The Hottest Way for Banks to Get Risk Off Their Balance Sheets

28:48And so the whole point of departure for this transaction is not speculation. It's actual hedging. And there's actually like long exposures behind it. But going back to you on the other end of this trade, I don't know if it's right to say you're a speculator, but you're looking to make money on this trade. I'm looking to hedge risk or I'm looking to deal with some balance sheet and you're looking to collect premium. You get paid a premium, right? So how does that work? What's the deal that we stay? Right. So again, a financial institution pulls credit risk together, transfers a portion of the risk out of the bank.

29:21The loans remain on balance sheet. Assets are not sold. Only credit risk is transferred. We gather a loan pool. And what we've seen here in the US, just to take a sort of a hypothetical transaction, in what's become a popular asset class is auto loans. And so a bank has a certain amount of auto loan lending exposures on balance sheet. They have to risk weight that according to current regulation at 100%. They take an identified subset of that pool and put it into a synthetic securitization. They trunch up, securitize that risk. generally speaking, right? They retain the first one or one and a half percent of cumulative portfolio losses.

30:08That's the expected losses. They sell the mezzanine tranche that references the next levels of loss, the unexpected loss. You can say maybe that's the next 10 or 11 % of losses. And then they retain again, the very remote senior levels of loss referencing the remaining whatever it is, 87, 88 % of loans after credit protection is exhausted. Different asset classes, different geographies will have different tranching, but that's the basic capital structure that generally stays the same. There are instances where banks also buy first loss protection. A bank can demonstrate to the regulator that the bulk of the unexpected loss is transferred out of the bank.

30:49Regulatory capital treatment is then transformed from just a normal loan pool to a synthetic securitization with different tranches of risk being risk-weighted according to the risk they represent to the bank. Now, that's the capital structure. Joe, I think more specifically to your question, what is the actual mechanism that transfers - Yeah, what are you paying me up front? Exactly. What is the actual mechanism for a bank to actually transact and acquire credit protection? Yes. Generally, what happens is that a bank enters a derivative or a financial guarantee that's transformed into a credit link note, which is a bond, right?

31:27An investor, hedge fund, pension fund buys a bond from the bank, a credit link note, CLN, and the performance of that bond, that CLN, is linked to the performance of the underlying reference pools. As losses arise, should they arise, then those losses, rather than being allocated to the bank, are allocated to this bond, right? And what does the investor receive? Well, you know, the investor puts up money up front fully collateralizes the transaction and buying this bond they get interest income over time and then at the end of the transaction they get whatever money remains there a little bit like less losses tracy it reminds me a little bit of like a catastrophe bond yeah or something like that where it's like you put up a bunch of money and you get an interest and if there's no hurricanes you get all the money back but if there are some hurricanes you get a little less money back so i can't tell you why that is a perfect analogy, right?

32:21And that is really the sort of genesis of many of these transactions. Maybe genesis isn't the right word, but the right parallel. And what we've also seen is that, you know, I just described sort of fully funded, you know, sort of bond format transactions. You know, what we also do, this is sort of a Guy Carpenter specialty, is put this risk in the form of a reinsurance contract with diversified reinsurers. Oh, interesting. So there's another layer. There's another layer or better yet, a different execution alternative. So if you look at globally the bank credit risk transfer market, most of it is in this sort of credit link note bond format that I just described, probably about 85, 90 % of it.

33:06Probably about 10 % and it's growing is in this reinsurance format with multi-line diversified reinsurers. If you look at Fannie Mae and Freddie Mac right now, in terms of outstanding, not volumes, just outstanding credit risk transfer, they have about almost$90 billion in risk transfer outstanding right now. I would say the latest reporting, roughly 35 % of that is in reinsurance markets, and about 65 % of that or so is in this bond credit note-like format. So I really like the cat bond for banks analogy where you're sort of getting insurance on the unexpected loss portion of your portfolio. I mean, explain again who's on the other side of this.

