Why are SRT's suddenly seen as a profound innovation

Title encapsulates it. I read a bloomberg article this morning (will paste below as a comment) about banks using credit default swaps to insure a portion of their loan books, but the article makes it seem like the invention of the lightbulb. This just seems like risk transferring to me, much the same as banks yielding to private credit. Explain to me why this is seen as a profound new innovation that the Americans have apparently borrowed late from the Europeans? It is just slapping a new moniker on the same old risk transferral, the same old regulatory arbitrage between beleaguered banks and shadow banks/private credit. Not that deep, imo.
 

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At his perch just across the river from the Federal Reserve, Neal Wilson likes to evangelize about the opportunity that the regulator is helping create for investment firms like his.

A campaign by US watchdogs to strengthen banks’ balance sheets is spurring lenders to explore creative ways to reduce risks on their books. Increasingly, they’re turning to significant risk transfers — a bit of Wall Street alchemy that shifts the first losses on loans for things like cars, commercial properties and corporate operations — to investors such as Wilson. If the loans perform well, he can reap a tidy profit.

In bank C-suites across the US, the idea is “starting to catch fire” this year, said Wilson, a co-founder of EJF Capital in Arlington, Virginia. “This is the acceleration phase.”

Indeed, the drumbeat of SRT deals from the likes of JPMorgan Chase & Co. down to mid-size US lenders is starting to look like the industry’s next big thing. It’s a trend emanating from deposit runs on regional banks last year and cracks in commercial real estate, spurring bank leaders to realize that balance sheets can always be a bit stronger. Another nudge came as US regulators unveiled proposals for tougher capital rules, known as Basel endgame, potentially forcing large banks to beef up buffers against losses. But perhaps most importantly, the Fed simply signaled a new willingness last year to recognize SRTs when measuring capital, making the deals a relief valve for various pressures.

To SRT investors, that means opportunity: About 2,800 banks with less than $100 billion of assets may do deals to reduce their risks on $200 billion of loans over the next few years, estimates Wilson, who has already snapped up SRT bonds tied to jumbo home mortgages in the US Southeast this year. And that’s on top of the deals larger banks are already ramping up. Just a few years ago, there was practically no such market in the country.

The moniker significant risk transfer is the market’s favored catchall for deals with a variety of similar structures, sometimes also dubbed synthetic or credit-risk transfers.

In a typical SRT, a bank earmarks a pool of loans on its balance sheet and buys credit-default protection on the first 5% to 15% of the losses of that pool. If losses do materialize, counterparties on the contracts absorb the hit. In regions such as Europe, where the transactions have been around for years, loans have typically held up well enough for investors to reap solid returns, frequently in the low double-digits.

Global issuance of SRTs swelled to $16.6 billion in the nine months through September — a record pace that could reach $28 billion to $30 billion by year-end, according to data compiled by Chorus Capital Management, a London-based alternative asset manager that invests in such deals. While European banks have long accounted for the vast majority of issuance, it’s widely expected that US banks will dramatically ramp up deals in the months and years ahead.

Or, as Ohio native Wilson, puts it: “European innovation has finally gotten to American shores.”

Yet veteran SRT investors and regulators worry about potential growing pains. There’s currently far more investor demand than supply, caused in part by a series of hiccups in the long-anticipated expansion of the US market.

Investor interest revved up in the US a half-decade ago, when JPMorgan designed a new breed of mortgage-linked risk transfer. The concept turned heads in the industry, but for years it struggled to win US regulatory approval for capital relief. Then last year, as regulators took up Basel endgame, the Fed published an innocuous-looking FAQ, outlining what sort of SRT structures could qualify and what benefits they would yield. Atop banks, boardroom conversations broke out. And investors began amassing cash to deploy.

Still, the Fed’s brief guide came with a hitch: the need to get the central bank’s approval on each trade. That led to complaints about the process, which can take most of a year. In the meantime, as regulators proposed a stringent version of Basel endgame, only to dramatically dial it back, some banks tapped the brakes on potential SRTs, waiting to see how that will play out. Donald Trump’s victory in the presidential election last week, and his history of easing regulations, may now add to the uncertainty.

That’s creating a combination of eager investors, too few deals to satiate their demand and participants on both sides who are new to SRTs — stoking concerns about the possibility that the budding market may soon be polluted with deals in which buyers accepted loose terms. Veterans say it’s important, for example, to scrutinize the fine print, such as replenishment clauses that could allow a bank to jam in lower-quality loans.

Now, when some SRT specialists look around, they see “tourists” with varying amounts of expertise.

