Provident Financial Group said it will try to steer around the threat of higher capital requirements by transferring some of its credit risk to third-party investors.
The Cincinnati banking company plans to cut its exposure to subprime loans by $100 million, possibly through a sale of bonds that would work like derivatives.
The risk transfer, slated for the fourth quarter, would help Provident comply with a tough capital rule proposed jointly two weeks ago by the Federal Deposit Insurance Corp., the Office of Thrift Supervision, the Office of the Comptroller of the Currency, and the Federal Reserve Board. The rule would increase the amount of capital that banks must hold against the riskier pieces they retain from securitizations.
The regulators drafted the rule in an attempt to prevent another failure like that of First National Bank of Keystone, W.Va., which had a high concentration of residual subprime securities.
Provident executives said they expect the final version of the rule will be less stringent than the proposal. Nevertheless, they said, the company is preparing for the worst-case scenario by bringing its capital levels up to the standard the proposal would set.
Christopher J. Carey, Provident's chief financial officer, said in a teleconference with analysts last week that the company also plans to raise $200 million of capital by selling $100 million of trust preferred equity and $100 million of subordinated debt, both in the fourth quarter.
Though Provident has not yet decided exactly how it would structure the risk-transfer deal, officials said it would reduce the company's per-share earnings estimate for next year by 7 cents, to between $3.20 and $3.30.
The risk-transfer bonds may resemble credit derivative instruments by J.P. Morgan & Co. and Freddie Mac.
Unlike traditional securitization, in which a lender repackages loans as bonds and sells them to investors, thereby raising money to make new loans and offloading the credit risk, credit derivatives are designed only to unload credit risk.
Charles Pardue, head of synthetic securitization for North America at J.P. Morgan, said that issuing a credit derivative can be compared to taking out an insurance policy on a loan portfolio. The lender pays a premium to investors, and if losses occur, they are covered by the investors, after the lender pays a deductible.
J.P. Morgan has been issuing credit derivatives through its Broad Index Secured Trust Offering program, or Bistro, since December 1997, when it offloaded the risk on a $9.7 billion corporate loan portfolio.
In the simplest Bistro deals, a trust sells bonds and uses the proceeds to buy Treasury securities, which sit in the trust. J.P. Morgan pays a fee to the trust, which pays bondholders an extra spread over the yield on the Treasuries, to compensate for the risk they are taking on. If the loans become delinquent or default, the trust pays Morgan, and investors' return is reduced or eliminated.
Two years ago Freddie Mac issued bonds called Mortgage Default Recourse Notes, or Moderns, which were linked to the performance of $20 billion of mortgages.
Provident's using a structure like Freddie's or J.P. Morgan's to lay off the credit risk from its residuals would represent "a natural step in the evolution of credit derivatives, by combining credit derivative risk transfer with traditional cash securitization," Mr. Pardue said.
In a regular securitization, he said, the issuer unloads the top 85% to 90% of the loans' credit risk and retains the other 10% to 15%. Issuing derivatives linked to the performance of residuals would be a way for lenders to transfer some of the risk of this bottom 10% to 15% to a third party, he said.
It would be "a terrific trade for Provident," he said, because most of the risk of a loan pool is concentrated in that bottom 10% to 15%.
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