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Wall Street explores novel ways to repackage bank loan risk

A street sign for Wall Street hangs in front of the New York Stock Exchange May 8, 2013. REUTERS/Lucas Jackson
A street sign for Wall Street hangs in front of the New York Stock Exchange

A financial product that enables banks to shed risk from loan portfolios is gaining more popularity among lenders in the United States, with investors and lawyers devising new structures to broaden its appeal.

In deals known as credit risk transfers, banks effectively buy insurance from hedge funds and other investors against the risk of losses from loans. The deals can free up precious capital for lenders, while producing juicy returns for investors and handsome fees for the arrangers.

The market for these products, already well established in Europe, has drawn more attention from US players since the regional banking failures in March prompted lenders to look for ways to build capital cushions to appease regulators.

But structures currently in use come with constraints. US regulatory requirements set by the Federal Reserve restrict participation from insurance companies in these deals. The types of loans, mostly auto and mortgages, also limits the pool of potential investors, five investors and lawyers involved in credit risk transfer deals said.

Now, some of those parties are pitching US lenders with different variations of credit risk transfer products that could address those issues.

Insurance companies, for example, are keen to participate in capital relief trades but under current U.S rules, banks cannot gain capital relief on loans where risk has been sold off to insurers, the industry sources said.

Introducing an intermediary is one of the solutions proposed.

Under this structure, an intermediary bank would buy protection against loan loss from an insurance company, and then sell protection to a different bank seeking to execute the risk transfer transaction, according to a senior portfolio manager at a large institutional investor who did not want to be named.

It is unclear whether the Fed would grant capital relief to a lender using such a structure as it would depend on whether the protection sold is funded – an insurance sale backed by a cash collateral – or unfunded.

The Federal Reserve declined to comment.

Certain transfers of risk backed by cash collateral are recognized under the bank capital rules.

But this kind of deal involving an intermediary is likely to meet some of the headline requirements for such transactions, including that the protection was sold by a non-insurer with sufficient capital, the portfolio manager said.

Gareth Old, structured finance lawyer at Clifford Chance, said investors were increasingly approaching banks to structure the deals they wanted.

“They bring in investment bankers on essentially a kind of fee-for-service model for placing notes,” Old said.



The Federal Reserve in the fall approved some such deals as a way for banks to reduce their capital requirements.

Since late September, seven US banks, including JPMorgan Chase (JPM.N) and US Bancorp (USB.N), have trimmed the risk of losses on mortgage, corporate and automobile loans using risk transfers – many for the first time, according to bank filings, term sheets, investor estimates and regulatory notices.

The trades, some of which price at double-digit yields, have attracted investors such as Ares (ARES.N), Blackstone (BX.N), and PGGM.

The opening up of the US market has boosted global volumes.

Issuing banks in the private sector sold off an estimated $25 billion of the risk of losses on loans totalling $300 billion globally in 2023, compared with $20 billion sold on $250 billion of loans in the previous year, according to Olivier Renault, head of risk sharing strategy at Pemberton Asset Management, which invests in non-investment grade debt on behalf of global institutional investors.

Official data on these trades is not public, but U.S banks are estimated to have placed around $7 billion of the $25 billion, on a portfolio of loans totalling around $72 billion, according to company filings, bank letters seeking regulatory approval and one large asset manager.

These deals have drawn some concern, including from US lawmakers. While they can give banks additional capacity to lend and reallocate capital toward other growth initiatives and shareholder returns, they also spread the risk into the lightly-regulated shadow banking area.

“It is the nature of financial markets to push the envelope and then try and find that wrinkle to squeeze some more gain out of a particular type of asset,” said Som-lok Leung, executive director of the trade group International Association of Credit Portfolio Managers.

But for now, a trading mentality of these products does not exist Leung said, as the primary motivation of investors was long-term returns from the core origination business of the bank with whom they were sharing in the risk.



Loans backing these transactions presently comprise assets with predictable cash flows, but some on Wall Street are keen to expand the types of loans offered, the industry sources said.

Some structures contemplate risk transfers of complex portfolios, with credit cards and consumer loans, where loan balances are shifting constantly, said Matt Bisanz, a partner in Mayer Brown’s financial services regulatory practice.

With the commercial real estate sector under fire, new trades to sell the risk of losses on performing property loans – instead of selling whole loan portfolios at a discount – are also being mulled, said Bisanz.

Loans for leveraged buyouts by private equity firms are also being analysed by credit transfer risk arrangers. These loans are also expected to attract more capital charges as per Basel endgame proposals, according to Bisanz.

Some investors are talking to banks about structuring risk transfer transactions that they can then repackage into smaller rated parcels to be sold to investors such as insurers and pension funds, according to Bisanz and Old.

The risk offloaded in 2023 is equivalent to only around 2 per cent of the issuing banks’ combined balance sheets, Pemberton’s Renault said. It is the “tip of an iceberg,” he said.

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