Fudge or fix?

Barclays announced in September it had sold $12.3 billion of credit assets to a newly established fund called Protium Finance. The acquisition was largely financed by a loan from Barclays, meaning the bank has insulated itself against further mark-to-market volatility but risks losses if Protium is unable to repay the loan. Does this present a model for other banks? Christopher Whittall investigates

Governments across the globe have collectively spent trillions of dollars to help prop up ailing banks via capital injections, pump liquidity into the financial system and breathe life back into economies through a hotchpotch of stimulus packages. But so far, initiatives to rid bank balance sheets of the toxic assets that helped trigger the crisis have been limited.

Although many have made use of the US Term Asset-Backed Securities Loan Facility or looked to reduce the size of balance sheets by selling problem assets on a piecemeal basis, there have been few large-scale attempts to offload whole structured credit portfolios. The last big transfer of assets occurred in July 2008, when Merrill Lynch sold a large chunk of its collateralised debt obligation of asset-backed securities (CDO of ABS) portfolio to a private equity firm (Risk September 2008, pages 21-23). Banks have individually reported billions in writedowns, yet many appear to be either tackling the problem bit by bit or hoping to ride out the storm - more so now some analysts have claimed a bottom appears to have been reached on mortgage-backed assets.

UK bank Barclays has bucked this trend. On September 16, it announced it would sell structured credit assets with a notional value of $37.8 billion to a Cayman Islands-based fund called Protium Finance for $12.3 billion. Protium is run by C12 Capital Management, a New York-based asset manager headed by two ex-Barclays employees. Crucially, the purchase of the assets is largely funded by a $12.6 billion loan to C12 from Barclays itself.

The deal received extensive coverage in analyst reports and the media, with some parts of the press deriding the deal as the kind of financial jiggery-pokery that sparked the crisis in the first place. As Barclays shares on the London Stock Exchange leapt from 369p on September 15 to 380p the next day, rival bankers scrambled to make sense of what some perceived to be little more than an attempt to avoid mark-to-market accounting.

"It's a complete accounting fudge: there is no risk transfer whatsoever. And structuring this so the asset manager gets paid first makes no sense at all," remarks one London-based head of credit trading.

According to a statement released by Barclays on September 16, Protium is supported by $450 million of funding provided by the fund's partners, as well as the Barclays loan. The loan itself has a maturity of 10 years and is priced at Libor plus 275 basis points - a rate that will amount to a cumulative total of $3.9 billion, the bank said. The $450 million of funding comes through the issue of limited partner interests, which will entitle the holders to fixed payments of 7% a year for 10 years and will be amortised in equal instalments over five years.

The cashflows from the assets will be used first to service payment of management fees and distributions to the partners, followed by payment of interest and principal on the Barclays loan - something that has been criticised in parts of the financial press. Any excess cash remaining in the fund at the end of 10 years will go to Protium's partners, with Barclays not sharing in any further upside - again, something criticised by some analysts.

The bank declared the sale would mitigate the potential impact of short-term movements in market values on its balance sheet and, by effectively transforming its exposure into a loan, would deliver more stable risk-adjusted returns. The deal will enable Barclays to derecognise the assets, although the bank stressed the assets will remain on its balance sheet for regulatory purposes - meaning the transaction will not reduce regulatory capital. It also said it would continue to disclose the fair value of the underlying assets, as well as any "appropriate information" on the valuation of the loan to Protium.

"The financial reporting view of these assets has been represented by their fair value, which changes as credit spreads and other factors move. It has been our view for 12-24 months to look at the underlying cashflows on these assets as representing the real and economic value - that's how we do our credit risk. Because of the accounting regime we operate in, we felt it was difficult for investors to understand what these assets are worth, where we see the economic value, as well as what our intentions are," says a senior banker at Barclays in London.

"Protium creates a much more stable risk and return platform for the management of these assets and also locks us into continued access to a really good management team. And significantly, it represents to investors what we think the assets are worth and what we should realise from our $12.6 billion loan against them and the significant interest payment we expect to receive," he continues.

The expertise at C12 in managing the assets was one of the key attractions in doing the deal, says the banker. A direct spin-off of Barclays, C12 is run by Stephen King, former head of Barclays' principal mortgage trading group (PMTG), and Michael Keeley, previously a member of Barclays' management committee. Under King, PMTG managed the Protium assets in the years leading up to and during the credit crisis. C12 has siphoned off a significant portion of this team to continue to manage the assets: the new firm consists of around 65 employees, with 45 having made the transition from Barclays.

The genesis of the deal itself was lengthy. Over the previous two and a half years, King met Barclays' senior management on a weekly basis to discuss the performance of the structured credit exposures. Barclays had been considering various options for some time, but it wasn't until early 2009 that discussions around a Protium-type scheme intensified.

"Post-Lehman, the world became a very nasty place. Going into February to March of this year, there was just no bid for many of these assets. We were making decisions around that time about what we should keep, what we should sell and what's next, and the plan was really born out of that," says one person familiar with the transaction.

