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Hello and welcome to another episode of the Odd Thoughts Podcast. I'm Tracy Allaway.
And I'm Joe Wisenthal.
Joe, do you ever wonder what this show would have been like if we had been doing the podcast before two thousand.
And eight, Well, we would have had plenty to talk about it, you know, I actually have it right, It would have, man, now, I wish we could. We would have had like five bonus episodes every single week, so there were just so much content on those days.
I'm actually glad we weren't doing it back in two thousand and eight 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, uh, 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 two thousan and eight for obvious reasons.
No, you're totally right, Like, you know, we don't do many like credit 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 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 regular 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 two thousand and eight 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 SRT 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 JP Morgan and first pistro trades and.
Stuff like that.
Maybe we'll get all the way back to the nineteen nineties and JP 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 twenty five billion worth of SRTs issued in twenty twenty three. The average number of banks that have been tapping the market has gone from something like eight in sort of the twenty fourteen to twenty twenty period to something like thirty seven 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 two thousand and eight to twenty ten, and it was all about you know, CDOs and rmbs and housing reform. It is now all about SRTs. So you can see the sort of like transition that 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, counterparty 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 two thousand and eight, which is the
credit default swaps market. And conceptually, to me, this idea of like, okay, here's an entity it wants to use someone else's capital, you know, to essentially buy ensure or ensure away or risk. That was a thing. Then a lot of that market sort of dried up, and now there is this new market. So I want to understand a little bit more about how this is conceptually different or similar to 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 Shemy. 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 Structure credit business within the Global Mortgage and Structured Credit segment. I joined Guy Carpenter in late twenty twenty three.
I've spent my career in ass management and banking, working with financial institution 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 GCS. To Fannie May and Freddie Guy Carpenter has presence in the Americas, Europe globally structuring and placing credit risk transfer synthetic risk transfer for various financial institutions. We generally place this risk with multiline reinsurance companies in reinsurance format, but also place this risk into the capital markets.
We recently published with our colleagues at Marsh 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 bail 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 discussed as benefits of credit risk transfer, give some historic context, and also you know, 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 explained the way we think of SRTs or redcap 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 upfront. I would also say, you know your introduction. I think I agreed with basically every word there. Thank you, So that's an accomplishment. There are huge differences between what happens now in this market versus what happened in two thousand and eight, or more specifically in the lead up to
two thousand and eight. But generally speaking, as you both describe banks or 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. There 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 and outright sale of the assets. And then there's synthetic securitizations, 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 two thousand and eight 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 tools and we'll get into the benefits, but it also really has become for banks and other regulated financial institutions like Fannyman 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 SRT probably the largest single program for these types of transactions is Fanny May and Freddie Mac's program that's referred to here in the US as credit risk transfer CRT. If you see some of the US regional banks who have become inaugural issuers of these transactions, even in two Q earnings, they refer to these transactions as credit risk
transfers CRT. Globally, outside of the US and 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 pulling 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.
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 like the change in the nomenclature or what we actually call these things over time.
It's funny how many.
Different like phrases and words have fallen in and out of fashion to call these things.
I feel like synthetic is one of those words that like raises alarms, Yeah it's not real, or something like that. But why do 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 you know, 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 is attractive rather than the outright sale dyes.
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 GSE or anything in between, generally face expected
losses and they face unexpected losses. Expected losses perceived as a cost of doing business, bank's price for expected losses through lending an 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 while 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 one hundred dollars of a treasury security of cash on balance sheet, a mortgage, a corporate loan, you know that same hundred dollars 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 quits risk based capital. Oh yes, excuse me, yes, yeah, yeah, we're diving.
Into the episode with a lot of acronyms.
I keep going.
