An interesting and unexpected provision included in the Basel II guidelines could effectively nullify previously recognized synthetic risk transfers, if the protection seller is a special purpose entity.

Such is the case in the bulk of balance sheet synthetic CDOs, which have been a popular form of regulatory capital management over the past several years, particularly in Europe. In the U.S., many banks have begun synthetically referencing large portfolios of consumer assets as a method to shed exposure. If the risk is transferred to an SPE, as is usually the case, the Basel guidelines indicate this should not be recognized as a true transference of risk from a bank's balance sheet.

The use of synthetic regulatory capital-motivated securitizations is not as prevalent as it was in the late 1990s. According to a source at Moody's Investors Service, however, the market is likely to see at least one large "old-style" portfolio risk transfer before the end of the year.

"Even though we don't see as many balance sheet deals as we've seen in the past, we still see them periodically," said Yuri Yoshizawa, managing director in the structured derivatives product group, at Moody's.

That the provision was included in the final draft of Basel II was surprising, noted Jim Croke of Cadwalader, Wickersham & Taft, during a seminar on Basel II hosted last week by Credit Suisse First Boston. What's most surprising, according to Croke, is that the provision has survived the consecutive drafts and consultative papers, despite comments opposing its inclusion by industry parties.

In Basel II, there is no reference to grandfathering existing transactions, should there still be any outstanding when the rules are implemented, Croke said. In the end, however, Croke added that, "It's up to the regional [regulators] whether or not that provision stays there."

Copyright 2004 Thomson Media Inc. All Rights Reserved.

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