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

Episode Date: August 22, 2024

Synthetic risk transfers, in which banks purchase insurance-like protection on some of their loans, is a growing market on Wall Street, with billions worth of deals made in the US last year. But of course, anything with the words "synthetic" and "risk transfer" is probably going to remind people of the 2008 financial crisis, when securitizations of loans blew up and infected the banking system. So what exactly are these new trades? Why do banks want to do them and what are investors getting in return for taking on this risk? In this episode, we speak with Michael Shemi, North America structured credit leader at Guy Carpenter, about what these deals are, how they're structured, and what they say about bank capital and the wider financial system.Mentioned in this episode:One of the Hottest Trades on Wall Street, An Etymological StudyJPMorgan’s Risk Swap Ends Up at a Familiar Place: Rival Banks‘Blind’ Bets on Bank Risk Transfers Have Never Been So PopularOnly Bloomberg.com subscribers can get the Odd Lots newsletter in their inbox each week, plus unlimited access to the site and app. Subscribe at  bloomberg.com/subscriptions/oddlotsSee omnystudio.com/listener for privacy information.

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Saturdays and Sundays starting at 7 a.m. Eastern. Make us part of your weekend routine on Bloomberg Television, Radio, and wherever you get your podcasts. Bloomberg Audio Studios. Podcasts, Radio News. Hello and welcome to another episode of the All Thoughts podcast. I'm Tracy Allaway. And I'm Joe Wisenthall. Joe, do you ever wonder what this show would have been like if we had been doing the podcast before 2008?

Well, we would have had plenty to talk about. You know, I actually have it right there. It would have been, man, now I wish we heard. We would have had like five bonus episodes every single. a little week. So there were just so much content in those days. I'm actually glad we weren't doing it back in 2008 because I feel like that was a time when we, along with everyone else in the market, were still learning a lot about how everything works. But the one thing I'm kind of sad about is, you know, there was a lot of interesting stuff happening in structured finance in the securitization

market back then. Lots of interesting deal structures. And there aren't that many of those since 2008 for obvious reasons. No, you're totally right. Like, you know, we don't do many like credit default swaps episodes or CDOs or various other versions of structured finance, which I know that, you know, you've covered quite a bit. You know, you hear about that stuff a little bit less. But yes, that would have been a buffet of topics for us to choose from back then. A buffet is a good way of putting it. Okay. So I'm very happy to say this is an episode I have wanted to do for a while. We are going to gorge ourselves on a particular type of structured finance deal. Something that's been happening in the market for a number of years now, but it really seems to be

booming in some respects in recent years. We're going to be talking about synthetic risk transfers or SRTs. I have to admit that up until like two days ago, I had no idea what a synthetic risk transfer is. I also still don't have any idea what a synthetic risk transfer is. But I like, you know, get the impression that basically, this is what I seem to know based on a couple of things I've read. There's only so much risk or balance sheet that a regulated financial institution like a bank is supposed to take. And at some point, if they want to continue to make loans and continue to maintain a relationship with a client, whoever it is, some of that risk in order for regulatory balance sheet purposes, whatever, has to be unloaded to some third-party entity.

Right. So the interesting thing about these transactions is they didn't always used to be called synthetic risk transfers. I remember, I mean, I am so old that I remember when they were just called balance sheet securitizations or synthetic balance sheet CLOs, collateralized loan obligations. I remember when they were called regulatory capital trades or regulatory relief trades instead of SRT. And I think that name actually gives a much more concrete idea of what is happening here. So banks have portfolios of loans. They have to hold regulatory capital against those loans. Post-2008 and all the regulatory reform that we've seen, they have to hold more capital. And so they've looked at creative ways of lessening some of that burden. And one of the things they've come up with is this

S-R-T idea. So this idea that you purchase basically insurance protection on a portfolio of loans. And then if you do it in the right way, you get to hold less capital against it. And it frees up your balance sheet allows you to do more lending. Now, the interesting thing about these deals is, as I alluded to, they actually have a long history. Like, in some respects, they're sort of the essence of securitization itself, this idea of risk transfer. And you can kind of trace the history all the way back to J.P. Morgan and the first bistro trades and stuff like that. Maybe we'll get all the way back to the 1990s and J.P. Morgan in this conversation. I'm not sure.

