Unlock the Editor’s Digest for free
Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.
The writer is a former investment banker and author of “Power Failure: The Rise and Fall of an American Icon”
There is an old idea making new waves on Wall Street. Banks of all stripes are once again moving risk off their balance sheets, in line with the demands of their prudential regulators, to make room for taking on more risk.
These so-called “credit risk transfers,” or CRTs, enable banks to sell only the risks associated with various loans, or pools of loans — but not the loans themselves — to third-parties willing to assume those risks and take the associated rewards, or so they hope. They are also known as “significant risk transfer” or SRTs. “One of the major growing pains for this market is that no one can decide on a name. The product is known by different names in different places,” notes law firm A & O Shearman.
The intermediaries for such deals include the likes of Guy Carpenter, a division of the huge insurer Marsh McLennan, as well as some big Wall Street banks themselves. For a fee, they transfer some of the risk on banks’ balance sheets to the likes of Apollo Global Management, Blackstone, and Bayview Asset Management, among others, who like taking on the risk generated by others, hoping to profit from it.
Since 2017, the global market has grown by 20 to 25 per cent a year, reaching a record $24bn in 2023, according to data from credit investor Chorus Capital. It says there have been $16.6bn of deals this year up to September 30 involving 44 banks.
The idea is to free up regulatory capital placed against loans to allow for new loans to be made. Hopefully, it’s a virtuous cycle of reducing risk at depository institutions and housing it at other financial behemoths.
But just because risk is being removed from the balance sheets of the big Wall Street banks doesn’t mean that risk disappears from the system; it just means that it gets pushed around to others willing to assume it. The risk remains. The question always is whether the risk taken can be managed or contained, or whether it will soon explode in our faces.
And this is what worries people like Sheila Bair, the former chair of the Federal Deposit Insurance Corporation, and Simon Johnson, the newly-crowned Nobel laureate and MIT professor of entrepreneurship, who remember all too well how the promise of risk containment, using another creative financial product — “credit default swaps” — nearly blew the financial world to smithereens back in 2008.
Are CRTs another such ticking time bomb? Its proponents say no, of course, that CRTs could not be more different from credit default swaps. In an August interview with Bloomberg, Michael Shemi, the head of North America Structured Credit at Guy Carpenter, said that the collective experience of credit default swaps in 2008 “informed” the creation of the CRT market today — the aim is to not let the same thing happen again.
“Much of the polemic around this harks back to 2008 in the financial crisis,” he said. “And when people hear buzz words like ‘synthetic’ and ‘derivatives’ their stomachs start churning. But this is different in every possible way.” The difference, he said, is the CRTs hedge risk that arises out of normal course lending activities whereas credit default swaps allowed for uncapped leveraged speculation, whether you owned the underlying credit asset or not. “This is about true distribution of credit risk, rather than concentration of credit risk,” he said.
But Bair and Johnson, among others, worry that we could be witnessing the match being lit on the next powder keg. In an article in the FT last December, Bair wrote that “even if credit risk transfer is successful in protecting regulated banks, the risk is transferred to nonbank entities which appear less capable of managing and absorbing the losses.”
Johnson followed up in a September letter with his fellow co-chair of CFA Institute’s Systemic Risk Council Erkki Liikanen to Jay Powell, the chair of the Federal Reserve. He wanted the Fed to begin to “address the growing systemic vulnerabilities posed by” the use of CRTs. Johnson’s letter to Powell followed on the heels of one written by Senator Jack Reed of Rhode Island, who also urged Powell to “place additional guardrails” around credit risk transfers.
Some opponents of the use of CRTs also worry some of the buyers in these transactions are goosing their returns on these deals by using leverage, with money borrowed from the very same Wall Street banks that are transferring these risks to them. Senator Reed wonders “whether CRTs truly transfer credit risk to outside investors or further concentrate risk among a small number of Wall Street banks”. It’s a damn good question.