Take buyers of collateralized loan obligations. Though such investors have long picked up exposure to SRTs, some went deeper into that market after a slowdown in corporate mergers last year created a dearth of CLO products with attractive returns. More broadly, clients of money managers are encouraging them to look into SRTs, even if they hadn’t before.

More bidders means tighter spreads, paying investors less for the risks they take. Market participants say pricing on new SRTs has narrowed by at least 2 percentage points from about a year ago, relative to the benchmark. In August, Morgan Stanley offered an SRT tied to a more-than $4 billion portfolio of loans to private-market funds. It priced less than 4 percentage points over the benchmark, people with knowledge of the matter said, contrasting with similar financings that were much wider just months earlier.

Banks are well aware of the throngs hungry for SRTs. At Deutsche Bank AG, one of the more mature issuers in Europe, the list of prospective buyers can quickly swell into the dozens for syndicating large corporate transactions, people with knowledge of the matter said. Some banks are selling SRTs for other types of loans so broadly that they may no longer know the end buyer, something unthinkable years ago.

And some issuers have even tried to tuck widely known “bad credits” into deals, according to people with knowledge of the matter. Although veterans are quick to push the debt out, others may not be so prepared.

“Compared to the last 10 years, there is a flood of money chasing the SRTs right now, which means that pricing is more efficient, but also that banks can be more creative,” said Jonathan Lewinsohn, a co-founder of Diameter Capital Partners, who has been buying chunks of SRTs for more than a decade.

Spokespeople for JPMorgan, Morgan Stanley and Deutsche Bank declined to comment.

Ideally, buyers and sellers engage in a back-and-forth over which loans to include in pools, especially in corporate debt and commercial real estate portfolios. That can help set up deals that may be renewed again and again, even if the economy shifts, until the debts are repaid.

But the influx of new investors has also meant more are willing to take a “quantitative approach” to SRTs and focus their efforts on blind pools, said Diameter co-founder Scott Goodwin. That’s not something Diameter wants to do. It’s still sweating over the quality of the underlying collateral before getting the transaction over the finish line, he said.

Newcomers who rely on statistics and probabilities could later prove fickle, unwilling to reinvest if market conditions shift. In such cases, lending risks could return to the banks, undermining balance sheets. There’s even a term for that: flowback risk. International regulators have some familiarity with it, particularly those in the Nordic region, where watchdogs imposed onerous rules for securitizations, leaving the local market moribund.

​Another worry is leverage. Borrowing is an established part of SRT markets, but professionals say that its use to juice returns is becoming even more prevalent. One manager said he can count more than a dozen banks that lend to him.

In a report last month, the International Monetary Fund warned about the possibility of creating “negative feedback loops” during periods of stress: If buyers are using leverage to essentially insure banks’ lending portfolios, then risks aren’t really leaving the system. But capital coverage is lower.

Advocates of expanding the market point out that in Europe it has been largely calm and orderly for the past 15 years.

After the 2008 financial crisis, weakened banks embraced SRT deals to avoid dilutive capital raises. Policymakers were supportive. The additional capacity for new loans helped keep borrowing affordable. Eventually, the stop-gap practice for tweaking balance sheets became a permanent way of doing business.

Now, some US banks that have won regulatory approval for SRTs have signaled interest in becoming repeat users, too. Periodic SRT issuance can help a bank free up and recycle capital into more loans, making lending more profitable. Similarly, if banks have concentrations of loans to a certain type of client or sector, SRTs can be used to underwrite new debts that diversify portfolios. They’re most advantageous when interest rates are up, and less so when they’re low.

“It’s kind of there when it’s there, and we’ll look to opportunistically use that going forward,” Ally Financial Inc. Chief Financial Officer Russell Hutchinson told investors at a conference in September after completing a credit-risk transfer this year.

The advent of SRTs in the US also fits a longer-running trend in which banks have been dialing back classic balance-sheet lending in a variety of ways. Since the 2008 housing collapse, firms such as Wells Fargo & Co. that once dominated residential mortgage lending have ceded market share to online lending platforms. Others have left commercial real estate lending to regional banks.

And much like when banks pumped out asset-backed securities before 2008, firms are finding more ways to originate loans and distribute the risks, rather than hold it all themselves. For example, some are setting up partnerships to sell corporate and consumer debts to private investors.

Still, SRT fans like Goodwin are confident that the instruments are a step in the right direction.

“SRTs are a win-win for banks and investors,” he said. “Banks receive more capital, allowing them to grow their balance sheets.” Investors end up receiving attractive returns on a pool of high-quality assets. And the fact that banks still have skin in the game keeps interests aligned.

The question is how the SRT market might evolve. An “originate-to-distribute” model would worry EJF’s Wilson. But the deals they’re doing now are good for SRT investors, he said. “Banks underwrote these assets for the life of these assets.”