So, unlike the leverage framework, right, cash on balance sheet right will attract far less than 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 at 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 and regulatory capital. Less regulatory capital, not no regulatory capital, right right, And the bank is relieved of some of this capital it held pre transaction. And that's sort of where the concept r 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 then in the US. In the US it's really only begun to take off in the past year or so, despite a
lot of bankers. I remember in like twenty thirteen or something having conversations with I think it was someone at City Group talking about how they wanted to structure a bunch of red cap trades for smaller banks and then lo and behold. Ten years later, it feels like the US 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 US 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 two thousand and eight, because banks had already adopted did what's known as the BOZEL two framework that had a lot more risk sensitive risk base capital requirements. The US, on the other hand, was delayed in that process in transitioning from BOZEL one to BOZL two, continue to operate under BASIL one for a while, and then in around twenty twelve thirteen sort
of leapfrog straight to BASL three from BOZEL one. And another aspect of this, I think that's important to note. One of the post GFC, post Global Financial Crisis reforms in BOSL three and the bank capital reforms was the introduction of this leverage ratio requirement, right, So it was all sort of risk base capital based beforehand, and now the leverage ratio requirement is supposed to be sort of
a backstop. But interestingly, in the US, and earlier than two thousand and eight and earlier than BASIL 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 US. So it's real, there's real regulatory capital regime differences between the US VERSUS Europe, even
between the US 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 twenty twelve and twenty thirteen around this for US banks. In my view, and maybe this is a minority view, but I think it's been born out. Credit risk transfer for US banks in the years following the financial crisis was a solution in search of a problem. Coming out of the financial crisis, US banks race capital
to shore up balance sheet. You know, maybe they were forced to do so. Actually, I think I think you would ask certain bank bank bank managements. You know, they were 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 pose this question earlier. So if a bank did need to raise capital for something, you know, it was relatively easy to do, you know, at attractive valuations. So the business need wasn't clear for US banks in my opinion, as it was for European banks who did not recapitalize in the same way as US banks did
post GFC. They were and are 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 I just think, you know, sort of post two thousand and eight around like the lingering sagas for banks across the continent right in the European sovereign debt crisis, but even even beyond, I would also say, you know, moving out of the banks a little bit, the gcs 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 tax payer 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 US, banks and bank managements generally didn't really prioritize active balance sheet management as as they are now.
That was a fantastic and very clear answer, and it makes a lot of sense why setting aside regulations, why economically there wasn't much need to prioritize these sort of balance sheet trades. 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, two, I guess there's two questions.
Who are you? Are you like a hedge fund, are you a pension fund?
Like?
Who is taking sure 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 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. 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 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 leverage 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 that risk
capital purposes for risk management purposes. And so the whole point of departure for this transaction is not speculation, it's actual hedging, right, and there's there's actually 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 you get paid a premium.
Right, So what's the deal that we do?
Right? So so so again, A financial institution pools credit risk together transfers a portion of the risk out of the bank. The loans remain on balance sheet. You know, assets are not sold, only credit risk trans is transferred. We've we gather a loan pool in what we've seen here in the US, just to just to take up
sort of a hypothetical transaction. A 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 have to risk weight that according to current regulation at one hundred percent. 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, that's the expected losses. They sell the mezzanine tranch that references the next levels of loss, the unexpected loss You can say, maybe that's next ten or eleven percent of losses, and then they retain again the very remote senior levels of loss, referencing the remaining whatever it is, eighty seven eighty eight percent of loans
after credit protection is exhausted. Different act 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 losses 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 they represent to the bank. Now that's the capital structure, Joe, I think more specifically to your questions, like, what is the actual mechanism that transfer? Is this exactly that? What is the actual mechanism for a bank to actually
transact and acquire credit protection. 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 polls 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 and buying this bond, they get interest income over time, and then at the end of the transaction they get whatever money remains there less losses.
Terracy. 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 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 reinsures.
Interesting, there's another layer.
There's another layer, or 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 eighty five ninety percent of it, probably about ten percent, and it's growing, is in this reinsurance format with multiline
diversified reinsures. If you look at Fanny May and Freddie Mack right now in terms of outstanding not not volumes outstanding credit risk transfer, you know they have about almost ninety billion dollars in a risk transfer outstanding right now. I would say the latest reporting roughly thirty five percent of that is in reinsurance market in about sixty five percent 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 lost portion of your portfolio. I mean, explain again, who's on the other side of me. 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 they approach you and they find us a counter part?
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 ensure 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 this life.
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 ask the class is the banks put into these transactions, and then we can get into you know, part three, four, five, and
seventeen of your of your multipart question. I think one important to make upfront is that generally speaking, these transactions are programmatic issuances from 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 banks 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 of exposures you know, to to single borrowers too much chunkier portfolios like corporate exposures that a bank has on balancey, 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 US more commonly known as just the middle market companies. And it's important to just to just bear that in mind. You know, that's 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. They're just looking and the bank is looking for ways to protect that borrower relationship another aspect of it for a bank. So so in terms of assets selection, right, So for the GSCs, they're sort of you know, monoligned guaranteurs, right, they do single family and then you know 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?
Right.
