Barclays transfers bad debt to Cayman fund

Barclays announced on Thursday that it is selling US$12.3bn of risky credit market assets to Protium Finance LP, a Cayman-registered fund.

In a complex financial transaction Barclays will also lend US$12.6 billion to Protium over ten years at a comparatively low interest rate of 2.75 per cent above the US dollar Libor base rate.

The fund will use most of the debt to buy $8.2bn structured credit securities, $2.3bn residential mortgage-backed bonds and $1.8bn unpacked mortgages from Barclays. These types of instruments were widely blamed for the global financial crisis and have been weighing down Barclays’ balance sheet as their value declined.

Barclays faces costs from underperforming credit instruments in that the bank is forced to put up regulatory capital against the assets. Accounting rules prescribe that Barclays also has to regularly assess the market value of the assets and recognise any gains and losses in the instruments in its profits.

Any further loss in the value of the credit instruments would therefore lead to direct losses for the bank. As a result investment banks have been looking for ways, sometimes dubbed ‘smart securitisation’, to reduce the capital costs and mark-to-market effects related to toxic assets.

Under the Barclays deal, however, the bank will continue to carry the under-performing assets on its balance sheet and not reduce capital costs. Chris Lucas, Barclays’ finance director, said: ‘We are not seeking through the transaction to effect a change to our underlying credit risk profile, but we are restructuring a significant tranche of credit market exposures in a way that we expect will secure more stable risk-adjusted returns for shareholders over time’.

The sale ensures that Barclays no longer has to write down any losses in the value of the assets as these are sold at market value to Protium.

Barclays thereby effectively exchanges the credit risk related to the value of high-risk assets for the risk that Protium may default on the $12.6bn loan.

Protium is backed by investors, which have put up $450m and will receive fixed interest of 7 per cent for ten years from the underlying cash flows of the credit instruments. In addition the investors, two unidentified hedge funds, will benefit from any increase in the value of the assets and the resulting surplus cash remaining in the fund, once Barclays is repaid in full.

Some analysts criticised that the equity contribution by investors gives Barclays very little protection with regard to the loan risk. They also pointed out that the bank gives up the upside potential of the sold credit assets, should they increase in value.

Jonathan Pierce, banks analyst at Credit Suisse suspects that the motivation for the deal is to reduce exposure to credit assets insured by monolines, Monolines, which took a hit during the subprime crisis, are bond insurers who guarantee the repayment of bond principal and interest in case an issuer defaults. The credit downgrade of a monoline would directly affect the value of the insured instrument, which in turn would have to be recognised by the bank as a loss in the financial results.

‘The transaction is, if you like, a way of swapping the fair value adjustment that would otherwise be taken on a monoline downgrade over a longer period of time through reduced net interest income,’ Mr Pierce said.

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