But there's definitely a lot to discuss primarily why these things seem to be growing now. So I think there was about $25 billion worth of SRTs issued in 2023. The average number of banks that have been tapping the market has gone from something like eight in sort of the 2014 to 2020 period to something like, 37 now. So that's a big jump. More banks are doing this. Investors are getting interested in this. One funny thing that I just realized is like some of the, do you remember the trade press on structured credit, like structured credit investor? I used to read them all the time sort of 2008 to 2010 and it was all about, you know, CDOs and RMBS and housing reform. It is now all about

Srt's. So you can see the sort of like transition, the evolution of the market happening in real time. I am really looking forward to this conversation. You know, I think to me, conceptually, part of my question, what I want to learn is like a financial institution hedging out some of their credit risk exposure, counterpart exposure, whatever it is, is not really new. And we had this whole thing, you know, that we would have talked about a lot in 2008, which is the credit default swaps market. And conceptually, to me, this idea of like, okay, here's an entity who wants to use someone else's capital, you know, to essentially buy insurer or insure away a risk. That was a thing. Then a lot of that market sort of dried up.

But now there was this new market. So I want to understand a little bit more about how this is conceptually different or similar to that. Right. This is a very big debate in this space. Like to what degree do these potentially pose a risk to financial stability? There's been some excellent coverage by our colleagues. at Bloomberg about one particular aspect of this that seems kind of sketchy. We are going to get into that. But I have to say, we really do have the perfect guest to discuss this. Someone I've

been wanting to speak to about this for a long time. We're going to be talking to Michael Schemi. He is the North America Structured Credit Lead at Guy Carpenter. So Michael, Mickey, welcome to the show. Thank you, Tracy. Thank you, Joe, for having me. Appreciate it. It's great to be here. What does Guy Carpenter actually do? Guy Carpenter is part of the Marsh McLennan family of companies that includes risk and insurance services, Guy Carpenter, Marsh, along with consulting Oliver Wyman and Mercer. Guy Carpenter is Marsh McClennan's reinsurance specialist, advisor, broker. I lead the North America Structured Credit business within the global mortgage and structured credit segment. I joined Guy Carpenter in late 2023.

I've spent my career in asset management in banking, working with financial institutions on matters related to regulatory capital, capital management, risk transfer. Most immediately before my current position, I had spent time working at a regulatory agency at FHFA, the federal housing finance agency, working on similar issues, but specifically related to the GSEs,

to Fannie Mae and Freddie Mac. Guy Carpenter has presence in the Americas and Europe, globally structuring and placing credit risk transfer, synthetic risk transfer for various financial institutions. We generally place this risk with multi-line reinsurance companies in reinsurance format, but also place this risk into the capital markets. We recently published with our colleagues at March and Oliver Wyman, a white paper in June about the potential for,

expanding banks portfolio management toolkit and exploring specific opportunities for North America banks to avail themselves of credit risk transfer transactions in that space. Much has been written about this recently, as you both alluded to. This was a bit different geared towards bank issuers, discusses benefits of credit risk transfer, gives some historic context, and also discusses what is required of a bank to launch such a program. It's a good paper, and I made sure to read it before this conversation. So why don't we, given your expertise, have you fact-check us in real time? Both Joe and I sort of explain the way we think of SRTs or reg cap trades.

Talk to us about what's your understanding and maybe give us a specific example, like in the evolution of one of these deals. How does it start and how does it actually come to market? Yeah, so there are a few things to say up front. I would also say, you know, your introduction, I think I agreed with basically every word there. Oh, thank you. So that's an accomplishment. Boom, boom. There are huge differences between what happens now in this market versus what happened in 2008 or more specifically in the lead-up to 2008.

But generally speaking, as you both describe, banks are regulated institutions. They face a variety of constraints on their balance sheets, their business, liquidity, capital. and they have developed tools to manage those constraints. It could be loan sales, it could be loan participations, that could be partnerships and securitizations. Credit risk transfer, synthetic risk transfer, is just one of those tools to manage these constraints through a securitization.

In the banking framework, they're really conceptually two sorts of securitizations. There's a traditional securitization that involves actual sale of assets. out of a financial institution. Where you put them in like a trust, basically. There's an SPV. There's a trust.

