The sales were cheered by the investors as a sign the banks were cleaning up their balance sheets. But the banks’ remaining exposure to the loans is less well understood, in part, because of the lack of public disclosure.
The banks generally sold the loans at a price of about 85 cents on the dollar, people familiar with the deals said. The banks also granted the buyers new loans – at below market rates – to help them buy the old loans. The new loans amount to about 80 cents for each dollar of old loans bought.
If the old loans drop in value, the deals are structured so that the private equity firms take the first losses, up to about 20 cents on the dollar. If the old loans fall further – as could be the case in a severe economic downturn – the banks could suffer additional losses on the loans they “sold”.
Deutsche Bank acknowledged that it retained exposure to the original loans, but said that any further losses would be negligible.
For the bank to book more losses, it said, the old loans would have to drop to about 65 cents on the dollar – a calculation reflecting the 15 per cent writedown on the sales and the 20 cents on the dollar invested by private equity.
Of course, even if companies default or file for chapter 11 bankruptcy protection, lenders usually get some money back. In the bankruptcies this year, lenders have recovered an average of up to 60 cents on the dollar – less than in earlier economic cycles.
In a regulatory filing, Citi said its loan sales “substantially mitigate the company’s risk related to these transferred loans”, implying it retained some risk. The bank said it hedged retained risk by buying derivatives called total-return swaps but it declined to say how much it has paid for the instruments.
Analysts say such hedges can be expensive – sometimes costing more than the position being hedged. They say banks can be willing to pay so much because it is easier to tell shareholders they spent money on hedges than to report loan losses.