Does your CVA hedge generate CVA? April 26, 2012 at 9:10 am

Yes, it (often) does. Credit Suisse offers us an example. First, what we know, from CS themselves.

In 1Q12, we entered into the 2011 Partner Asset Facility transaction to hedge the counterparty credit risk of a referenced portfolio of derivatives and their credit spread volatility. The hedge covers approximately USD 12 billion notional amount of expected positive exposure from our counterparties, and is addressed in three layers:

  1. first loss (USD 0.5 billion),
  2. mezzanine (USD 0.8 billion) and
  3. senior (USD 11 billion).

The first loss element is retained by us and actively managed through normal credit procedures. The mezzanine layer was hedged by transferring the risk of default and counterparty credit spread movements to eligible employees in the form of PAF2 awards, as part of their deferred compensation granted in the annual compensation process.

We have purchased protection on the senior layer to hedge against the potential for future counterparty credit spread volatility. This was executed through a CDS, accounted for at fair value, with a third-party entity. We also have a credit support facility with this entity that requires us to provide funding to it in certain circumstances. Under the facility, we may be required to fund payments or costs related to amounts due by the entity under the CDS, and any funded amount may be settled by the assignment of the rights and obligations of the CDS to us. The credit support facility is accounted for on an accrual basis.

Basically, then, three parties own the credit exposure on CS’s OTC derivatives portfolio: the bank themselves, their employees, and a senior hedge provider. Selling the mezz to the employees (in lieu of bonus) is really smart as it gets around all sorts of disclosure and alignment of incentives issues associated with a third party hedge.

What’s left is presumably AAA risk or pretty close. But – and here’s the rub – the hedge provider has written a CDS on it. That’s an OTC derivative. So that generates CVA. Moreover like any senior tranche, while losses on it might be unlikely, there can be serious MTM volatility. So I bet, to keep the CVA down, CS has got its counterparty to agree to daily cash collateral but the counterparty, worried about the liquidity implications of this, has got CS to agree to lend it the money. It’s just a round trip. CS’s loan book lends money to the counterparty, who post it straight back as collateral under the CDS. Look, no CVA on the hedge, and all of our capital requirements on the CVA are gone. Magic, isn’t it?

(HT Dealbreaker.)

6 Responses to “Does your CVA hedge generate CVA?”

  1. So if you convert CVA into a loan, there’s no CVA charge on the loan … but there’s still a capital charge for credit risk on the facility/loan, right? It’s just not a capital charge *for CVA*. And there ought to be liquidity charges too?

  2. Magic! It brightens my day.

  3. Somewhat different risks and structure, but reminiscent in concept of Barclays’s Protium deal, which also involved (ex) employees. Converting MTM to accrual accounting through a something disguised as a loan. A CDS in one case, equity in the other. Of course, Barclays ended up unwinding Protium fairly quickly when the accrual accounting didn’t work out.

  4. @Phil – Yep, you have indeed done magic. Derivatives = fair value = CVA charge; loan = historic cost accounting = no CVA. (Drum roll, audience applauds.) Of course, financing someone to buy your risk isn’t really risk transfer as such, but who cares about that?

    @Ginger – Agreed, it is the same basic technology as Protium.

  5. To me the best comparison I can think of is the finite reinsurance deals between AIG and Gen Re that got them into so much trouble. The key difference, of course, is that AIG did not disclose it properly but CS did, so I’m not suggesting there is anything legally improper in CS’s approach.

    However I’m not sure if your suggestion about the collateral is the full story. I’m particularly interested in the words: “and any funded amount may be settled by the assignment of the rights and obligations of the CDS to us”. In other words, CS is not only funding its own risk, it appears to me to be assuming it as well – eg if the contract makes a loss for the counterparty, not only will CS provide the liquidity, the ‘repayment’ of the loan can be made in terms of the loss-making CDS, even though the CDS value may be minimal or negative. In my experience “may be settled” normally implies that there is a definite option of this kind built into the loan, although I accept it is not really clear.

    In fact, I think the description given is even consistent with the idea that the ‘third party’ may be an orphan SPV, as if I am correct it would not really need any financial resources of its own. I may be assuming too much from a relatively short description though.

  6. JH – Yes, you are right, that ‘and any funded amount may be settled by the assignment of the rights and obligations of the CDS to us’ language _is_ interesting. Hmmm, I need to dig into that a bit…