There's an actual sales, an outright sale of the assets. And then there's synthetic securitization, which does not involve actual sale of assets. Assets remain on balance sheet. Customer relationships aren't interrupted. Only credit risk is transferred out of the institution. What's also important here in these transactions, you know, people think of like 2008 and credit risk and shedding credit risk and bad assets.

This really is not strictly about shedding credit risk. Certainly it's a risk management tool and we'll get into the benefits, but it also really has become for banks and other regulated financial institutions like Fannie Mae and Freddie Mac more of a capital management tool than anything else. And just one thing I'll say in terms of nomenclature, because there's a lot of this floating around CRT, SART, probably the largest single program for these types of transactions is Fannie Mae and Freddie Macs program. That's referred to here in the U.S. as credit risk transfer, CRT. If you see some of the U.S. regional banks who have become inaugural issuers of these transactions, even in sort of two-queue earnings, they refer to these transactions as credit risk transfers, CRT.

globally outside of the U.S. in Europe specifically, these are generally referred to as SRT, significant risk transfer, even synthetic risk transfer. And SRT is really a regulated term. It's a formal regulatory term in that context. But ultimately, it's all the same. Generally speaking, it's the pooling of credit exposures by a financial institution transferring a subordinated portion of the risk to a third party either through a synthetic securitization rather than a traditional securitization. This is Tom Keene inviting you to join us for the Bloomberg Surveillance podcast. It's about making you smarter every business day. I'm Paul Sweeney. We bring you complete coverage of the U.S. market open. We cover stocks, bonds, commodities, even crypto, all the information

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Bloomberg Surveillance, Essential Listening, each and every business day. Joe, I did an etymological study of what people are calling these deals. I think I published it like a month or maybe two months ago because I was bored. And it was more than a thousand words long. Just tracing the change in the nomenclature or what we actually call these things over time. It's funny how many different phrases and words have fallen in and out of fashion to call these things. I feel like synthetic is one of those words that raises alarms. It's like it's not real or something like that.

But why don't you explain to us from the perspective of a bank? You mentioned the two ways that they can offload credit risk. One is outright selling it. The other one is keeping it on the balance sheet and then offloading some of the credit specific risk. We'll get to how that's structured and who's buying. and who's on the other side. But what do you explain from a regulatory or bank capital efficiency standpoint why the risk transfer is attractive rather than the outright sale of the asset? Oh, and just to add on to that because it's related, but why don't banks just raise more capital

for their loans? So I think it's important to understand some of the conceptual foundations for bank regulatory capital, what it's designed to achieve and what it isn't designed to achieve. At the very highest level, financial institutions, again, whether you're a bank or a GSC or anything in between, generally face expected losses and they face unexpected losses. Expected losses perceived as a cost of doing business, banks price for expected losses through lending, and account for expected losses also through loan loss provisioning in their normal course of business. banks don't hold regulatory capital for expected losses. In essence, what concerns bank regulators is unexpected losses, the losses above expected losses, and regulatory capital is there

to absorb these unexpected losses as defined by regulators. And so you can really see bank capital as a proxy for those unexpected levels of loss, above expected loss, for which banks provision and price for. Now, how do bank regulators sort of transcribe that sort of philosophically into capital requirements? Well, they look at two general frameworks right now. There's a risk-based capital requirement, and then there's a leverage capital requirement. Leverage capital requirements sort of assign same requirements to different asset classes, no matter the risk, same amount of capital. So whether you have $100 of a treasury security of cash on balance sheet, a mortgage, a corporate loan, you know, that same $100 of exposure will attract the same level of capital.

For risk-based capital requirements, the RBC assigns different capital requirements to different exposures based on the perceived risk they post to the bank by assigning different risk rates. Yeah, RBC? risk-based capital. Oh, yes, sorry. Excuse me. Yeah, yeah. Yeah, we're diving into that.

This is going to be an episode with a lot of acronyms, I feel. Yeah, just keep going. Keep going. So unlike the leverage framework, right, cash on balance sheet will attract far less in capital requirements than a mortgage loan or corporate loan or a consumer loan. And because of this differentiation in riskiness under the risk-based capital framework, not the leverage capital requirements, banks seek to execute these transactions.

