Understanding Bank Returns on Derivative Transactions with Corporate Counterparties July 10, 2014
Overview Recent regulatory changes, including Basel III, are have far reaching implications for banks pricing of derivatives to end users such as corporations and private equity sponsors. In this environment. Nauset Derivative Advisory concentrates on working with end users to reduce derivative related funding costs on new and existing hedge positions. Nauset has a special emphasis on reducing credit charges brought about by Basel III and CVA, and in executing in illiquid underlyings. Nauset Derivative Advisory 2
Interest Rate Swap Pricing Determinants I. Market Swap rate the price at which a bank would transact with a collateralized counterparty Government bonds Swap spreads Basis Swap II. Swap Credit Spread Adjusts the market price for banks analysis and pricing of counterparty credit risk. Return on Equity Capital Regulator driven Pricing varies widely varies amongst global banks Credit Value Adjustment (CVA) Market price of credit Driven by credit spreads, PD, and LGD The all in swapped rate payable by a Corporate Counterparty is the sum of Market Swap rate and Swap Credit Spread Nauset Derivative Advisory 3
Top Line Revenue $100mm 10 year Interest Rate Swap (PV01= $89,800) I. Market Swap rate the price at which a bank would transact with a collateralized counterparty Bank executes with Corporate at: 2.68% Bank offsets risk in market at: 2.67% Execution revenue (1 bp) $89,800 II. Swap Credit Spread Adjusts the market price for banks pricing of counterparty credit risk. Credit Spread for BB counterparty 0.20% Swap credit spread revenue (20 bp) $1,796,000 Bank revenue derived from Swap Credit Spread is significant. Corporations should have a method of analyzing bank returns when negotiating spread. Nauset Derivative Advisory 4
I. Market Pricing and Execution in Less Liquid Underlyings
Competitive pricing via multiple bids SWAP SPREAD VOLATILITY 30 YEAR SPREAD Execution History/Market Risk to End User Requesting multiple bids in illiquid underlyings moves market against end users. In May 2012 30 swap spreads narrowed and provided an attractive opportunity for fixed rate payers. A corporate counterparty attempted to benefit from low Canadian swap spreads late May. However, asking multiple counterparties for pricing resulted in the market moving from 7 bps to 32 bps (approx notional $500mm) Based on $500mm notional and 25bps execution slippage, incremental hedging cost to the Corporate Counterparty had PV ( Loss ) of $23.775mm ( 25bps x $951,000 PV01) Attempting to achieve best price execution by way of multiple bank bids is self defeating Nauset Derivative Advisory 6
Market Pricing and Execution Considerations 1) Bidding by multiple banks will adversely move the market 2) Banks without capabilities in Canadian curve (or other Illiquid underlyings) have no natural offsets, and will offer inferior pricing 3) Limiting the number of execution providers will eliminate the adverse movements associated with transacting in illiquid sectors of curves. 4) In many cases, savings may be achieved by appointing a sole execution provider 5) Third party verification is required to ensure end price shown to client is consistent with inputs (government bonds, swap spreads) at time of execution. Nauset Derivative Advisory provides Execution Advisory expertise to ensure end users achieve best market pricing. Nauset Derivative Advisory 7
II. Swap Credit Spread Equity Capital Credit Value Adjustment (CVA)
Swap Credit Spread Equity Capital COUNTERPARTY CREDIT RISK (CCR) CHARGE Derivatives exposures are calculated over the contract s life to determine a loan equivalent value for purposes of applying equity capital. The CCR risk charge (aka Default Risk Capital charge) takes into account MTM movements in the underlying derivative and adjusts for credit risk of the corporate counterparty. CREDIT VALUE ADJUSTMENT (CVA) RISK CAPITAL CHARGE Basel III introduced a CVA Risk Capital Charge to cover the risk of MTM losses on expected counterparty risks (ie. CVA adjustments) This in addition to the already existing Default Risk Capital requirement for CCR (the CCR charge) determined on models prescribed in Basel I through III, is significantly increasing the derivative credit spread charged to end users Conflicting adoption of Equity Capital models by global banks is resulting in divergent credit spread pricing to End Users. ( regulatory arbitrage ) Nauset Derivative Advisory 9
Swap Credit Spread Credit Value Adjustment Credit Value Adjustment ( CVA ) is the market price of taking counterparty risk over the life of a OTC derivative transaction Used by banks as a cost of taking counterparty credit risk over the life of a derivative contract. Complex for banks to price and hedge, resulting in pricing disparity among global banks. >Recovery rates >Default Probabilities >Cross asset nature of books / Netting >EPE/ENE >Hedge Treatment >Termination Events Cost to banks of facing a counterparty over the life of a derivative heavily assumption driven Nauset Derivative Advisory 10
Swap Credit Spread CVA and Profitability Bank A Bank B Counterparty Credit Spread (10 year) 300 bps 300 bps Bank Credit Spread (10 year) 109 bps 169 bps Exposure Assumption Base Case 10% lower (EE) Bilateral CVA $1,418,000 (16 bps) $ 685,000 (7.75 bps) Swap Credit Spread quote $4,254,933 (48.5 bps) $3,767,500 (42.5 bps) Less: Bilateral CVA cost $1,418,000 (16 bps) $ 685,000 (7.75 bps) Profitability to Banks $2,836,622 $3,053,600 Despite providing End User with a lower swap credit spread, Bank B s profitability is significantly higher. Bank s profitability is reduced by CVA charges. Simply choosing the bank with lowest credit spread does not mean a Corporate Counterparty could not have dealt at a better price. Nauset Derivative Advisory 11
