In separate announcements last week, Dai-Ichi Kangyo Bank and Bankers Trust New York Corp. said they had each established programs that would allow them to act as triple A-rated counterparties in derivatives deals.
Dai-Ichi Kangyo said it had reached an agreement that would allow its New York-based derivatives unit, DKB Financial Products, to funnel its derivatives business through Merrill Lynch Capital Services' triple-A rated derivatives conduit.
Bankers Trust established its own program by initially posting the combination of $75 million in collateral and a $25 million policy from Financial Security Assurance Inc.
Ultimately, the programs will allow the two banks to enter interest rate and currency swaps and other derivatives contracts with governments, financial institutions, and corporations that insist on triple A rated counterparties.
The announcements to form triple-A programs come as both institutions face slipping credit ratings. The ratings on $9.3 billion of outstanding debt at Bankers Trust and its banking affiliates were lowered Thursday by Standard & Poor's Ratings Group. The downgrade was due in part to the "impairment of the derivatives franchise."
Ratings at Dai-Ichi Kangyo have suffered as well, due in part to concern over loan quality in Japan.
Richard Robb, executive vice president and head of derivatives at DKB Financial Products, said that some counterparties have expressed concern about the slipping credit rating. But he added the primary reason for the arrangement with Merrill Lynch was to enable the company to underwrite more European debt issues for sale to its Japanese clients.
"If we were a natural triple-A, we wouldn't need this arrangement," he said. "We need to be able to provide derivatives to our customers so that we can become as active as we need to be in the Eurobond market."
He said the company's Tokyo-based parent was willing to "write a $300 million check" to create a triple A-rated subsidiary of its own. But in discussions with a friend at Merrill Lynch, he said, the companies found a better way of investing the capital.
"Unless you're one of the top two or three players in the market, there is no way you are going to make a return on that kind of capital," he said.
As many as 12 institutions worldwide have created these structures, sources say, with each committing $150 million to $300 million in capital to achieve a triple-A rating. At the same time, though, some structures have completed as few as two or three deals.
The conduit DKB is using - Merrill Lynch Derivative Products Inc. - had $130 billion in outstandings at yearend and is backed by $350 million in capital, said Ernest Goodrich Jr., managing director of swaps with Merrill Lynch Capital Services Inc. He said the arrangement will allow the conduit to generate fee income and use the capital invested more efficiently.
"We feel these kinds of collaborative arrangements will be the next stage in credit intermediation in the derivatives markets," he said. "I'm particularly excited about the innovative quality of this arrangement and the implications for efficiencies for the industry in general down the road."
Nonetheless, Bankers Trust decided setting up its own structure was the better way. While not relying upon the kind of separately rated subsidiary that Merrill Lynch has, Bankers Trust's program requires that counterparties wanting to deal with the triple-A program sign agreements that are distinct from those entered into with Bankers Trust Co.
In doing so, customers will have the benefit of the collateral provided by the bank and the policy from Financial Security Assurance to guarantee the replacement value of their contracts, according to a report released by Moody's Investors Services. Customers will receive the replacement value even if Bankers Trust Co. is deemed insolvent or fails to meet the collateral requirements, or if the program's counterparty rating falls below A3.
"These two experiments may be harbingers of more innovation in the future," said one Wall Street swaps dealer. "That's likely to benefit not only swap dealers but also other institutions with large credit exposures to manage."