So bringing this together, right, credit risk transfer transactions, transfer a portion of the credit risk, typically the unexpected levels of loss, as defined by regulators, for an identified pool of assets out of the bank. And so as a result, for the risk-based capital framework, the bank can demonstrate to its regulator that the bank faces a significantly lower level of unexpected loss and thus is permitted to hold less in regulatory capital. Less regulatory capital, not no regulatory capital. Right. Right. And the bank is relieved of some of this capital that held pre-transaction. And that's sort of where the concept, I trace you mentioned before, where the concept of capital relief trades

comes in. And I think from there we can talk about some of the more specific structures that we're seeing. I definitely want to get into structures. I want to ask one question before we move to that, though, and it's sort of, I think it fills out the regulatory aspect of this. But why is it that the market for these things seems to be much more mature and larger in Europe, so for European bank issuers than in the U.S.? In the U.S. in the U.S., it's really only begun to take off in the past year or so, despite a lot of bankers. I remember in, like, 2013 or something having conversations with, I think it was someone at Citigroup talking about how they wanted to structure a bunch of red cap trades for smaller banks.

And then, lo and behold, 10 years later, it feels like the U.S. market is actually starting to do something. So why was there that discrepancy? So you're absolutely right. In contrast to the global experience, credit risk transfer never expanded meaningfully in the U.S. beyond the GSCs in any programmatic way. And there's several reasons for that. We just hit on one of them. Regulatory capital differences are one. You know, we talked about the capital requirements, risk-based capital versus leverage.

These transactions were more embedded in Europe already pre-2008 because banks had already adopted what's known as the Basel 2 framework that had a lot more risk-sensitive risk-based capital requirements. The U.S., on the other hand, was delayed in that process in transitioning from Basel 1 to Basel 2, continue to operate under Basel 1 for a while, and then in around 2012-13, sort of leapfrog, straight to Basel 3 from Basel 1. And another aspect of this, I think that's important to note. One of the post-GFC post-Global financial crisis reforms in Basel 3 in the bank capital reforms was the introduction of this leverage ratio requirement, right?

So it was all sort of risk-based capital based beforehand, and now the leverage ratio requirement is supposed to be sort of a backstop. But interestingly, in the U.S. and earlier than 2008 and early, then 2008 and early, earlier than Basel three reforms, the US banking regulators already subjected banks to a leverage capital requirement, unlike their global peers. And in that regime, banks don't benefit

from the impacts of credit risk transfer since all risks are treated equally. And so there was also just up until now, less of a focus historically on risk-based capital requirements in the US, so implicitly less of a focus on credit risk transfer. You know, on top of that, during this transition into Basel, three, there wasn't much regulatory clarity about the treatment of these transactions here in the U.S. So it's real, there's real regulatory capital regime differences between the U.S.

versus Europe or even between the U.S. and, say, Canada. But I also don't want to put this all at the feet of regulators. Because in my view, you know, Tracy, you mentioned having conversations in 2012 and 2013 around this for U.S. banks. In my view, and maybe this is a minority view, but I think it's, been borne out, credit risk transfer for U.S. banks in the years following the financial crisis was a solution in search of a problem. Coming out of the financial crisis, U.S. banks raised capital to shore up balance sheet. You know, maybe they were forced to do so, actually. I think you

would ask certain bank management. They're subjected to regulatory stress tests early on. They have been, were and have been perceived to be better capitalized with stronger balance sheets than their global peers. They were never really balance sheet constrained in the years coming out of QE. And this is also reflected in their valuations across their capital structure. I mean, most of these banks traded a premium to book value. So if a bank, and Tracy, you posed this question earlier, right? So if a bank did need to raise capital for something, you know, it was relatively easy

to do at attractive valuation. So the business need wasn't clear for U.S. banks and my money. opinion, as it was for European banks, who did not recapitalize in the same way as U.S. banks did post-GFC. They were, in our, risk-based capital, constrained. And again, that was reflected in their valuations where most of these banks still trade at a discount to book value. And just think, you know, sort of post-2008 around like the lingering sagas for banks

across the continent, right, in the European sovereign debt crisis. But even beyond, I would also say, you know, moving out of the banks a little bit, the GSCs, like European banks in a way, you know, similar but not the same. The use case was clear there as well, you know, the need to sort of de-risk the taxpayer during the conservatorship and going through the capital build process. But, you know, in any event, you know, ultimately, in addition to regulatory uncertainty here in the U.S., banks and bank management generally didn't really prioritize active balance sheet management as they are now.