33:54So you mentioned insurers, but I believe there are lots of hedge funds involved as well. And then secondly, I'm still unclear on the genesis of these trades and who approaches who. Is it the bank issuer that goes out and talks to a potential counterparty and says, hey, we're looking to do this? Or do they approach you and say, fine, does it counterparty? Yeah. And then also, how do they decide exactly which loans to put into these structures? Because my understanding is one of the criticism of some of these deals is that sometimes hedge funds are just offering to insure these things basically without actually knowing what's in the underlying portfolio.

34:33It can be opaque at times. So there are a lot of questions. I know. I'm sorry. I think that might have been four questions. So let me start off with that last bit, Tracy, around sort of what are the typical asset class classes that banks put into these transactions, and then we can get into part three, four, five, and 17 of your multi-part question. I think one important to make up front is that generally speaking, these transactions are programmatic issuances from banks that have issued them. So it's not like there's a one-off deal. They've identified some bad asset on their balance sheet, and then they want to get rid of it and then they go home.

35:15No, it's more around programmatic issuances and transactions typically reference assets and businesses that the bank likes. Transactions reference assets that the bank wants to grow and they're looking for tools to support that growth. Now, the assets span a whole range of them and reference pools really range from very granular exposures like consumer and mortgage and auto loan type of exposures to single borrowers, to much chunkier portfolios like corporate exposures that a bank has on balance sheet, like lending to large corporations. And then you have also asset classes somewhere in the middle.

36:00In Europe, these are sort of known as SMEs, small and medium enterprises here in the US, more commonly known as just the middle market companies. And it's important to just bear that in mind. That's a big part of how reference assets are selected. And underlying borrowers may have a much broader relationship with the bank rather than just this loan. They could be involved in other fee generating activities for the bank. And the bank is looking for ways to protect that borrower relationship. Another aspect of it for a bank, so in terms of asset selection, so for the GSEs, they're sort of monoline guarantors.

36:44They do single family and sort of multifamily acquisitions. So mortgages are really their business. A bank would typically look across its asset portfolio and say, well, what's the most capital intense? So from a cost of capital perspective, what makes the most sense in terms of targeting for capital relief? So oftentimes, exposures like mortgages, conversely to the GSEs, may not make the most sense for a bank to see capital relief on because they have lower capital. And there's just lower capital requirements on mortgages versus, say, a corporate or consumer loan that draws double in the capital requirements a bank is required to hold.

37:28And so just implicitly, there's also that calculation for a bank. What is the most capital-intensive asset I have on balance sheet? And where does it make most sense to seek capital relief? What about the transparency of the loan portfolio? If I agree to do this, if I'm a hedge funder or an insurer on the other side, how much visibility do I get into the loans. Right. And so that relates to sort of the granularity of the transaction or of the reference pool. So in very granular pools, really what you're looking at is more of a statistical exercise, right, with not a lot of visibility into like the identity of like one individual borrower.

38:06You'll have a loan tape, you'll have all the relevant credit and performance information that you need. But like picking one loan out of thousands won't necessarily help you in your credit work. It has to sort of be seen together. Conversely, in chunkier portfolios, including portfolios that include corporate exposures, there usually individual obligors are identified and their names identified. And so the investors on the other side can do their own individual credit work on top of what the bank already provides. One can question how much merit that additional credit work actually has or provides to the transaction.

38:51But there's certain investors that just generally, because of their investment requirements, just require sort of full disclosure of all their borrowers in an underlying reference pool that just may not look at more granular sort of consumer assets and rather just look at corporate exposures, for example. Can you walk me through a sort of simplified math? so you're going to take this risk off my book but i'm going to pay you for that service i'm going to pay you some spread over whatever some risk-free reference rate whatever i don't know walk us through like the really simplified math of how much it's worth me to pay you for that because it frees up regulatory capital for me so in the example that that we just discussed a few minutes ago around that hypothetical auto loan transaction.

