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Tuesday, 28 October 2008

Crime of the week: Barclays' black diamond

Who knew about Barclays $1bn snafu last week?

On Friday, BARC's balance sheet underwent a little unwelcome expansion: a $970m position comprising corporate loans (including such choice credits as GM) CDO tranches and revolving credits surfaced on the books.Bidding opens today on the sale of the position, which the bank is naturally rather keen to (re)dispose of.

S&P LCD reports on a dispute between BARC and a fund managed by Black Diamond Capital Management:Black Diamond said last week that BDC terminated a derivative facility with Barclays because Barclays did not return excess collateral that was due on Oct. 7 and then failed to cure a default stemming from the bank's failure to return the collateral. BDC Finance on Oct. 17 sued Barclays in the New York State Supreme Court, alleging that Barclays failed to deliver to BDC no lessthan $302 million of posted collateral and interest, according to court filings.

The Black Diamond fund in question entered into a series of total return swaps (TRS) written on various assets on BARC's balance sheet. Those assets being the things BARC is now trying to sell.The existance of those swaps, of course, hitherto effectively wrote the assets out of regulatory existance on the balance sheet: BARC has not had to account for them before.The swaps naturally required collateral posting, which the Black Diamond fund had to put up with BARC. Alas, as spreads came down, collateral haircuts fell, and it seems BARC did not return the money to Black Diamond as you'd expect it was wont to do (the marks on the assets were recalculated on a daily basis - the dispute centres around Black Diamond's claim that the assets were worth more than Barc's marks said they were). Black Diamond consequently terminated the TRS, suddenly writing the $970m position back into regulatory existance at BARC.

This is bad for several reasons. BARC will have to take a writedown on the position. It is selling the assets into a collapsing market, so it will likely be an unpleasant affair.The bank has to sell the assets because the alternative - holding them - would incur too punitive a risk-weighted asset requirement under Basel II.Given that BARC's core capital is under particular strain, this is a no-no.

Then there are the broader implications. Barclays and many of its European peers have been big users of synthetic CDOs as a balance sheet arbitrage: creating off-balance sheet synthetic structures which net arrangement fees but which also, crucially, provide massive balance sheet relief.As with the Black Diamond fund, such structures typically enter into total-return swap agreements or CDS contracts with banks, securing an income stream and, supposedly, risk. But with corporate spreads now gapping out to unprecedented levels and the prices on loans cratering (see graph from Bank of America below), the synthetic CDO market might be a huge shoe to drop: banks may find themselves with, to repeat a phrase coined by Citi analysts at the start of this year, further massive "involuntary asset growth".

Not good when you need to rapidly delever.

The Barclay's/Black Diamond debacle might have been caused by an idiosyncratic dispute over collateral posting, but the broader issue - of risks thought conjured off balance sheet using synthetic technology coming back to haunt banks - is a developing theme.

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