Magazine article American Banker

AAA-Rated Subsidiaries for Derivatives Seen as Limited Profit Producers

Magazine article American Banker

AAA-Rated Subsidiaries for Derivatives Seen as Limited Profit Producers

Article excerpt

An AAA rating is no guarantee of success for a derivatives unit, according to a study by the Federal Reserve Bank of New York.

The report, released on the same day last week that NationsBank Corp. announced it had approval to set up its own AAA-rated derivatives subsidiary, said there is only a limited market for these separate entities. The units have failed to generate the windfalls anticipated by their sponsors, it said.

"The amount of capital they need is so large per dollar of a swap transaction that they are not likely to be dominant players outside of the triple-A market," said Eli M. Remolona, a research officer at the New York Fed and one of the report's authors.

The collapse of Drexel Burnham Lambert in 1990 gave rise to these derivatives units, and there now are 11, including NationsBank's new one and the unit set up by Bankers Trust Co. this year.

Merrill Lynch Derivatives Products was the first, posting $300 million of capital to garner an AAA grade from the rating agencies.

To maintain this sterling rating, the separately structured derivatives product company acts as an intermediary between its parent company and the customer.

The derivatives unit passes on most of the credit and market risks created by each transaction through offsetting transactions with its parent company. The parent then decides whether to hold the risks or hedge them elsewhere in the derivatives markets.

Despite the assurance this structure gives to the counterparty, it has yet to gain favor outside institutions like the World Bank, European Bank for Reconstruction and Development, sovereign governments, and a limited number of corporations. Mr. Remolona attributes the poor showing to the expense involved in such structures.

"Outside of that niche, they're not going to be very competitive because in terms of capital they're very expensive," he said. …

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