it than is publicly known at this time. 

Operational Risk, or What Credit Suisse Will

There are some serious questions.

It would seem Credit Suisse would have a massive informational advantage over the other side: they would know their operational strengths and weaknesses better than anybody else.   That's okay, as long as it's well understood.  

But the real questions start when there is a loss, 

Can one always put a value on the operational portion of the cost, easily separating out all of the factors?   Suppose for example that a loss is magnified as the market turns against a bank while it was slowly extricating itself from a large, unauthorized trade -- as happened in the case of JPM's London Whale?  Is that additional writedown the fault of the bank or the operational shortcoming?  How much of the supposedly unauthorized trade would have been "okay" and how much was "unauthorized"?  One issue here is that the party that knows best if probably Credit Suisse ... but it may often be a conflicted party, benefiting directly or indirectly through the decisions in makes in quantifying the losses.  

Next, the category of operational risk can be difficult to define, and items may fall in the grey zone. Might CS, knowing it has insurance, be more likely to categorize the marginal loss as operational?

And might it change Credit Suisse's approach to fixing up an issue to the extent it knows of certain insurance providers' interests or exposure?  At worst, knowing that they're insured, might they be less particular about buffering against the risk?  Could that create an adverse incentive from a cultural perspective? 

Banks might not need a second invitation!

If this all goes wrong ... we're insured!  Double down!  Lock and load!

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