That was a fantastic and very clear answer. And it makes a lot of sense why just setting aside regulations, why economically there wasn't much need to prioritize these sort of balance sheet trades. On April 4, 2023, around two in the morning, a man was found stabbed multiple times on a sidewalk in downtown San Francisco. Hey, who did this to you? What happened next turned the story into a political firestorm. Reports have identified the victim as Bob Lee, the founder of Cash App.

From Bloomberg Podcasts, this is Foundering, the Killing of Bob Lee, beginning April 16. All right, let's talk about how these are structured. So I'm the first bank of Joe, and I want to take off some of my books, some of my credit risk. And you're some other entity. What's our deal? First of all, I guess there's two questions. Who are you? Are you like a hedge fund?

are you a pension fund, like who is taking on this, an insurer who is taking on this credit risk? And then in the most vanilla example, what is the deal that we're striking? Right. I think that's an important question also to sort of think about who the counterparty is. Generally in these transactions, these are done in what's sort of known as fully funded format. Okay. There's a synthetic securitization. We're taking a loan pool. and a bank typically hedges the mezzanine level of risk while retaining the first loss, right? That's really the expected loss we were talking about a few minutes ago and retain then the senior trunch.

So mezzanine is like the middle. That's right. The clue is in the name. But also this is kind of different to the securitizations, the synthetic securitizations of old, where I think they were mostly selling the senior, right? Yeah, and those that were even selling full stack securitizations, right? And, I mean, one of the key differences, and we can get into this as well, right, one of the key differences then was really to sort of allow uncapped, leveraged speculation. Where we're here, what we're talking about is a bank, first bank of Joe, having actual credit exposure on their balance sheet through normal course of lending operations and then seeking to hedge a portion of their risk for capital purposes, for risk management purposes.

And so the whole point of departure for this transaction is not speculation. It's actual hedging. And there's actually like one exposure to being 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. So how does that work? What's the deal that we do?

Right. So again, a financial institution pulls credit risk together, transfers a budget. portion of the risk out of the bank. The loans remain on balance sheet. You know, assets are not sold. Only credit risk is transferred. We gather a loan pool. And what we've seen here in the U.S. just to just to take a hypothetical transaction, a, and 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% or some. They take an identified subset of that pool and put it into a synthetic securitization.

They tranche up, securitize their risk, generally speaking, right? They retain the first one or one and a half percent of cumulative portfolio losses. That'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 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. Regulatory 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-weighted according to the risk they represent to the bank. Now, that's the capital structure.

Joe, I think more specifically to your question, like, what is the actual mechanism that transfers is this, exactly, that what is the actual mechanism for a bank to actually? 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? An 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

pulls as losses arise, should they arise, then those losses, rather than being allocated to the bank or allocated to this bond, right? And what does the investor receive? Well, you know, the investor puts up money upfront, fully collateralizes the transaction in buying this bond. They get interest income over time. And then at the end of the transaction, they get whatever money remains there, you know, less losses.

Tracy, it reminds me a little bit of like a catastrophe bond. or something like that, where it's like you put up a bunch of money and you get 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? And 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, or better yet, a different execution alternative, right? 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 percent of it, probably be about 10 percent. 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 volume, it's outstanding credit risk transfer. You know, 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 market, and about 65% of that or so is in this bond.

credit link 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 them. So 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, find us a 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. It can be opaque at times. So there are a lot of questions in me. I know. I'm sorry. I think that might have been four questions in that. So let me start off with that last bit Tracy around sort of what are the typical asset classes that banks put into these transactions and then we can get into, you know, part three, four, five, and 17 of your, of your multi-part question. I think one important to make up front is that generally speaking, these transactions are programmatic issuances for from banks that have issued them, right? 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. No, 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, they ask, 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 corporate corporations and then you have also Asset classes somewhere in the middle in Europe you know these are sort of known as SMEs small and medium enterprises here in the U.S., more commonly known as just the middle market companies. And it's important to just bear that in mind. You know, 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. There could be involved in other fee-generating activities for the bank, and they're just looking, 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, right, so for the GSCs, they're sort of, you know, monoline guarantors, right? They do single family and, you know, sort of multifamily acquisitions, you know, so mortgages are really their business. A bank would typically look across its asset portfolio and say, well, what's the most capital intense, right?