39:41We would probably estimate in that sort of capital structure, the capital requirement for the bank just dropped by 60%. Okay. Right. Because the risk weighting on that portfolio has dropped from 100 % on just like outright bank holding auto loans to roughly 40 % under this synthetic securitization framework. typically the different tranches of risk you know will have different different pricing you know what we've seen more recently for that type of mezz tranching on balance right and this is just this isn't just a spread this is sort of all in coupon yeah we're probably talking about you know mid to high single digits okay type of payment on the mezzanine tranche now that's sort of the headline coupon that a bank has for these transactions.

40:36A bank, however, won't just look at the headline coupon and say, you know, this is what we're paying. What the bank will do is say, okay, these are our annual costs on the mezzanine tranche, and they will compare that relative to the amount of capital that's freed up. And together, they'll take a look and say, okay, well, that's my cost of capital. The amount of paying investors relative to the amount of capital I freed up, that's my cost of capital. And then they can also look, the bank can look and say, well, what are my alternatives? Well, I can go out and issue common equity, but the cost of common equity will probably be far north of anything I just described.

41:20You could issue preferred equity, right? But even on yields today, it'll probably be far north of what I just described without that same sort of common equity benefit. And that's sort of like the general approach a bank would take to pricing and really sort of assessing the financial viability of these transactions. Okay. So it has to make financial sense for the bank, for the issuer. It can't cost more than issuing equity, for instance. My understanding, and now we're getting into some of the financial stability questions around these is that because of this, the yields or returns being paid on these deals to investors on the other side of the trade, the hedge funds, the insurers, whatever, have sometimes been, let's just say, mediocre.

42:10And so there has been a temptation in recent years for hedge funds to basically juice the returns by using the deals, the credit link notes, as collateral in the repo market. So basically borrowing against them and then you get cheaper funding and then your return goes up. So I don't know, instead of this is totally hypothetical because I don't know the exact numbers, but instead of getting 6%, you get 9 % or whatever. Is that a worry? Because it seems kind of weird that we're offloading risk from the financial system, But then hedge funds are turning around and getting leverage on that risk by borrowing from another bank.

42:54It's hard to assess the amounts outstanding here. And it's hard to say whether this is a real or perceived risk. My experience, including my experience at FHFA, I think with our in conversations I had had with our other federal partners, call it whether or not the risk is real or perceived. The concern is real. like i said we can't tell you exactly how much that actually happens i saw a bit of that in my past professional life even before fhfa in the early days of the pandemic in march of 2020 you know for a brief time uh when bank supplied leverage for gsc crt crt for credit risk transfer for gsc credit risk transfer keep up with the whole episode sorry that's the whole episode So I'd seen some of that in the early days of the pandemic for a brief time with a bank supply leverage for GSC, CRT, given that at that time the world was basically hit by a meteor or the equivalent thereof.

43:58This piece of it was hardly systemic. I would say this, I happen to know that many of the dedicated traditional asset managers in this space are really buy and hold investors. you don't really rely on that type of leverage to boost sort of short-term returns. I think this gets, Joe, to your question a little bit, who are these people on the other side? And many of these more veteran investors really are just relying on the current coupon and the current interest that these deals throw off. Certainly what I know in the reinsurance markets, right, reinsurance markets are buy and hold investors, counterparties, I should say.

44:41They're not really affected by the vagaries of the secondary market. But even to the extent, say, that there is bank supplied leverage to these transactions. I think, Trace, you mentioned at the outset, you had an estimate of about$25 billion or so of these deals getting done in 2023. Even if that number doubles this year, I don't know that it will, but let's just say that it does. if some of that risk transfer has some bank leverage on it, is that systemic? You know, 40, 50, 2023, 25 billion of risk transferred, you know, that could increase this year. But is that systemic? You know, for the global banking system, doesn't seem to be so.

