US risk transfer market finally opens up
The risk transfer market has been growing for years, with new jurisdictions, new collateral types, and more issuers waking up to the potential of the tool. But while investors welcomed debut deals from Canada, Japan, and Mexico, there was always one country which was the biggest prize of all. Last year, finally, the US stirred for real, with a deal between JP Morgan and PGGM hopefully firing the starting gun on a major market expansion. Owen Sanderson reports.
Risk transfer, or risk-sharing transactions as some investors prefer to style them, are synthetic securitizations in which an external investor takes the subordinated risk on a given portfolio of bank loans. The loans stay on balance sheet, but the bank can then claim capital relief against the portfolio, as the investor bears any unexpected losses.
The deals can be structured in several different formats — credit-linked notes, credit default swaps, separate SPVs or not, financial guarantees, insurance contracts and others — but the idea remains straightforward enough.
But that doesn’t mean the deals are easy to do. The main ingredient is a supportive regulator — while the structure works as an effective portfolio hedge, gaining maximum benefit from these trades means claiming a regulatory capital benefit. In Europe and the UK, regulators generally have to pre-approve structures before the trades are concluded, confirming that the risk transferred to external counter-parties really is commensurate with the capital relief the bank wants to claim.
That’s not always easy — especially in the US, where bank regulation and supervision is fragmented among multiple agencies, some with a history of hostility to the securitization industry.
“In the post-crisis period, securitization generally and synthetic securitization in particular had a bad name — not because of risk-sharing deals but because of synthetic CDOs of ABS and similar instruments,” says Angelique Pieterse, senior director, credit risk sharing transactions at PGGM. “This meant that any bank wanting to go through with one of these transactions had to be prepared to do a lot of work with their regulator to get them comfortable. The fact that in CRS risks are shared in a synthetic way should, however, provide additional comfort to regulators: the loans and the client relationships stay with the bank, and are not vanishing into the shadow banking system, but stay under supervisory oversight.”
It’s a lot of work — and it means bank teams need the appetite and bandwidth to go through these negotiations.
“The question we have all been asking is, ‘why has the US not come on sooner?’,” says Kaelyn Abrell, portfolio manager at ArrowMark Partners, speaking at IMN’s Credit Risk Transfer conference in June. “I think there’s a view that there has been some regulatory pushback around US issuance. But when you look at the landscape, there’s a very large US bank that has been an active issuer since 2007, and clearly that bank is not going to issue without regulatory oversight, given the size and scale of that balance sheet.”
Abrell is probably referring to Citigroup, which has indeed been very active in the market — but largely transferring risk on its non-US emerging market assets, and helping to arrange client deals for predominantly European banks.
Regulatory issues around whether SPVs can use credit derivatives — one standard risk transfer structure involves a fully collateralised SPV facing the bank with a bespoke credit default swap — have also caused problems in the past. Most of the US risk transfer deals have been in credit‑linked note format, meaning that investors take on not only the credit risk of the portfolio in question, but also the credit risk of the bank as a counterparty.
GSEs to start
The US has long had a thriving risk transfer market focused on the government-sponsored enterprises, Fannie Mae and Freddie Mac. During their long “conservatorship”, both entities have been government-owned — but encouraged by their regulator, the Federal Housing Finance Authority, to transfer the risk of their mortgage portfolios to the private capital markets.
This inaugurated by far the largest and most liquid risk transfer securitization market in the world, through Fannie’s Connecticut Avenue Securities shelf and Freddie’s STACR shelf. These form an integral part of the broader US RMBS landscape, and participation in the market is broad and deep across US securitization investors. It has even spawned highly complex re-levering transactions, which aim to boost the efficiency of legacy risk transfer deals. One of these, CAS 2020-SB1, which references a staggering $152bn of Fannie Mae mortgage loans, was chosen as GlobalCapital’s Innovative Securitization Deal of the Year.
Following the GSE lead, banks also started to explore credit risk transfer structures again, focusing first on mortgage-related risks. JP Morgan took some regulatory flak for its attempt to do a risk transfer deal in 2016, earning a rebuke and rejection from the Office of the Comptroller of the Currency (OCC), before the regulator eventually relented, allowing the bank to launch Chase Mortgage Reference Notes 2019-CL1 in 2019.