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 seek capital relief on because they have a lower capital... And there's just lower capital requirements

on mortgages versus, say, a corporate or a consumer loan that draws double in the capital requirements a bank is required to hold. And so just implicitly, there's also that calculation for a bank. What is the most capital intensive asset I have on balance sheet? You know, 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, you know, if I'm a hedge fund 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. You'll have a loan tape.

You'll have all the relevant credit and performance information that that you need. But like picking one loan out of thousands won't necessarily, you know, 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. You know, one can question, you know, how much merit that additional credit work actually has or provides to the transaction.

But 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 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 be. pay you for that because it frees up regulatory capital for me.

So in the example that we just discussed a few minutes ago, you know, around that hypothetical auto loan transaction, you know, we would probably estimate in that sort of capital structure, you know, the capital requirement for the bank just dropped by, you know, 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, we'll have different, different pricing.

You know, what we've seen more recently for that type of mes tronching 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. type of payment on the mezzanine tranche. Now, that's sort of the headline coupon that a bank has for these transactions.

A 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, you know, on the mezz trunch, on the mezzanine tranche, and they will compare that relative to the amount of capital that's freed up. Yeah.

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. You could issue preferred equity, right? But even on yields today, it would 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 of 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. And 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. It'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 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 when bank supplied leverage for GSC CRT. CRT for credit risk transfer, for GSC credit risk transfer. Keep up with the acronyms, Joe. Sorry. There's the whole episode.

Sorry. So I'd seen some of that in the early days of the pandemic for a brief time with a bank supplied leverage for. for GSC CRT, given that, you know, at that time, the world was on fire. Basically hit by a meteor or the equivalent thereof, you know, this piece of it, you know, was hardly systemic. I would say this, you know, 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, you know, more veteran investors really are just relying on the current coupon in 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. They're not really affected by the vagaries of the secondary market. But even to the extent, say, that there is bank support. leverage to these transactions. I think Tracy, you mentioned at the outset, you know, 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 transferred has some bank leverage on it, is that systemic? You know, 40, 50, 20, 23, 25 billion of risk transferred, you know, that in, that could increase this year. But is that systemic?

You know, for the global banking system doesn't seem to be. Well, so speaking of systemic risk, and I mentioned in the introduction that if we, and Tracy mentioned it too, you know, if we've 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? Joe, 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, right? And much of the, I'll call it polemic around this harks back to 2008 in the financial crisis. And when people hear buzzwords like synthetic and derivatives, you know, their stomach 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. This is about true distribution of credit risk rather than concentration of credit risk at a number of highly level. counterparts, counterparties. I wasn't going to mention it, but you mentioned AIGFP, right? There was the poster child for all of this. And, you know, we take the AIG experience and say, this is completely different because of this hedging versus speculation point.

I would also say this. Most of these deals are fully funded, like we talked about. So no counterparty risk. The investor puts up up. The money is already in the pot. The investor puts up cash day one, fully collateralizes the bank for the life of the transaction. So 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. Yeah. And that's it. And 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.

You know, the issuer of these transactions, banks or the GSCs, have skin in the game in almost every tranche of this, 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? And name the individual, so I can look them up on LinkedIn. No, just kidding.

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. 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, there aren't just like normal consumers. And then externally, they have regulators.

And 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. Banks 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. Very diplomatic answer. That's a very diplomatic answer. We'll have to get the real answer, I guess, off the air. When we turn the mics off. Yeah, so apologies to the listeners.

But 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 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. But 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. Apparently, 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. And if they lose money, that's okay 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. 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. There'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.

sort of gave its blessing to these things and said, like, okay, if there's a genuine risk transfer here, we're okay 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. Yeah, 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 were 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? Like 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 bonds to juice my returns. And 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, you know, 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. But, you know, like I said, the market is 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 risk should emerge. Yeah. That seems not like what was intended. But anyway, this was a fun. Yeah, it was great. It's a fun, like, nibble at structured credit. Yeah. In the interests of 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. 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 Wisenthal. You can follow me at the stalwart. follow our producers, Carmen Rodriguez, at Carmen Erman, Dashel Bennett at Dashbot, and Kail Brooks at Kail Brooks. And thank you to our producer, Moses, Andom. And for more Oddlots content, go to Bloomberg.com slash oddlots, where we have transcripts, a blog, and a newsletter.

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