Capital Relief Trades: Structuring Considerations For Synthetic Securitizations (A Three-Part Series Providing A US And UK Perspective)

Why Are US Banks Interested in Synthetic Securitizations?

A US bank may be interested in a synthetic securitization for a variety of reasons, including risk mitigation through the sharing of credit risk with investors or financing assets that cannot easily be sold or transferred in a traditional securitization. However, the primary reason for engaging in a synthetic securitization is typically the release of capital.

Under the US capital rules,1 banks are able to reduce risk-based regulatory capital required for residential mortgage and other loan portfolios by converting exposures from wholesale or retail exposures to securitization exposures. This is due to the fact that the risk-weight under the US capital rules for typical senior securitization exposures is 20 percent, while the risk-weight for most other exposures is 100 percent for banks using the standardized approach.2 That means a senior securitization exposure can have required capital of 1/5 the amount required for holding a position in the unsecuritized loans. This result makes sense given that credit risk has actually been transferred in typical securitization transactions. However, in this regard, not all securitizations are treated equally, at least not under the US capital rules.

Operational Requirements under US Capital Rules

The operational criteria for traditional securitizations under US capital rules differ from those under the Basel framework in a way that can create a significant relative disadvantage to US banks. The operational criteria for traditional securitizations under the US capital rules require that the underlying exposures not be on the transferring bank's consolidated balance sheet under GAAP.3 In contrast, the Basel framework requires, among other requirements, that a traditional securitization include a transfer to third parties of a "significant credit risk associated with the underlying exposures," but does not require that the underlying exposures be removed from the transferring bank's balance sheet.

Unlike the operational criteria for traditional securitizations under US capital rules, the operational criteria for synthetic securitizations under the US capital rules do not require off balance sheet treatment (but do require some transfer of credit risk in the underlying exposures). As a result, engaging in a synthetic securitization and recognizing the use of a credit risk mitigant to hedge underlying exposures provides a potential means of capital relief.

Because a synthetic securitization does not remove the underlying assets from the balance sheet of the transferring bank, the bank will look to the rules regarding credit risk mitigation to determine the resulting capital treatment of the exposure it holds in relation to the transferred tranche of credit risk. This normally will be a zero risk-weight if the exposure is secured by financial collateral (i.e., cash on deposit including cash held by a third-party custodian or trustee) or it will be a risk-weight corresponding to the risk weight for the counterparty providing the guarantee or credit derivative, if that counterparty is an "eligible guarantor"4 under the US capital rules.

As an initial matter, in order to constitute a "synthetic securitization," as defined in the US capital rules, a transaction must meet the following requirements:

All or a portion of the credit risk of one or more underlying exposures is transferred to one or more third parties through the use of one or more credit derivatives or guarantees; The credit risk associated with the underlying exposures has been separated into at least two tranches that reflect different levels of seniority; Performance of the securitization exposures depends upon the performance of the underlying exposures; and All or substantially all of the underlying exposures are financial exposures (such as loans, commitments, credit derivatives, guarantees, receivables, asset-backed securities, mortgage-backed securities, other debt securities, or equity securities).5 In addition, the bank must also satisfy the operational requirements for synthetic securitizations,6 including that the credit risk mitigant is one of the following three options: (1) financial collateral, (2) a guarantee that meets all criteria as set forth in the definition of "eligible guarantee"7 (except for the criteria in paragraph (3) of the definition) or (3) a credit...