Via a structuring team at Lehman Brothers, Provident Bank recently closed what is believed to be the first-ever synthetic risk transfer specifically designed to score rating agency capital credit.

This groundbreaking deal, called Sherpas Ltd., essentially uses synthetic technology as a tool to manipulate and influence the fundamental corporate ratings analysis. And Lehman has got two more in the pipeline, one to close in the next few weeks.

"This is something that everyone's been trying to do for a while," said a banker at a competing firm. "One of the biggest problems has been, how do you convince the corporate rating analysts that the right risk has truly changed hands?"

While corporate analysts have recognized true risk transfers in structures like J.P. Morgan's Bistro deals which alleviated the bank's exposures in commercial lending - Sherpas marks the first time this technology was tailored specifically to address fundamental ratings issues as a client-oriented product.

What makes the deal unique is that it satisfies concerns and issues on the corporate ratings side specific to Provident Bank, while meeting the structural criteria of the deal itself. Lehman has spent well over a year working with analysts from both ratings groups, said John Fernando, a senior vice president at Lehman.

In this case, Lehman was able to transfer off balance-sheet a portion of the residual risk associated with nine previous Provident home-equity securitizations.

"I think what we're seeing is the tip of the rating agency benefit [these structures are capable of], as well as the tip of the pure capital benefit," said Martin Kennedy, a mortgage-backed analyst at Standard & Poor's who was part of the rating team on Sherpas. "Obviously it always takes one to be out there and be successful, and then you'll have a series of copies that follow suit, sort of walking the minefield that's already been cleared," he added.

In the last year, S&P's mortgage group has looked at as many as 10 similar structures proposed, some closer to fruition than others. The candidates have been other banks, as well as conduits and mortgage insurers looking for ratings relief, Kennedy said.

Though Lehman has made the most headway, several other firms have ongoing efforts, including Morgan Stanley Dean Witter and Credit Suisse First Boston.

How big will this be?

While these types of structures can be applied to managing other types of exposure, Lehman's approach is to start with first-loss on securitized assets, because investors are used to seeing this type of risk.

"What we're trying to do is leverage off a lot of the work that has already been done in the ABS market," said Kent Peer-Nous, a consultant for Lehman Brothers who was brought on to work on these deals. "Investors have done a lot in the way of evaluating the various risks inherent in the different portfolios like credit-cards, mortgages and others."

Unlike the bank reg-cap deals, which are most applicable to government-regulated financial institutions, manipulating risk to achieve ratings capital credit applies to any company with a fundamental rating.

Peer-Nous sees this technology being used for other risks embedded in a company's balance sheet, beyond securitized exposures. The rating agencies agree.

"Financial institutions tend to be sophisticated in how they manage their risk profiles, but I think it's not unreasonable to think that corporate treasurers will start to use the same tools," said Roger Merrit, a derivatives and CDO analyst at Fitch.

Indeed, Moody's Investors Service has established a "Securitization Standing Committee," made up of both corporate and structured finance analysts, to develop a methodology for looking at these structures and deciding out if and how much capital credit should be awarded.

"There's been a lot of different parties pitching these deals, and I think a lot of them will get done," said Adam Glass, an attorney at Sidley & Austin. "I think the challenge is bringing the synthetic product to a customer base that isn't used to seeing it."

Beyond stabilizing corporate ratings, companies can use these tools to add further leverage. For example, a company may remove exposure from one loan portfolio so that it can continue originating loans.

Ultimately, proponents of these structures - like Lehman Brothers - are hoping this technology takes off the way the securitization market did in the 1980s, when companies looked at the market in a strategic vein, such that if they ever needed off balance-sheet funding, they would already have the program in place.

"I can see people doing the same thing with this sort of risk transfer product, where they might not need the equity capital relief today, but they might want to do a transaction just to establish an outlet in the risk transfer market," Peer-Nous said. "This is a way to take technology that has existed for 15-years, and create a type of off-balance sheet equity."

How it works

Although securitization itself was originally envisioned as a means of transferring risk off balance-sheet, fundamental corporate analysts generally do not give credit to issuers for securitizing loan portfolios, because profitability of the securitization is not sufficient to cover the expected first loss, which issuers typically retain.

For the underlying transactions referenced by Sherpas, Provident had provided a spread account, putting up cash or equivalent securities to support the retained pieces of its securitizations.

From the rating agency perpsective, capital credit is not given against that cash account. So in order for Provident to get capital relief, the bank needed to sell off, or insure the risk of the first-loss pieces.

Like a standard synthetic deal, Sherpas uses a special purpose vehicle to issue credit-linked notes referencing a pool of assets: in this case, subprime home-equity loans from nine previous Provident securitizations dating back to 1998. The notes essentially absorb losses based on the performance on the underlying pool.

The proceeds of the notes are placed into an investment account, whereby the note holders will be paid interest on the proceeds at a promised rate. Provident acts as a swap counterparty to pay the difference between the actual interest and the promised interest.

When a loss happens in the reference portfolio, Provident's cash account is reduced by that amount. However, Provident is reimbursed after putting a claim in to Sherpas. In this sense, pure risk is displaced, similar to the way it is in a catastrophe bond.

"This is a real credit derivative, in that it gets rid of some of the risk that had been sold off in prior securitizations,' which were really just funding securitizations," said Tonya Azarchs, a bank analyst at S&P. "So we like that, because it [achieves] what we always thought was the purpose of the funding transaction."

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