45:29Well, so speaking of systemic risk, and I mentioned in the introduction that if we, and Tracy mentioned it too, you know, if we'd been talking about this in 2008, we would have been talking about credit default swaps, et cetera. There are other mechanisms for any financial entity to take some credit risk off their book. And so for a while they're buying CDS and unfortunately a bunch of them were all buying it from one company, AIG, and then we all know what happened with AIG, et cetera. But structurally, like what happened to that market And why from the sort of at the most sort of conceptual abstract level, how would you describe the sort of market structure differences between these synthetic risk transfers or credit risk transfers and credit default swaps?

46:15Joe, that's a great question because I actually happen to think that much of the current SRT, CRT market is actually informed by the experience of 2008. We all saw 2008. We said, don't let that happen again. And much of the, I'll call it polemic around this harks back to 2008 and the financial crisis. And when people hear buzzwords like synthetic and derivatives, their stomachs start churning. But this is different in every possible way. This is really about hedging actual credit risk that arises out of actual normal course of lending activities, not uncapped leveraged speculation that was the hallmark of many synthetic securitizations pre-2008.

47:10This is about true distribution of credit risk rather than concentration of credit risk at a number of highly level counterparties. I wasn't going to mention it but you mentioned AIGFP right um that was the poster child for for all of this um and you know we we take the AIG experience and say this is completely different because of this hedging uh versus speculation point uh um I would also I'd also say this uh most of these deals are fully funded like we talked about so no counterparty risk right the investor money's already in the pot The investor puts up cash day one, fully collateralizes the bank for the life of the transaction.

47:56So it's not like the bank exchanges the underlying credit risk of the portfolio for the counterparty risk of the investor. Now, to the extent that these are transacted with the reinsurance market rather than with the capital markets, these reinsurance counterparties are exactly the opposite of AIGFP. They're highly diversified, highly regulated, highly rated, multi-line companies where the credit exposure that they take on through these deals is actually a diversifier and not correlated to their sort of underlying core property and casualty business, right? AIGFP was in the business of selling credit protection and that's it.

48:39And I think a big part of this is also alignment of interest, there is actual skin in the game from the issuers, right? So we just talked about some illustrative capital structure. The issuer of these transactions, banks or the GSEs, have skin in the game in almost every tranche of these transactions, right? And I think that's also a key differentiation in terms of alignment of interest and risk retention. So we kind of came full circle just then back to 2008 and the experience there. Given that and given your storied career in working with banks and advising banks, I have to ask you, what's the dumbest thing you've ever seen bank management do?

49:26And name the individual so I can look them up on LinkedIn. Don't do that. Maybe we could save this for some off the record conversations. I have seen many things in my career, both sort of pre-2008 through 2008 and since. I don't want to name any individual banks. Of course, of course, of course. But this is what I would say. And I really came to even appreciate this more during my time in government. And this, Tracy, to your point, going full circle, banks face many constraints. they have many stakeholders right both internally and externally whether it's you know banks have employees whether they have shareholders whether they have depositors that aren't just like normal consumers uh and then externally they have regulators and this then again this isn't just like you know regulator supervisors right this is also you know things like the fdic right we're actually protecting depositors.

50:31Banks face many constraints. They have a lot of stakeholders they have to answer to. And I think that's just an incredibly difficult job this day and age. And I think that these types of transactions, again, are just like one tool in their toolkit to help manage these different stakeholders. I've seen bank leaderships and other financial institutions sort of get in trouble when they lose sight of all these different stakeholders they have to manage to. Very diplomatic answer. That's a very diplomatic answer. We'll have to get the real answer, I guess, off air. When we turn the mics off. Yeah, so apologies to the listeners.

51:09But Mickey, that was a fantastic conversation. I feel like I understand these deals a lot better now. So thank you so much for coming on All Thoughts and explaining them to us. Tracy, Joe, thank you very much. Appreciate the invitation. Yeah, that was really fantastic. That was great joe i enjoyed that conversation so much it just it feels good to have a sort of acronym laden yeah discussion i'm trying to think of all the ones that we hit like crt srt rwa rbc SME, CDS, CLN. There was probably more. You know, it was an acronym-laden conversation, but he was very clear about describing it. And I think the two things that I really, you know, two of the big things that I think about, like as he mentioned, we sort of mentioned, you know, people's like alarm bells go off and they hear things like synthetic risk transfer and all that stuff.

