Barclays Capital is a division of Barclays Bank, a U. K.– based multinational financial institution. On September 16, 2009, Barclays Capital announced a deal to sell US$ 12.3 billion of “ toxic” ABSs and other mortgage- related securities to Protium Finance, a Cayman Islands fund owned by C12 Capital Management Holdings and operating from New York.
The announcement indicated that 45 of Barclays Capital managers would leave the division to manage C12, which would receive $ 40 million annually from Barclays Capital to manage the portfolio.
Protium is highly levered. Its purchase of the securities is financed by a $ 12.6 billion 10- year, prime plus 2.75%, loan from Barclays Capital, plus $ 450 million of loans contributed by two unnamed U. S. and U. K. institutions.
The effect of this deal was to remove $ 12.3 billion of securities from Barclays’ balance sheet, replacing it with a loan receivable. That is, Barclays derecognized these securities. However, they were not derecognized for purposes of reporting to regulators. That is, Barclays’ legal capital ratio was not affected by the transaction. Barclays did not explain why the regulator took this position.
Speculation about the motive for this deal quickly appeared in financial media. Reasons included the following:
Counterpart Risk. Most of the financial instruments were insured by CDSs (Section 1.3). However, there was continuing concern in the market about the solvency of insurers following the collapse of AIG in 2008. Fair value of the transferred securities fluctuated daily with fluctuations of the market’s assessment of this risk. In particular, should an insurer become financially distressed, fair value of the transferred instruments would plummet, requiring a huge writedown on Barclays’ books. Under the announced deal, this risk would be borne by Protium.
Earnings Volatility. By substituting an interest- bearing loan for the transferred securities, Barclays’ earnings is freed from the volatility induced by fair- valuing them. It should be noted, however, that if Protium could not collect sufficient cash to pay interest and principal to Barclays, the value of the loan would have to be written down. Thus Barclays retained the ultimate risk of non- repayment of the mortgages underlying the transferred securities, even though it had gotten rid of the short- term fluctuations in fair value. Manager Compensation. Since the securities in question were transferred to Protium at fair value (they had already been written down from $ 13.5 to $ 12.3 billion earlier in 2009), any subsequent increase in fair value would accrue to Protium and C12, not to Barclays. Given that securities markets in 2009 were recovering from the 2007– 2008 meltdowns, given the high leverage of Protium, and the large amount of securities involved, even a small increase in fair value would convey a huge increase in wealth to Protium and, presumably, to the 45 former employees now with C12. In effect, Barclays gave up the prospect of such gains in exchange for lower counter-party risk and earnings volatility. However, since several world leaders at the time were calling for controls on bonuses paid to financial institution managers, suspicion emerged that the deal was really a device to enrich certain Barclays managers through fair value appreciation instead. The extent to which new derecognition standards will discourage such transactions remains to be seen.
a. Would Barclays’ derecognition of the $ 12.3 billion of transferred securities be consistent with IFRS 9 and related FASB standards?
b. Should Protium be consolidated with Barclays for purposes of financial reporting to investors under IFRS 10 and related FASB standards?
c. On September 16, the day of the announcement of the deal, Barclays’ share price rose 11 pence sterling to 390, an increase of 2.9%. On the same day, the U. K. FTSE 100 index rose 82 points, to 5,124.10. Barclays’ beta, per Yahoo! Finance UK at the time, was 2.1568. Assume that the daily risk- free interest rate was effectively zero. Assume securities markets efficiency. Also assume that no other significant firm- specific information about Barclays became available on September 16. As evidenced by its share price performance, did the market approve or disapprove of this deal? Explain, and show calculations.