III. Ancillary Revenue and Bank Share of Wallet
Ancillary Bank Revenue Components Bank loans: Capital utilization based on committed and drawn amounts Revenue and ROE relatively easy to model due to known committed facilities Equity origination / M&A / Debt Capital Market origination Theoretically viewed as revenue that does not attract equity capital utilization ROE is infinite OTC Derivatives: Loan Equivalent exposures must be calculated to which capital percentages can be applied. Opaque nature of models makes it very difficult for a corporate counterparty to calculate expected exposures ( loan equivalent ) when estimating Bank s profitability and return on equity. Corporations and Financial Sponsors can gain negotiating leverage in Bank pricing with an understanding of Derivative profitability Nauset Derivative Advisory 13
Ancillary Bank Revenue Loan Equivalent Exposure $100mm USD interest rate swap does not translate to $100mm of Loan Equivalent Exposure. ROE should be based on capital employed on Expected Exposures. Nauset helps corporations and financial sponsors calculate derivative profitability paid to Bank Group in context of overall ancillary revenue. Nauset Derivative Advisory 14
IV. Sole Execution Mandates
Sole Execution Mandate Relative Revenue Banks market their ability to execute transactions in relatively illiquid underlyings, and secure lucrative Sole Execution mandates. The bank then executes the entire transaction and syndicates the market hedge to other syndicate members. Syndicate banks apply swap credit spread to achieve target ROE PV01 total New Swap $ 89,800 PV01 of Syndicate Bank Hold Amounts (20%) $ 17,960 Syndicate Bank Hold revenue (15 bps) Top Line: $269,400 Post CVA $140,000 Execution Bank revenue (4 bps on total) $359,200 Execution Bank ROE is virtually infinite due to CSAs with bank syndicate counterparties Sole Execution Bank has opportunity to generate significantly higher revenue than Hold Banks, without incurring additional capital utilization Nauset Derivative Advisory 16
V. Early Termination Clauses and Opportunities for Banks to Generate Incremental Revenue
Early Termination Clauses» Early Termination Clauses (ETC s) are used by banks as a Credit Mitigant for long dated derivative exposures with corporate counterparties.» Typically are included in confirmations when tenor of derivative is greater than the term for which bank would otherwise lend to the counterparty» Enables bank to exit (terminate) transaction at a specified date prior to maturity Early Termination Clause provides a safety valve for bank if credit worthiness of corporate counterparty deteriorates Nauset Derivative Advisory 18
Early Termination Clauses Post Financial Crisis» The 2008 financial crisis had (among other things) the following effects on the OTC derivative markets Dramatic decline in yields, resulting in large MTM s on positions in which banks were receiving fixed rates An increase in capital that must be employed against OTC derivative positions (Basel III) Post financial crisis, Global Banks returns on Legacy positions deteriorated dramatically Nauset Derivative Advisory 19
Early Termination Clauses Incremental Revenue $100mm 15 year interest rate swap maturing July 10, 2023 Execution Date: July 10, 2008 Fixed rate: 5.00% Early Termination Clause Exercise Date August 1, 2014 MTM July 10, 2014 (9 year IRS = 2.50%) $20,850,000 The MTM owing to the bank translates to a Risk Weighted Asset for which capital must be set aside. Nauset Derivative Advisory 20
Early Termination Clauses» Bank has right to terminate the transaction and receive a $20,850,000 termination payment» May create a liquidity problem for corporate counterparty» In lieu of termination payment, Bank may instead attempt to negotiate a higher fixed rate on swap for remaining term to generate acceptable ROE on legacy position» Bank suggests increasing fixed rate from 5.00% to 5.20% for remaining term PV of incremental interest expense: $1,667,000 (20 x $83,350) Return on Equity to Bank of Incremental Revenue??? Nauset works with corporations and financial sponsors to ensure derivative related restructurings costs are minimized and are commercially reasonable. Nauset Derivative Advisory 21
Nauset Derivative Advisory EXECUTION ADVISORY CREDIT MITIGANT RESTRUCTURING ANALYSIS DERIVATIVE PORTFOLIO COUNTERPARTY OPTIMIZATION» Ensure market transparency of bank execution,» Swap credit spread analysis (CVA/FVA) and fairness opinions» Analysis of marks-to-market on legacy positions» Negotiation of optimal credit mitigation terms on new transactions» Portfolio Modifications» Vettting of commercial terms of ISDA and confirmations» Expertise in illiquid underlyings» Analysis of CVA/Equity Capital charges for extension of derivative contracts beyond initial mitigation date» Adjudication of pricing concessions offered by banks for changed mitigation terms» Verification and negotiation of cash settlement amounts offered on terminations/unwinds» Calculation and negotiation of potential FVA and/or funding charges on transaction novations» Analysis of CVA/FVA and Equity Capital charges held by banks against legacy positions» Novation Exercises across asset classes» Netting benefit discovery» Debt/Derivative refinancing» Collateralization replacement Nauset Derivative Advisory 22