So oftentimes exposures like mortgages, conversely to the gcs, may not make the most sense for a bank to see capital relief on because they have lower capital and they're just lower capital requirements on on mortgages versus say a corporate or a consumer loan that 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, you know, 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 low 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 borrow. You'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 chunk your portfolios, including portfolios that include corporate exposures, they're usually individual obligors are identified in 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 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, at 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 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, you know, around that hypothetical auto loan transaction, now we would probably estimate and that sort of capital structure. You know, the capital requirement for the bank just dropped by sixty percent. Okay, right, because the risk weighting on that portfolio has dropped from one hundred percent and just like outright bank holding auto loans to roughly forty percent.
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 mes tranching on balance right, And this is just this isn't just spread. This is sort of all in coupon. We're probably talking about, you know, mid to high single digits type of payment on the mezzanine tranch. 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 say you know, this is this is what we're paying. What the bank will do is say, okay, these are our annual costs no on the mes tranch, on the mezzanine tranch, 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. It could issue preferred equity, right, but even on yields today will 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 of these transactions.
Okay, so it has to make financial sense for the bank, for the issuer. 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 six percent, you get nine percent 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, with our 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 twenty twenty, you know, for a brief time when bank supplied leverage for GSC CRT ZRT for credit risk transfer for GC credit risk transfer.
Keep up with the whole episode. 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 GSC CRT, given that you know, at that time the world was basically hit by a meteor or the equivalent thereof. You know, you know, this piece of it, you know, was was 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 and and many of these you know, more veteran investors really are just relying on 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 supplied leverage to these transactions. I think trace you mentioned at the outset, you know, you had an estimate of about twenty five billion or so of these deals getting
done in twenty twenty three. Even if that number doubles this year, I don't know that it will, but let's just say that that it does if some of that risk transferred has some bank leverage on it. Is that systemic? You know, forty fifty twenty twenty three, twenty five billion of risk transferred. You know that that could increase this year, But is that systemic? You know, for the global banking system doesn't seem to be.
So 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 two thousand and eight, we would talking about credit default chops, 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 structuring like what happened to this mark to that market and why. From the sort of at the most sort of conceptual, abstract level, how do 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 SRTCRT market is actually informed by the experience of two thousand and eight. We all saw two thousand and eight. We said, don't let that happen. Yeah, right, And much of the i'll call it polemic around this harks back to two thousand and eight in the financial crisis, and when people hear buzzwords like synthetic yeah and derivatives know, their stomach start churning.
But this is different in in 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 two thousand and eight. 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 aig FP, 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 I'd also say this, most of these deals are fully funded, like we talked about, so no counter party risk.
The investor money, 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, you know, rather than with the capital markets, these reinsurance counterparties are exactly the opposite of ai g f P. There are highly diversified, highly regulated, highly rated, multiline 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, AI g f P was in the business of selling credit protection 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 so we just talked about some you know, illustrative capital structure. You know, the issuer of these transactions, banks or the gcs have skin in the game and almost every tranch
of this of this of these transactions, right. And I think that's also a key differentiation in terms of linement of interest and risk retention.
So we kind of came full circle just then back to two thousand and eight 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.
Just don't do that.
Maybe we could save this for some off the record conversations. I have seen many things in my career, both you know, sort of pre two thousand and eight through two thousand and eight, and since I don't want to name any individuals, of course, of course, but but but but this is what I would say.
Uh.
And and I really came to even appreciate this more during my time in government. Uh 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. Uh uh.
And then externally they have regulators and this and then again this isn't just like you know regulator supervisors, right, this is also you know things like the fd I C 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 just like one tool in their toolkit to
help manage these these different stakeholders. I've seen 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 I'll yeah, So apologies to the listeners, but Micky, 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 very fan.
That was great, Joe.
I enjoyed that conversation so much. It just it feels good to have a sort of acronym Leyden discussion. I'm trying to think of all the one that we hit, like CRT, SRT, RWA, RRBC, SME, CDs, CLN, there is probably more.
You know, it was an acronym laden conversation, but he was very clear, and I think the two things that I really you know, two of the big things that I think about, Like is he mentioned we sort of mentioned, you know, people's like alarm bells go off and they hear things like synthetic ris 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. 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 car counterparty like an AIGFP. And then also there's other big theme that we've seen in the post grade financial crisis era of
like distributed risk. Yes to non regulated institutions like hedge f 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 PLUS two thousand and eight, 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 banker.
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 US, at least you can trace that back
to regulators as well. So last year, I think it was September twenty twenty three, the FED basically issued guidance on these deals, so 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.
And what's in the notes and all, 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, 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 juce my returns. And if I'm borrowing from a bank. This is fineancial 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. But I'm 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. This is 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 Yes Trades, Like let's just go back, let's do a financial history down for that kind 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.
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