Banks’ Hot New Trade Could Burn Others, For Once

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Big U.S. banks claim overzealous regulation puts them in handcuffs. So in response, they’re embracing a hot new trade that turns them into balance-sheet Houdinis. It’s called the synthetic risk transfer and is a riff on pre-crisis financial engineering wheezes. The danger to banks themselves is minimal, though as lenders get more creative with their use, investors will need to read the fine print.

These acts of financial escapology, already used by firms including Morgan Stanley, JPMorgan and Banco Santander, are gaining popularity because banks are caught in an ever-tighter bind. Lending fundamentally involves accepting risks, and regulators want banks to hold plenty of equity that can absorb losses if those risks go bad. That equity is expensive, though: a shareholder might expect a 10% return. And incoming new rules known as the Basel Endgame will force banks to hold even more equity capital than they already do.

Banks don’t want to sell off loans, since that can leave them with losses, especially if the loans were made in rosier times. And while they’ve threatened to pull back from certain kinds of business because of the Basel reforms – notably mortgage lending – they’d really rather not. That’s where the risk transfer comes in. A bank finds outside investors willing to take the first chunk of losses on loans if borrowers come unstuck, and in return pays a regular fee, almost like the coupon on a bond. This is invisible to borrowers, but protects the bank if things go wrong.

In theory, such transfers neatly solve the expensive capital problem. By passing on the riskiest part of a loan portfolio, regulators let banks reduce the amount of equity they must hold against it. An example: say a lender has $100 million of loans on its books. The U.S. watchdogs might demand equity equivalent to 8% of that, or $8 million, be held aside. But if the bank can slice off, say, the first $13 million of losses – covering the riskiest of the loans – regulators may let it treat what’s left as being akin to the safest slice of a securitized investment. In that example, the equity required would fall to less than $2 million.

Nothing comes for free. Investors in risk transfers, who include big-name firms like Blackstone, Ares Management and M&G, might demand coupons equivalent to around 15% of the losses they’re insuring in Europe, and perhaps 12% in the United States. That coupon has to include whatever the investors think they will lose in covering banks’ unrecoverable debts. For lenders, it’s still often worth it. As well as freeing up capital that can be put to other profitable uses, they have effectively smoothed out their costs by turning lumpy credit losses into a stream of interest-like payments.

Investors have thus far focused their attentions on the biggest, most sophisticated institutions, like Santander and its mountain of auto loans, or U.S. Bancorp. But many dealmakers think that risk transfers could also prove a useful tool for smaller banks who find themselves in a sticky situation. Some have loaded up on loans to commercial property owners that are now coming unstuck, and many will soon face higher capital requirements. Regional banks have been receiving approaches from private credit funds, though many are wary of the high cost of such deals, according to people familiar with the matter.

Whenever banks do something new, the question should be “how could this go wrong?” In a sense, the synthetic risk transfer is similar to the credit-default swaps banks gorged on in the years before the 2008 financial meltdown. Those didn’t end well: think of insurer AIG, which proved unable to meet losses it had underwritten on over $500 billion of bonds. This time, the amounts at stake are nowhere near those levels. Globally, the value of loans used in synthetic risk transfers in 2022 was a little over $200 billion, and overwhelmingly outside of the U.S., according to the International Association of Credit Portfolio Managers.

Fortunately, some lessons have also been learned. Unlike with swaps, investors in synthetic risk transfers stump up the money to cover losses upfront, sometimes putting it into a special company set up for the purpose. That means banks don’t have to chase their counterparties for repayment, or worry that they will be left short of promised cash.

Usage is also constrained by ever-wary regulators. The Federal Reserve has said that it will allow banks to do these deals only where certain criteria are met, and with limits. It recently approved a transaction by Morgan Stanley, but capped the firm’s transfers to $20 billion of loans. And the Fed’s proposed implementation of Basel Endgame rules could also penalize holding securitized credit. However, other bank watchdogs have said nothing on the matter, which leaves banks overseen by state-level authorities, for example, in a murkier place.

Assuming the trend gathers pace, it’s investors more than lenders who need to beware. In Europe, risk transfers often happen between sophisticated buyers and large, repeat sellers. In the U.S., smaller funds are muscling in on the act, and even large banks are unseasoned issuers. Some credit investors have found themselves presented with deals that allow a bank to swap in new loans from unidentified borrowers later, raising the danger that risk-transfer agreements become a trash can for unexpected and undesirable IOUs.

That makes pricing key for investors, and vigilance important for regulators. It’s worth remembering that bank rules exist precisely because big financial firms have a record of carrying innovations to excess. Synthetic risk transfers are a potentially helpful tool, and as they exist today, the banks aren’t likely to end up on the wrong side of these trades. But as their use gets more common, and more creative, it’s a good bet somebody else will.

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Disclaimer: This article is for information purposes only and does not constitute any investment advice.

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