Zions Jettisons CDO Risks - Analyst Blog

On Wednesday, Zions Bancorporation ( ZION ) entered into a total return swap (TRS) deal with Deutsche Bank AG (DB) to lessen credit risks for certain securities in its portfolio. Through this arrangement, the company could unload risks from $1.16 billion portfolio of collateralized debt obligations (CDOs).

 

A TRS deal allows the party to receive total return-to-gain exposure and benefit from an asset without the risk of actually owning it. CDOs are a type of structured asset-backed security (ABS) whose value and payments are derived from a portfolio of fixed-income underlying assets.

 

As a part of the deal, Deutsche Bank will take over all the credit risks of this particular CDO portfolio and provide timely payment of principal and all the interest when they become due to Zions.

 

Though the securities entrenched in the CDOs are rated “A” and “BBB”, much above the junk status, they hold the highest risk weighting in Zions’ securities portfolio and therefore, the company opted for this arrangement. The transaction does not involve any hedge accounting nor does it bring any change to the accounting methodologies of the underlying assets.

 

The swap deal will cost Zions approximately $35 million in the first year, which will be recognized in the third quarter of 2010. Thereafter, as long as the deal remains in place, it will incur a quarterly $5.3 million to Zions. However, Zions’ cost is subject to possible adjustment in the event of changes in the regulatory requirements in future.

 

After the first year, Zions can cancel the deal and with the permission of Deutsche Bank, can also transfer a part or the whole to the third party. However, Deutsche Bank cannot revoke the deal except in case of underperformance by Zions and under certain conditions related to the swap accord.

 

Following this risk mitigation efforts, Zions’ regulatory-capital risk weighting for these investments decreases to 20% compared with an average risk weighting of 455% at the end of June quarter. The company estimates its regulatory risk-weighted assets to fall about $4 billion or 8.4% of the June end balance.

 

Accordingly, on the pro forma basis, as of June 30, 2010, Zions’ tier 1 risk-based capital ratio would have been 13.76% as against 12.64% which was reported for the quarter. Similarly, tier 1 common- to risk-weighted assets ratio and total risk-based capital would have been 8.59% and 16.47%, respectively, instead of 7.91% and 15.22%.

 

With this agreement, Zions moves a step further to repay $1.4 billion of money taken from the Treasury’s Troubled Asset Relief Program (TARP). The company is expected to repay the TARP money after it returns to profitability.

 

 

Zions reported second quarter 2010 net loss of $135.2 million or 84 cents per share was also substantially higher than the Zacks Consensus Estimate of a loss of 54 cents. The company’s results suffered due to continued weakness in loan demand and increase in non-interest expense. These were partially offset by an improved credit quality and increase in net interest income.

 

 

While Zions’ deposit growth remains satisfactory, its falling net interest margin and demand for loans remain causes of concern. The company has been successful in enhancing capital ratios by reducing the cost of debt through the equity exchange program and efforts on the cost control front. Also, this particular deal will help the company in improving its capital ratios.

 

While the near-term outlook remains cautious based on deteriorating credit metrics primarily in the construction portfolio, we believe that Zions is well poised to drive growth in the future.

 

Zions currently retains a Zacks #3 Rank, which translates into a short-term Hold rating indicating no directional pressure on the shares over the near term. Also, considering the fundamentals, we are maintaining our Neutral recommendation on the stock in the long term.