Perhaps most intriguingly, however, is a $2.5bn deal it struck with Dutch pension fund PGGM, since this references large corporate loans, and takes a more traditional approach to risk-sharing.
Many of the US deals so far have been rated and syndicated issues, predominantly with investment grade ratings, reflecting the strength of mortgage collateral — and targeting an investor base already very comfortable with the GSE risk transfer deals.
But that’s a very different animal from the predominantly corporate risks that are the mainstay of risk transfer elsewhere in the world. For many private banks outside the US, selling mortgage risk makes no sense — mortgages are too safe to make the trades economically viable. First loss positions in a portfolio of corporate loans also have much more in common with instruments such as CLO equity, and are effectively well below investment grade with spreads to match.
The biggest issuers, including Credit Suisse, Deutsche Bank and Barclays, focus in this area, with programmatic risk transfer shelves regularly packaging up the risks of their corporate lending.
It’s no coincidence that these banks are also among JP Morgan’s international competitors in leveraged finance — hedging corporate lending in this way allows them to recycle balance sheet used to support their leveraged lending franchise, and pass on the risks of continued exposure to corporate revolver.
Part of the reason US banks have been slower to turn to the market is the availability of other, easier options to mitigate risk. A deeper domestic capital market and more flexible tools for hedging individual corporate risks means less need to hedge entire portfolios at once. The booming risk transfer market in Europe has coincided with shrivelling liquidity in single name CDS, while the CDS indices cover only a tiny subset of the corporate risks banks are exposed to.
Too much capital
Another obstacle to the opening up of the US market has been internal management perception within institutions. The deals generate incremental capital but most of the US banks have had plenty of capital for years, and have been struggling not to raise more, but to figure out how to return it to shareholders while still meeting the Fed’s stress test standards.
“For long periods, doing risk sharing trades in the US was perceived as something a bank might do if it needed capital, partly because some of the banks in Europe really did need capital and couldn’t access it cheaply elsewhere,” says Pieterse.
For banks with too much capital, risk transfer deals act as a drag on returns — the bank has to pay away the coupon on the transaction, which might be anything from 8% to 14%, depending on the assets and structure, which can be more than an institution’s overall capital cost.
But the counter-argument is that it frees up capital to grow the business — and that different units ought to be given different capital allocation costs. Just because JP Morgan’s overall cost of capital is low, it doesn’t follow that its wholesale corporate book should have a low cost of capital as well, and most sophisticated banks recognise the differences.
Some management teams, though, even if they accept the capital arguments, might be reluctant, because risk transfer deals require opening up to third parties.
“You need to learn a bank’s risk language, appetite and approach, which means taking in a lot of information that banks keep close to their chest, because it’s at the core of what they do,” says Pieterse.
“At every bank, there’s always some hesitation about sharing this information with third parties, but we need to know, because that’s the risk that we are sharing in. Our track record has shown that such insights are kept fully confidential.”
Goldman followed JP Morgan with a corporate risk transfer deal in the autumn of last year, Absolute 2020-1, with two investment grade credit-linked notes referencing the risk on a pool of investment grade revolvers.
Others are yet to follow, but it’s likely to come soon, with better regulatory certainty and more and more transactions.
“We are talking seriously to some of the other banks about this but it’s a long process,” says Pieterse. “With many banks there are several years between the first conversation and starting the risk sharing transaction. As an investor in these transactions, we are dependent on whether senior management sees the benefits and understands what they are missing out on.”
Outside the top tier money centre banks in the US, there are also some green shoots emerging. Texas Capital Bank became the first US regional player to do a risk transfer deal earlier this year, selling on the risk of its mortgage warehouse lines, which it extends to non-bank lenders. With many more regional institutions out there, often with different capital needs from the top players, this promises healthy growth to come.
“We are in many discussions with our regional bank clients on pending CRT transactions, not only warehouse financing, but student loans, insurance premium finance, subscription lines and others,” says Susan Mills, MD in global spread products solutions sales at Citi, the arranger of the Texas Capital Bank deal, also speaking at IMN’s event. “This is a great trade for any high quality asset class that has 100% risk-weighting.”GC