Credit intermediation trades

Background :

ANZ entered into a series of structured credit intermediation trades from 2004 to 2007. The underlying structures involve credit default swaps (CDS) over synthetic collateralised debt obligations (CDOs) (78%), portfolios of external collateralised loan obligations (CLOs) (13%) and specific bonds/floating rate notes (FRNs`) (9%).

Under these Credit Intermediation Trades, ANZ sold protection using credit default swaps over these structures to investment banks and purchased matching protection from eight financial guarantors.

Notional exposure on credit intermediation trades

The total notional exposure as at 30/9/09 is US$10.95 billion. There are no sub prime or mortgage exposures.

There are 37 structures comprised of 19 synthetic CDOs with approximately 650 underlying reference entities, 10 CLOs tranches across 6 CLO structures with approximately 700 underlying reference entities, and eight bonds/floating rate notes over five corporate names. Although the underlying names in the CDOs (and CLOs) are referenced in more than one structure, there is minimal overlap of reference assets (less than 5%) between the CDOs and CLOs.

The maturity profile for the CDOs and CLOs runs from 2010 to 2022, with an average remaining term of 6 years.

First loss protection

All the CDO and CLO structures have a defined subordination level or level of first loss protection (called the attachment point). This averages just over 15% for the CDO’s (with a range of 6.75% to 29%) and averages around 30% for the CLOs (with a range of 28.5% to 32%)

Typically, the lower range attachment points reflect structures with a greater proportion of more highly rated names and / or shorter maturities. Similarly the detachment points selected reflect the relative risk of the structure, with the average detachment point being 35% for the CDOs (varying from 12% to 100%) and 100% for all of the CLOs.

Each structure can sustain a significant level of defaults of reference entities before ANZ incurs a cash loss (i.e. the attachment point is breached). ANZ conducted a scenario test in October 2008 on the portfolio using Moody’s historical corporate default rates going back to 1920. Using 20th century stressed environments (for example the mid 70s, early 90s), only under the Great Depression scenario were any of the attachment points breached (i.e. default rates were sufficiently high to erode the attachment point). However such historic scenarios are not necessarily indicative of future economic stressed events.

Credit Risk on Derivatives Charge - Mark-to-market impact

As derivatives, both the sold protection and purchased protection are marked-to-market. Prior to the commencement of the global credit crisis, gains and losses were not significant and offset each other in income.

The value of the obligation under the sold protection is $A1.01 billion (30/9/08 : $A1.69 billion), for which the purchased protection has provided only a partial offset as a result of:

• one of the purchased protection counterparties defaulting, and
• ANZ making a credit valuation adjustment on the remaining counterparties which reflects in part the significant widening in their credit spreads which has occurred.

As a result of the above, the life to date (i.e. aggregate or cumulative) Credit Risk on Derivatives expense for the credit intermediation trades is $A584 million before tax as at 30 September 2009 (2008 : $A531m). While it is expected the Credit Risk on Derivatives charge will remain volatile, actual cash losses are expected to be substantially less.

Note that around one-third of the tranches were booked in the Australian offshore banking unit and therefore a 10% tax rate applies to these deals.

ANZ restructured some of the trades for which ACA was a financial guarantor during the first half of the 2009 financial year in order to ensure levels of subordination were maintained broadly in line with that present at the inception of the trades.

In the 2nd half, ANZ exited 1 of the 20 CDO exposures which reduced the total notional value of the structured credit trades. We will continue to monitor developments in global credit markets and take advantage of any opportunities which may arise to reduce our exposure to these trades.

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