Goldman believed to use GS Finance subsidiary to test regulatory waters, comply with Fed

By Emma Trincal

New York, Nov. 19 – Goldman Sachs Group, Inc. has been first in adopting new ways to issue structured notes complying with the recent “too big to fail” regulatory requirements. But more large banks deemed to pose systemic risk are expected to follow suit soon, sources said.

Market participants noticed that since summer, Goldman Sachs has priced very large deals through one of its subsidiaries, GS Finance Corp., rather than under the traditional issuance platform of Goldman Sachs Group, the holding company.

While the number of GS Finance offerings remains limited to six this year, their size is considerably bigger than the rest of the market (up to $350 million for one of those), causing observers to pay attention.

GS Finance has brought to market $985 million, averaging $164 million per deal, according to data compiled by Prospect News.

Another one is set to price Friday.

Prior to the recent deals, the last time Goldman Sachs used GS Finance to issue deals was in April 2008 for about $20 million.

Fed, FSB

According to conversations with sources, Goldman Sachs Group is astutely using its subsidiary in an effort to adjust to recent regulatory changes. The holding company continues to fully guarantee the GS Finance-issued notes.

The Federal Reserve Board last month proposed rules requiring bank holding companies to maintain a minimum of assets that can be used to “absorb” losses or recapitalize a bank in a dire situation. Those are called total loss-absorbing capital.

The rules also require bank holding companies to hold a minimum amount of long-term debt.

Unfortunately, most structured notes currently issued by U.S. bank holding companies would not be considered total loss-absorbing capital and are also not eligible as long-term debt, according to legal sources.

The idea is to avoid “too big to fail” by imposing a sufficient amount of loss-absorbing capital on banks’ balance sheets in order to guarantee that banks could sustain a systemic financial shock without a bailout from taxpayers.

Earlier this month, the Financial Stability Board, which comprises regulators and central bankers from the Group of 20 nations, released its final rules on the topic. The conclusions were similar to the Fed’s proposed rules 10 days before. Structured notes or derivatives as debt instrument are excluded from total loss-absorbing capital. Therefore bank holding companies seen as posing systemic risk may not count those liabilities as cushioning capital against losses.

“Going forward, you should expect all issuances or the majority of issuances to be by GS Finance. Based on the Fed’s proposal, structured notes – other than rate-linked – cannot be issued by the holding company, GS & Co.,” a lawyer with knowledge on the issue told Prospect News.

Parent, subsidiary

A sellsider noted that Goldman Sachs is for now alone in experimenting with its subsidiary but that things could change rapidly in this market environment.

The reasons for not using the parent company are a way to navigate the regulatory landscape.

“We’ve heard that Goldman is testing a different issuing vehicle based on possible regulations coming down the pipe and how it’s going to affect their issuance platform.

“I don’t know why other banks are not doing it yet. So far Goldman is the only one we’ve seen. Bank of America is a little different. They sell via other issuers a lot. I guess it helps.”

Goldman Sachs for now is still using both issuance entities. While the GS Finance offerings are much bigger in size, the bulk of the volume remains continues to be issued by the holding company via smaller notes.

But the disparity between the size depending on who the issuer is – Goldman Sachs Group or GS Finance – is baffling for some.

Goldman Sachs Group has brought to market this year $4.13 billion in 611 deals, which is more than four-fold the volume issued by its subsidiary.

But the pace of GS Finance issuance is rapidly accelerating in frequency and in deal size.

Sources believe those larger deals are institutional in nature given the low fees ranging from 5 basis points to 29 bps.

The deal size makes no difference for Goldman in its decision to use one issuing vehicle versus another, the lawyer commented.

Other banks are “eventually” going to follow suit in issuing notes out of their subsidiaries, this lawyer said, adding that this would include Bank of America, which is also the bank holding company.

Red flag

While lawyers are creative enough to keep the business of structured notes running, some on the desks are worried.

“Everyone is trying to figure out what’s the right approach and what type of world we’re going to be living in. When those new capital requirement rules recently announced by the Fed are going to take place, it’s going to affect our overall business. Definitely,” the sellsider said.

“Everyone is putting their thinking hat on right now. People are trying to understand how you can issue structured notes without violating these rules, how it’s going to work in general.

“There is still a lot of confusion. Interpretations vary from one counsel to the next.

“But I think everyone agrees on one thing: those new regs are going to limit issuance of structured notes one way or the other.”

From their recent statements, the G-20 and Fed regulators appear to view structured notes as not reliable enough to facilitate the quick recapitalization of a bank’s holding company under stress. The decision to exclude them from total loss-absorbing capital has consequences, he said.

“If the regulators are not going to view structured notes as viable deposits that banks can use as a buffer against potential losses, treasuries are going to look for funding in other ways,” he said.

“When you issue a structured note, when you sell a bond, you receive cash. It goes into your treasury as cash coming in.

“If structured notes are not considered sticky enough, you’ll have to change the business, obviously. Maybe banks will do notes on different durations. Maybe they’ll do more rate deals, since those are exempt from the rule.

“It’s everyone’s guess.”

Almost $1 billion

GS Finance so far this year has issued six offerings totaling $985 million, according to data compiled by Prospect News.

The largest among those offerings priced on Oct. 22 for $350 million. Tied to the S&P 500 index, the one-year notes offer 1.5 times leverage on the upside up to a 13.65% cap with a 5% buffer on the downside.

The smallest offering priced at $63.5 million on July 20. It was the first one for the year. The product was a three-month delta-one linked to the performance of the MSCI Europe index.

Aside from its top $350 million issue, GS Finance brought two other S&P 500-based offerings last month and earlier this month for $150 million and $250 million respectively. The notes offer roughly the same 12-month maturity with identical terms –such as the 1.5 times leverage multiple and the 5% buffer. The caps are just slightly lower.

In addition, GS Finance issued two short-term tracker note offerings based on the Topix index. The first deal priced on Aug. 7. It was a three-month offering for $75 million. The second was issued on Nov. 9 for $100 million. It is an ultra-short product with a six-week term.

And now

GS Finance will price Friday 0% leveraged notes due May 18, 2016 linked to the common stock of Bank of America Corp., according to a 424B2 filing with the Securities and Exchange Commission.

The notes will be guaranteed by Goldman Sachs Group.

J.P. Morgan Securities LLC is placement agent.

The notes offer a 200% upside participation rate up to a 16.2% cap. The downside is not protected.

The Cusip number is 362273AD6.

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