Q&A: Ovid Capital Bets On Banks’ Need For Regulatory Capital Relief

May 21 2012 | 9:59am ET

The Basel III Accords, regulations covering banks which will take effect in Europe in 2013, have created an investment opportunity that newly formed Stamford, Conn.-based Ovid Capital Advisors is ready to exploit. The Ovid Regulatory Capital Relief Fund, founded by Glenn Blasius, who spent eight years running a similar fund for Christofferson Robb & Company, and Sam Adams, founder and managing director of the credit specialist Woodhull Capital, will advise funds selling protection to banks which, under the new regulations, will be required to retain more capital against their investment books. Initially, says Blasius, the target market is Europe, where banks are already in need of capital relief, but that need will eventually be felt in the U.S. Blasius spoke recently to FINalternatives Senior Reporter Mary Campbell about the new fund.

I have to ask about the name of the fund—is it Ovid like the poet?

Exactly…because the objective here is to transform the banks and transform their risks. Ovid Capital Advisors will be advising funds that will sell protection to banks—the initial target is the European banks—to provide them with regulatory capital relief, by selling the banks protection against loss on certain identified parts of their portfolio allowing them to retain less capital against those parts of the portfolio…[T]he idea is that by selling them protection we transform the risk of their portfolio and allow them to metamorphize it into a better-functioning, more well-capitalized institution.

When you say ‘certain identified parts of their portfolios,’ what exactly do you mean?

The idea behind the strategy is that we sell loss protection against parts of a bank’s investment book, usually, that protects them against unexpected losses…[A]s a result of buying protection against these unexpected losses they’re able to go back to their regulator and say, ‘I’ve protected myself against the risk of loss on this particular part of my portfolio,’ and if the regulator signs off, then they can hold less capital against that part of the portfolio….I have a lot of experience in identifying characteristics of loans that would exhibit low risk of loss yet essentially the bank is still incentivized by the regulators and by their need to raise capital to purchase protection against these parts of the portfolio.

How risky is this sort of investment?

Well, I don’t think it’s risky at all. Look, five years ago, people were saying sovereign bonds were all riskless…[T]his fund…sells protection against very specific, targeted portfolios of risk within the bank’s balance sheet…[W]e don’t believe in selling protection against a bank’s portfolio which is part of the bank’s business of asset disposal. We want to participate with the bank and allow them to optimize their balance sheet by selling them protection on part of their balance sheet which is part of their core, illiquid book of business.

We actually feel very strongly that a well-run bank operates as a credit intermediary and well-run banks actually are pretty good at measuring and predicting [the] volatility of losses in most parts of their portfolio. It’s usually when they get outside of their remit that they start getting into trouble…and we have examples…from mid-last decade of banks expanding into leveraged loans, project loans, sub-prime lending, all sorts of activities which they were probably not best-qualified to participate in. But I think one thing [that] still remains the case—and it’s probably true in the U.S. as well as in Europe—is there are many banks that have core competencies at which they’re very good…and have demonstrated consistent returns in those parts of the portfolios and those are the areas that we’re trying to identify.

Are there many other funds that follow this strategy?

My former fund, Christofferson Robb, moved into that [area] in about 2006 and were actively involved in that…[Y]ou hear a lot of talk right now about funds being set up; I don’t think many of them have the skill-set nor the contact book that I do. I think it’s very easy for people to talk about regulatory capital relief, given the fact that it’s been becoming more visible as it’s become obvious that the European banks have to raise a lot of capital. And I think lots of people will say, well, there’s this regulatory capital need because the bank has to reduce the amount of capital it has to set against certain parts of its portfolio. In many instances those are asset disposals or quasi-public capital markets transactions where the risks [to] investors obtaining and claiming to provide capital relief [are] very similar to the kinds of risks that any investor can get in the capital markets. So, for example, they’ll sell protection to the bank against a publicly traded name and say, ‘Okay, [the] banks got capital relief because we sold them protection.’…But we’re focusing on a subset of that which is the bank’s illiquid book of business which it doesn’t really have capital market access for.

Unlike in the States, many European banks still operate under an originate-to-hold model rather than an originate-to-distribute model. I think in the U.S., obviously, all the rage was recycled capital and it went wrong in many different asset classes because, ultimately, the banks took their eye off the ball, which was the need to underwrite and ensure that the loans they were making were actually well-structured and thoughtfully originated loans.

Many European banks operate a bit differently, and even though they are involved in capital markets extensively, a lot of the risk that they have on their balance sheet was originated without the intention to ever distribute it. So, this is the area of our focus…In many instances, the banks don’t want to dispose of these loans because it’s a relationship that they want to keep and it’s a profitable relationship and it’s a longstanding relationship, so they don’t want to dispose of that relationship, they just want to reduce the amount of the capital they hold against it because, in many instances, as you [saw]…with the Federal Reserve stress test, the regulator’s are making banks hold more capital against all sorts of risks. Our fund will identify those risks that the bank wants to reduce capital against but still wants to retain the relationship with the borrower and risks that we think that the bank is very well positioned to judge and to gauge. And in fact, the capital relief funds that we will be managing will effectively be viewed as a partnership with the bank—we’re helping them manage their capital base…to really let them get down to the business of running their business.

You’re targeting European banks initially, can you imagine a market for this in U.S.?

Yeah, absolutely. I think there are a couple of necessary pre-conditions, though.

U.S. banks still report their regulatory capital ratios under Basel I, which is a vastly simpler regime which really doesn’t measure the risk of the loan portfolios too accurately. Now, although there’s been a lot of talk in the U.S. about moving over to Basel III, that hasn’t happened yet, probably because of the dislocations we’ve been going through the last two years, there’ve been other fires to put out. But as Basel III gets closer to being implemented in the U.S., I think banks in the U.S. will definitely have a great need for it. [T]here’s an immediate need in the European banking system, there will be an eventual need in the U.S., and ultimately, the way we see it, is that this will be a tool in the bank’s toolbox as it manages its capital base. So, when a bank looks at all of its businesses and the risk it has on its books, and it looks at its capital ratios, it may choose to raise more equity, if that’s an appropriate strategy, it may also choose to reduce lending or sell businesses, but equally we feel that they may choose to purchase protection against certain parts of their portfolio as a way to manage their capital base…

[W]e’re at the early stages here, Basel III is being adopted by the European banks in 2013, there’s an implementation schedule which will last a number of years, and I think banks’ behaviors will begin changing and become more influenced by Basel III and we want to be a tool in their toolkit as they begin managing their risk on the books under Basel III.

What stage are you at right now? What is the optimal size for this fund?

Right now we’re in discussions with a number of potential, key, cornerstone investors. We’re looking to launch at a minimum size of $150 million and the ultimate size, maybe I’d prefer to answer it this way: Depending on who you talk to, European banks’ capital needs range from $400 to $800 billion over the next five years. We’re just aiming for a small slice of that. The market for these kinds of transactions is a private market; it’s bespoke and reasonably illiquid, so there’s not a lot of visibility to outside players as to what transactions are actually being issued but we have seen a pickup in interest from banks over the last couple of months and I think, in a certain way, the ECB’s provision of long-term funding via the LTRO, the three-year funding facility,…has removed a lot of the European banks’ preoccupation with securing funding over the next couple of years and is allowing them to turn to more pro-actively managing their capital base.

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