The negotiations around the valuation of the assets provided an obvious conflict of interest: having managed the assets over the past few years, King was effectively both buyer and seller. Barclays maintains it kept an extensive backlog of monthly marks taken on the assets going back several years, which have been verified for financial reporting by middle office, valuation committees and independent auditors.

The partitioning of C12 from Barclays began in early June, when King and Keeley signed contracts precluding them from representing Barclays on an official level outside the bank. The team that was to become C12 was physically moved to a different area in the office and no longer had access to certain trading books and information. Meanwhile, Keeley and King stopped attending high-level meetings in the bank.

The benefits to C12 are readily apparent: the funding provided by the partners of Protium is repaid first, and once the Barclays loan is paid back, the partners receive all additional upside on the assets. With many of the assets marked down by 50% or more, this represents a potentially sizeable future payday. However, King and Keeley emphasise different benefits of the transaction for their new firm - specifically, the creation of an independent platform with the ability to purchase other legacy assets and to utilise the intellectual property inherent in that platform. C12 retains the trading team and the systems developed within the PMTG at Barclays.

There is, however, one aspect of the deal that Keeley and King feel has been wrongly described as being unusual: the payment of management fees prior to interest and payment on the loan. In fact, one equity analyst lent credence to the claim of a national newspaper that the Protium deal is a cunning ruse to avoid compensation restrictions on UK bankers. C12 deny this accusation, pointing out the payment of manager fees as a priority is standard practice in the fund management business. Keeley and King also argue that no financial institution would sell more than $12 billion in assets as a way of compensation planning.

For Barclays, shareholder opinion will ultimately be the litmus test for the Protium deal. So far, the senior banker says shareholders have been "generally positive" on the transaction, a sentiment some bank analysts tentatively share.

"By and large, I think the market is happier to see some of these assets being removed and replaced by a more predictable set of cashflows rather than the mark-to-market swings. We don't know precisely what the annual cashflows are, but we've now got an indication of the aggregate cashflows," says Mike Trippitt, banks analyst at Oriel Securities in London.

But this is far from the consensus view. Many analysts question the wisdom of a deal that fails to insulate the bank against credit risk, does not free regulatory capital and largely removes the potential upside to be garnered from the assets. Some analysts believe Barclays must have a negative view on the monoline sector, highlighting the roughly $8.2 billion of structured credit assets wrapped by monoline insurers included in the sale. This embraces $2.08 billion of monoline-insured residential mortgage-backed securities, $2.45 billion of wrapped commercial mortgage-backed securities and $752 million of monoline-insured collateralised loan obligations. Barclays declines to comment on whether it fears further deterioration of monolines, but the September 16 statement stated the deal would mitigate the potential impact of short-term movements in market values and monoline downgrades.

Monoline speculation aside, it is widely accepted the Protium transaction was designed to switch one kind of accounting treatment - mark-to-market valuation of the structured credit assets held on its balance sheet - for another. In this case, the loan would be reported on an amortised cost basis.

"This is management of the mark-to-market volatility - this is not real value to the shareholders. The only conceivable value to shareholders is cynical in my view: that the public market may see Barclays' quarterly net income is not as volatile as it used to be, and as markets like it when earnings are less volatile, the share price may go up," says one US-based consultant.

The debate over the value of mark-to-market accounting, and whether it exacerbated the crisis by forcing banks to mark illiquid assets at distressed market prices, has been raging for some time. But the senior banker is quick to dispel any suggestion the Protium deal is an indirect criticism of accounting standards. "It was not intended in that way at all - it wasn't even 1% of our thinking. We think fair-value accounting for appropriate assets is very valuable and the right thing to do," he says.

He also bats aside the accusation that Protium is nothing more than a mark-to-market avoidance vehicle, stressing the fair values of the underlying assets will still be disclosed. "This is not an accounting reclassification exercise. That has been available under International Financial Reporting Standards, and some banks have used that option. We have not done that for these assets. This is a transaction, and we think the way it is set up today will give an analyst or an investor a much better picture of what the value of these underlying cashflows are," he says.

The International Accounting Standards Board (IASB) modified its rules in October 2008 to allow banks to reclassify non-derivative financial assets out of the ‘fair value through profit and loss' category in certain, rare circumstances. The rule change also allows an asset in the available-for-sale category to be transferred to loans and receivables if the bank has the intention of holding the asset for the foreseeable future (Risk January 2009, pages 83-85; Risk May 2009, pages 47-50).

However, there is still plenty of uncertainty about the future rules on classification. In October, the IASB confirmed it would cut the number of measurement categories from four to two, following a consultation period that began in July (Risk August 2009, page 15). Under the new rules, expected to be mandatorily adopted from 2012, an asset or liability would be measured at amortised cost if the instrument has basic loan features and is managed on a contractual basis. Otherwise, it would be measured at fair value with changes reported in the net profit and loss.

Regardless of the motives, the fact remains that the accounting treatment for a significant portion of Barclays' structured credit exposures has changed. At June 30, 2009, the fair value of the assets included in the Protium transaction was $12.1 billion, increasing to $12.3 billion by the time of sale. The assets included in the deal represented a pre-tax loss of £1,193 million in 2008. In that year, the profit before tax of Barclays Group was £6,077 million.

