Insight: Wall Street gets creative as regulators demand more capital

PacWest Bancorp

27/11/2023 17:00

(Adds links to related stories)
    By Shankar Ramakrishnan
       Nov 27 (Reuters) - Earlier this fall, Morgan Stanley
 MS.N  bought $300 million worth of protection against losses on
some of its loans from Blackstone Group  BX.N  and other
investors, two sources familiar with the matter said. 
    The transaction, details of which have not been previously
reported, was effectively insurance, structured as a sale of
bonds called credit-linked notes, according to the sources and
regulatory filings.
    By transferring the risk to investors, the $1.4 trillion
asset bank could reduce the amount of capital it has to hold
against those loans to cover for potential losses.
    Morgan Stanley and Blackstone declined to comment.
    The deal is one of several such credit risk transfer
transactions that U.S. banks are considering in the aftermath of
a March crisis in the sector and as regulators look to increase
capital they have to hold, bankers, lawyers and investors said. 
    Interviews with eight people involved in the deals show
different forms of credit-linked notes and insurance contracts
are being discussed to free up precious capital.
    While it is known that banks have been looking to offload
risk through such transactions, these interviews offer new
details on the types of deals and their terms, providing a rare
window into a market that's shrouded in secrecy.
    These deals help banks meet capital requirements more
efficiently, allowing them to keep lucrative businesses that
would otherwise become unprofitable. 
    But they come with risks. Investors in these deals include
lightly-regulated entities like hedge funds, shifting risk to
the shadow banking sector. That raises the prospect that
regulators will have less visibility and understanding of the
dangers that lurk in the financial system. The ability to shed
the risk could also encourage banks to get more aggressive on
lending, leading to problems later.  
    "If a bank didn't manage interest rate risk well, does it
appreciate potential risks associated with these transactions?"
said Jill Cetina, associate managing director at Moody’s.      
"It raises the need for better and more fulsome disclosure in
banks' regulatory filings."   
    Over the last few months, banks including JPMorgan Chase
 JPM.N , Merchants Bank of Indiana and US Bancorp  USB.N , have
sold the risk of losses on billions of dollars of loans for
cars, multi-family homes, private funds, junk-rated companies,
commercial equipment and consumers, these industry sources said.
    Jon-Claude Zucconi, head of tactical situations at Apollo's
 APO.N  ATLAS SP Partners, which structures such deals, said
many U.S. banks are setting up programs to issue credit linked
notes for the first time. 
        He expects U.S. banks to sell the risk on nearly $100
billion of assets over the next 12 months, freeing up nearly $15
billion of equity capital. Investors get yields ranging from 8%
to 15% from such transactions, Zucconi said. 
    JPMorgan and US Bancorp declined to comment, while Merchants
Bank did not respond to requests for comment.
    Wall Street's financial engineering is causing concerns
among some lawmakers and regulators. The Federal Reserve
approved the Morgan Stanley transaction in late September but
set limits, including on size, and is watching closely. 
    "If they perform as intended, then they might be more
generally available," said Fed Vice Chair for Supervision
Michael Barr in Congressional testimony this month. "If we see
risks arising in those transactions, then we would limit their
use for capital mitigation."
    
    SIGNIFICANT INCREASE
    The surge in interest in these transactions comes after
regulators, led by Barr, proposed capital requirements earlier
this year that were tougher than what banks had hoped. 
    Smaller banks not affected by the proposal have also been
looking at these deals as a way to free up capital as conditions
tightened after the regional banking crisis. 
    "Banks are spending a lot of time on their loan books and
figuring out how to optimize what they have," said Missy Dolski,
global head of capital markets at Varde Partners, which invests
in such transactions.
    Some banks have sold loan portfolios, businesses and cut
down their lending, which were not optimal strategies because it
reduces their market share and competitiveness, said Sam
Graziano, managing director at advisory firm Chatham Financial.
    Some considered raising capital by selling shares and
preferred equity but it was expensive due to low stock
valuations and high interest rates, Graziano said.
    Credit risk transfer is another tool for them to pursue
after the Fed’s clarification on what is allowed, said Cory
Wishengrad, head of fixed income at Guggenheim Securities.
    Jed Miller, a partner at Cadwalader, Wickersham & Taft, said
often these transactions were structured so that proceeds must
be retained by the bank on deposit for the life of the trade.
The upfront cash gave Fed comfort in Morgan Stanley's case,
according to Barr's testimony. 
    
    DIFFERENT DEALS     
    Credit risk transfers are common in Europe, where banks
transfer the loans to off-balance sheet entities, called special
purpose vehicles (SPVs), before selling the risk on those loans.
Those deals are called synthetic credit linked notes. But SPVs
can come with tax and other complexities. 
    Morgan Stanley's transaction kept the loans, a portfolio of
revolving credit lines to private funds, called subscription
lines, on its balance sheet, according to the sources and the
regulatory filing.
    U.S. Bank followed up with a similar deal in late October
and received approval from the Fed last week for a similar
transaction, according to sources and a regulatory filing. 
    Reuters could not determine why Morgan Stanley and U.S. Bank
chose to do a direct credit linked note rather than a synthetic
one. 
    Other U.S. banks have been opting for synthetic deals. One
of the earlier ones this year was done by Merchants Bank, an
Indiana-based lender with $16 billion in assets. The details of
its structure shed light on how these deals work.
    Merchants priced a $158.14 million credit-linked note on
March 24, providing credit protection on some commercial
mortgages, including loans to nursing and assisted-living
facilities, the deal's terms show. The transaction freed up
Merchant's capital, allowing it to use it to make new loans.
    Through the trade, the bank would absorb the first 1% of
losses on the portfolio, while the next 14% would be absorbed by
investors, according to the term sheet. That means Merchants
sold the riskiest tranche of the loan portfolio, maximizing the
capital relief it could get on it. 
    The investors deposited cash in a collateral account as
protection to Merchants Bank, the term sheet shows.
        Merchants did not respond to requests for comment.
    Then last month, JPMorgan did one of the largest trades of
this kind. It placed synthetic credit linked notes for $2.5
billion with investors, three sources said. They referenced a
pool of mortgages and loans totaling about $20 billion, the
sources said. 
    Deborah Staudinger, banking and loan finance partner at
Hogan Lovells, said banks are also considering transactions to
lower risk on a single loan or a portfolio by buying insurance.
    The deals, which are yet to happen, can be secured by cash
or other collateral posted by one or more insurers. Whether U.S.
regulators will allow such insurance deals to qualify for
capital relief is still untested, Staudinger said.

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Explainer: What is the 'Basel III endgame' and why are banks
worked up about it?    https://www.reuters.com/business/finance/what-is-basel-iii-endgame-why-are-banks-worked-up-about-it-2023-07-24/
BREAKINGVIEWS-New bank rules cage a tiger, feed a dragon   
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 (Reporting by Shankar Ramakrishnan; Editing by Paritosh Bansal
and Nick Zieminski)
 ((Shankar.Ramakrishnan@thomsonreuters.com; +1 2017590156;))