Don’t cry for me, Credit Suisse March 1, 2013 at 6:52 pm

Matt Levine is sad:

Today is a dark day.

His grief is for PAF2, an innovative regulatory arbitrage ahem I mean risk transfer deal whereby CS had their bonus pool write protection on a mezz tranche of derivatives receivables to get CVA capital relief. Or not. This deal probably wouldn’t have worked in most jurisdictions, and even in Switzerland it seems that its days are numbered. As IFRE tells us:

Credit Suisse may be forced to scrap or, at the very least, radically restructure [the deal]

The problem is that CS had to get protection on the senior to get relief, and no one really wanted to write that for what CS wanted to pay, so CS had to reduce the liquidity risk of the senior CDS by agreeing that if there was ever a payment on the senior, they would lend the counterparty the money to make it. So if the world goes to hell and CS lose a lot of money on counterparty credit risk – really* a lot of money – then they make a claim on the senior CDS which CS’s counterparty pays with money they have just borrowed from CS**. Um. Is that risk transfer?

As Matt says, Basel says no. Hence the problem.

Now, unlike Matt, I’m not sad, because this deal should never have worked. Regulatory arb that finds a clever way to transfer risk at the right price in order to exploit mis-designed rules is fair enough; reg arb that purports to transfer risk but doesn’t seems to me to be basically an arb not of the rules but of the regulator’s understanding of the trade. Unless, that is, they understood it but didn’t see the problem, in which case we have a bigger issue.

*Matt seems convinced that the senior attachment point was so high there was practically zero risk in the senior; I haven’t seen the trade details so I don’t know, but I will say that wrong way and concentrated sovereign risks can be significant in derivatives receivable securitisation structures, so one would want to be rather careful about the modelling before asserting something like that.

**And which, it appears, they can ‘pay back’ – in a very loose sense – by assigning the CDS back to CS.

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