Barclays and Protium: back to the future

I am astounded at how quickly we have returned to the pre-crisis days of yore. Credit spreads are down, the stock market is up, volatility is down, earnings are up and bonuses are up.  It looks like happy days are here again.

But, I can’t help thinking this is all too much and too soon.  It’s as if we have learnt absolutely zero from the financial crisis.  Witness the recent goings on at Barclays.  The deal they have done with a newly-formed hedge fund called Protium is all over the news these days. 

The story goes like this: Barclays has a bunch of so-called toxic assets on its books that are marked way down from face value – over $12 billion worth. They are selling these assets to a supposedly arms-length hedge fund and loaning that fund the money to buy the assets.  In a weird vendor-financing way, Barclays has now removed the risk of the assets from its balance sheet, but has also capped their upside because any gain or loss now accrues to the hedge fund.

This fund, Protium Finance is based in the Cayman Islands. No one knows who is financing it. But, there is a Barclays connection in that 45 former Barclays employees are the actual asset managers via a fund called C12 Capital Management which manages the assets on Protium’s behalf.

Now, if all of this seems odd and mysterious, it should.  The structure of these arrangements is so opaque I am still not sure if I have the outline correct in my head.  Here’s how Reuters describes it:

Consider the terms of the deal that Barclays has disclosed.

The bank will sell $12.3 billion of assets to Protium, a fund whose backers are not identified. To fund the purchase, Barclays is lending the entity $12.6 billion for 10 years and Protium’s backers are contributing a further $450 million. The loan and the external capital injection exceed the amount that Protium is actually paying Barclays. This excess capital will be used by Protium to buy other distressed assets.

Protium intends to repay the loan out of the cashflows generated by the assets.
So far so clear. But here there’s a bit of a twist. The Barclays loan ranks junior to the $450 million of external capital Protium is raising. This means that almost all of the risk seems to remain with the Barclays shareholders. Yet all of the upside after the loan is repaid goes to Protium.

So if the assets, which have already been heavily written down, ultimately turn out to be worth $14 billion, say, rather than $12.3 billion, Protium would take home $1.4 billion. Not a bad return on its $450 million. But if the assets were to fall in value by a similar amount, to $10.6 billion, Protium would still get its $450 million back.

What’s more, Protium gets a fixed 7 percent return on its senior capital contribution, while the Barclays subordinated loan is struggling on at 2.75 percent over Libor — which would at present imply an interest rate of about 4 percent.

Got that?  Barclays claims this deal gives shareholders “more stable risk-adjusted returns for our shareholders over time.” So, my interpretation of Barclay’s animus behind is to reduce the number of volatile assets on its balance sheet in order to avoid having to mark-to-market.  While Barclays says this is not regulatory arbitrage because the loan behind the exchange with Protium is still on Barclays books, we all know that loans are viewed as less risky than some dodgy and marked down toxic assets.  And the bank is still on the hook for the assets via the 10-year loan it has given Protium.

Gillian Tett gives voice to the concerns that this is just another version of those ill-fated SIVs which we were causing problems in late 2007.

…entities such as SIVs and conduits have traditionally had a semi-detached status with banks. That served the banks dangerously well in the years of the credit boom, since they used SIVs as a place to store irritating stuff which they did not want cluttering up their balance sheet – such as a household stuffing rubbish into a cellar, so that it does not mess up the smart front room.

These days, of course, the word “SIV” has become almost as taboo as the phrase “subprime securitisation”. Yet, as I perused this week’s announcement that Barclays plans to sell $12.3bn of credit assets to a “newly established fund” called Protium Finance – which will be independent but mostly financed by a loan from Barclays – it was hard to escape a twinge of déjà vu.

To be sure, the details of the Barclays plan differ in some crucial ways from the old SIVs-cum-cellars. One central sin that bedevilled the SIVs was that banks often used them for regulatory arbitrage. Another was a reliance on cheap, short-term financing – which disappeared, with disastrous consequences, when the crisis started in 2007.

However, as Barclays repeatedly stressed this week, Protium is not focused on regulatory arbitrage: those $12.3bn assets will stay on Barclays’ balance sheet for regulatory purposes, in the sense that the bank will be forced to make big capital provisions against a $12.6bn loan it is extending to Protium. Moreover, Protium is not exposed to the funding risk that blew up the SIVs, thanks to that monster loan.

But in another sense, there is an uneasy echo of the past. Most notably, by selling those $12.3bn assets to Protium, what Barclays is essentially doing is taking a pile of toxic items out of its front room (ie the balance sheet) and stuffing it into an entity that is not inside the house (the garage, or cellar).

Whether you think this sort of think is wise or not, what the Barclays-Protium transaction makes abundantly clear is that risk is back. Global institutions are back to their old ways and there is nothing anyone is willing to do about it. When we face another crisis, you will know why.

Do read the Tett piece because she makes important conclusions regarding the lack of a coordinated regulatory response and the desire of banks to move to unregulated vehicles when the regulators do come a-calling.