The Federal Reserve sent letters to several large banks in the fourth quarter approving favorable regulatory-capital treatment for pursuing synthetic credit-linked notes (CLNs), raising expectations that lenders will use the products more frequently. Now, Wall Street is seeking to develop structures to facilitate synthetic CLNs, in which lenders directly transfer to investors the credit risk of their loans while retaining the assets on their books, for a wider range of banks.
The letters informed the banks that they can retain the loans on their balance sheets and still exclude those assets from their regulatory-capital calculations, allowing them to manage their regulatory capital and potentially use it in more profitable ways. Traditional securitizations also enable banks to manage regulatory capital, but banks must move the assets from their books to bankruptcy-remote, special purpose vehicles (SPVs).
Since the assets stay on banks' books, investors in CLNs face the risk of lenders failing to make payments on the bonds. Hence Wall Street firms, anticipating more national and regional banks issuing CLNs, are mulling deal structures that enable favorable regulatory capital treatment while alleviating investors' concerns.
"We've seen a couple different flavors of how parties are contemplating these structures," said Ian Rasmussen, managing director in Fitch Ratings' U.S. ABS group. "I think it will be an important part of the financing mix this year."
In Europe, banks carry large loan portfolios and routinely employ credit risk transfer (CRT) deals to transfer loan credit risk to investors in bilateral or club deals. Those typically private transactions occur in the U.S. as well, and there have also been sporadic offerings of CLNs, a subset of CRT, over the last few years.
Matthew Mitchell, managing director S&P Global structured finance ratings, noted that Europe's CRTs generally have two or three tranches compared to the multi-tranche deals more common in the U.S.
"That naturally makes broader syndication possible for multi-tranche structures, because there are exposures that are eligible for managers with different risk profiles," he said.
Regulatory approvals easing the way
Last fall, the Federal Reserve approved favorable regulatory capital treatment for CLNs issued by Morgan Stanley, Santander Holdings USA, US Bank and Huntington Bancshares, although it limited the approvals to those banks and the deal structures it described in the approval letters. In each case, the regulator said, the value of the bank's credit protection provided by the CLNs was pre-funded at issuance by investors with cash, enabling the lower capital risk weighting provided by securitizations because the cash upfront mitigates investors' credit risk.
Interest and principal payments to investors will depend on the credit performance of the assets remaining on the issuer's books. One way to reassure investors of those payments and spur demand for such transactions may be to collateralize principal payments with cash while setting up a liquidity agreement to insure banks' interest payments, Rasmussen said.
Elaborating, Pasquale Giordano, senior director in Fitch's U.S. ABS group, said that "issuers could retain the first-loss portion on the pool's referenced assets, possibly up to the expected loss rate of the referenced assets, and then buy protection on the next first 5% to 15% of losses, depending on the asset type and structure."
We're acquiring high-quality bank-originated assets in diversified portfolios where risk is tightly distributed.
Besides managing regulatory capital, optimizing the returns on balance-sheet assets may be motivations to issue CLNs as well. Other factors for banks issuers to consider will be the types of loans referenced by the notes, since investors will demand higher premiums for riskier loans, and the capital charges banks will incur if they retain the first-loss portions.
Moody's Investors Service notes in a February 23 report that some banks have issued CLNs to bolster their regulatory capital and/or remove low-yield loans from their balance sheets.
Other issuers "have grown quickly over the last several years, which has also weighed on these banks' capitalization levels and may have led to some reliance on CLNs," the ratings agency said.
The fourth quarter's CLNs all reference auto loans, but performing student and residential mortgage loans have been referenced in earlier CLNs and could re-emerge in new deals. Despite the attractiveness of the referenced loans, to issue CLNs banks generally must pay an premium to investors, but regulatory capital relief warrants it.
"From a bank standpoint, it's about getting cost effective capital relief," said Alan Shaffran, senior portfolio manager at Evanston, IL-based Magnetar, a $13.4 billion investment firm that has engaged in CRT transactions since 2008, mostly in Europe and increasingly in the U.S over the last year. "From our standpoint, we're acquiring high-quality bank-originated assets in diversified portfolios where risk is tightly distributed, via structures that are reasonably resilient even in times of financial stress."
Expect greater bank participation
Shaffran added that he anticipates more CLNs and bilateral and club deals this year from the largest U.S. national and regional banks and eventually even smaller regionals, although the latter may face higher regulatory hurdles from state or other federal regulators.
A growing CRT market could eventually provide relief to banks facing headwinds later this year.
The Moody's report notes that "if some banks face asset quality deterioration later in 2024, it is possible that CLN deals on lower quality loan pools could be proposed."
The report says that U.S. bank issuance of CLNs is "poised to grow further," and it emphasizes that CLNs are not without limitations and risk. For one, CLNs only lessen the credit risk for a specific pool of loans, whereas increasing capital enables a bank to cover unexpected losses of any type, and the cost of CLNs can reduce the bank's profitability. In addition, Moody's says, banks' limited CLN disclosures can potentially obfuscate credit implications, high CLN use can signal credit weakness, and CLNs can pose conflicts of interest.