52:10But the two things that like this structure, the sort of cat bond fully funded, we're going to put the money in a pot up front, which we expect to take back minus any losses, inherently, I think, seems less risky. Although you mentioned there are ways to transform that risk, but it seems less risky than like one where you're depending on the credit strength of your counterparty like an AIGFP. And then also this other big theme that we've seen in the post-grade financial crisis era of like distributed risk to non-regulated institutions like hedge funds or so forth, which are designed in some level to take risk.

52:51And if they lose money, that's OK, because that's part of why they exist and why they make money. That's exactly what I was going to say is this outcome is kind of what financial regulators would have been envisioning post 2008, where they want to shift a lot of the risk of unexpected losses from bank loans onto non -bank entities who, you know, you don't have to. It's bad if a hedge fund goes under, obviously, or, you know. But it's less bad than if a bank goes under. Yeah. I was going to throw out another acronym, a BDC, a business development company goes under. But yes, it's less bad than if a regulated bank goes under.

53:28There's less systemic implications. Hopefully that was the thought process. And I should just say we didn't actually get to it because of time constraints. But the timing of these things in the U.S. at least, you can trace that back to regulators as well. So last year, I think it was September 2023, the Fed basically issued guidance on these deals. So sort of gave its blessing to these things and said like, OK, if there's a genuine risk transfer here, we're OK with the resulting capital relief that comes out of it. And again, I think there are questions about specific deals and how they're structured.

54:05Yeah, and what's in them, the reference notes and all this. And then the repo leverage. And there is some irony where if you have these deals and you're trying to shift risk out of the banking system and then it comes right back into the banking system because the investor is borrowing against the deal, like that doesn't seem to be an ideal outcome. But as Mickey was saying, we're probably not at the point yet where it's something that people are doing at like a massive scale. It's nowhere near massive, but it is your point, right? If I'm an entity and I buy one of these bonds, there's at least some chance that I'm going to try to borrow against that bond to juice my returns.

54:43And if I'm borrowing from a bank, this is financial markets. I mean, this is just what financial markets do. They find a way to press it. And so I think it sounds like something to watch, not like, oh, this is a big red flag and there's like a lurking time bomb underneath the banking system. Um, but you know, like I said, the market's not that big, but if I have this bond and it's designed to protect the banks from risk, but then I'm borrowing against that bond from a bank, you could see how risks would emerge. Yeah. That seems not like what was intended, but anyway, this was a fun, this was a fun like nibble at structured credit.

55:19Yeah. In the interests of, uh, continuing to gorge ourselves on this, I really want to do an episode on the original like JPM bistro trades. Like, let's just go back. Let's do a financial history series. I'm always down for that kind of thing. Okay. All right. Well, in the meantime, shall we leave it there? Let's leave it there. This has been another episode of the All Thoughts Podcast. I'm Tracy Alloway. You can follow me at Tracy Alloway. And I'm Jill Weisenthal. You can follow me at The Stalwart. Follow our producers, Carmen Rodriguez at CarmenEarman, Dashiell Bennett at Dashbot, and Kale Brooks at Kale Brooks.

55:50And thank you to our producer, Moses Andam. And for more Odd Lots content, go to Bloomberg.com slash OddLots, We have transcripts, a blog, and a newsletter. And you can talk about all of these topics 24-7 in the Discord, discord.gg slash oddloves. Go there and hang out. And if you enjoy Odd Lots, if you like it when we dive deep into the structured finance market, then please leave us a positive review on your favorite podcast platform. And remember, if you are a Bloomberg subscriber, you can listen to all of our episodes absolutely ad-free. All you need to do is connect your Bloomberg account with Apple Podcasts.

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