In future, the $12.6 billion loan, secured by a charge over the assets of Protium, will be measured at amortised cost. As a result, Barclays will not be subject to fluctuations in market prices, but will still be exposed to the credit risk of the structured credit portfolio, as the ability of Protium to repay the loan will be dependent on the cashflows of the underlying assets. As things stand, if there is objective evidence to support an expectation of default on the expected cashflows, Barclays will be required to recognise an impairment on the loan under International Financial Reporting Standards (although a proposal due from the IASB at the beginning of November could force banks to recognise and reserve for losses earlier). In other words, Barclays maintains downside exposure, up to the value of the loan.

Barclays has said it has confidence in the cashflows generated by the structured credit assets, but wanted to achieve more stable risk-adjusted returns given the multi-year duration and cashflow characteristics of the assets. However, some in the market are sceptical on this point. "If the marks are clean, why give away the upside?" asks one London-based head of investment banking.

There has also been criticism of the pricing of the loan itself. Several structured credit analysts estimate the loan should have been priced at around 400bp over Libor as opposed to 275bp. The senior banker shrugs off such criticism, noting that Barclays and its auditors are both "comfortable" with the loan and its pricing. He adds the loan has been modelled to be able to withstand "significant stress".

"Barclays has kept the clear majority of the upside, and that comes in the Libor plus 275bp interest payments the term loan is going to generate. Over the past two years, we have received two forms of criticism. One is we are not fairly recognising the losses on our books and should be writing everything down further. The other is we're selling these assets at very low values and giving away the upside. These things cannot both be true. We believe this transaction helps demonstrate the value of these assets as driven by their cashflows," the senior banker says.

That doesn't prevent analysts from hypothesising, however. Paul Noring, managing director at Washington, DC-based risk consultancy Navigant Consulting, offers one view: "As Barclays indicated, this transaction was profit-and-loss neutral - it implies the current marks were spot on. However, even with the recent spread-narrowing, 275bp over Libor for a loan levered 28-to-1, collateralised by these types of assets, seems low. Therefore, I suspect there may be some trade-off between the eventual downward mark pressure and the resulting yield on the loan."

Elsewhere, some bankers question the wisdom of selling at a time when market sentiment on distressed assets appears to have improved in recent months. Those involved in the deal counter that Protium wasn't conceived overnight, and the rally in certain securities is still in its nascent stages.

Nonetheless, Ashish Dev, managing director at New York-based risk consultancy Promontory Financial, believes this lack of participation in future upside would be a major sticking point for other institutions interested in following the Protium model. "Post-December 2008, the idea of having basically no upside participation and still having the downside exposure is not palatable to most banks," he says.

Barclays says taking equity in Protium was not a good option, as it may have been seen to compromise C12's independence in managing the portfolio. Lawyers say it also may have hampered Barclays' attempt to derecognise the Protium assets. Instead, Dev and his colleague John Costa, chief executive of Promontory Asset Finance, suggest triggers could have been built into the $12.6 billion loan that would permit upside participation if the internal rate of return in Protium exceeded a predetermined level.

Other bankers, consultants and analysts have proposed alternative amendments to the Protium structure. One consultant, for instance, believes Barclays should have tried to syndicate the loan, as this would have demonstrated the market took the same view as Barclays on the underlying cashflows. Others have drawn attention to the assets not being auctioned in a competitive bid.

Faced with this criticism, the senior banker stresses the structure was designed with simplicity, expediency and suitability in mind, and insists Protium was not the only avenue the bank considered before making its decision. Triggers in the loan would have overcomplicated the structure, and Barclays was looking to keep it as simple as possible, he says. Syndication is a good idea in theory, he continues, but in reality it would have been difficult to co-ordinate the various banks. And a competitive bid would have prolonged the disposal process and ultimately could have led to "a train wreck", he adds.

On this last point, most analysts agree dumping a large portfolio of assets in a market lacking depth would be hard to disguise as anything other than a fire-sale. And while detractors of the deal point to ready appetite for these kinds of assets among some private equity firms, most analysts concur the $12.3 billion price tag would have been difficult to achieve.

Having completed one deal, some analysts have suggested further sales will materialise. Barclays still holds a considerable amount of structured credit assets on its balance sheet, including $2.5 billion of US subprime and Alt-A securities, $3.7 billion of super-senior CDO of ABS tranches, and $962 million of structured investment vehicles (SIVs) and SIV-lites. Barclays has confirmed it is considering further disposals under a number of different structures.

King and Keeley are keen to stress their independence from their former employers, and confirm there are ongoing discussions with other financial institutions about the services they provide.

The jury is still out on whether Protium provides a viable model for other institutions to replicate. Opinion among industry participants is very much divided. Nonetheless, even some of Protium's fiercest critics refused to rule out using a comparable structure in the future for their banks. Others see some sense in the transaction.

"It makes sense - it's not a bad way to stabilise your earnings volatility. Barclays has not bought first loss protection on the assets, but restructured the position and taken the risk back in loan form," says Jerome Wong, head of credit structuring at BNP Paribas in New York.