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FT editor Roula Khalaf selects her favorite 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’s an old idea that’s causing a stir on Wall Street. Banks of all types are once again de-risking their balance sheets, in line with the demands of their prudential regulators, to make room for more risk-taking.
These so-called “credit risk transfers,” or CRTs, allow banks to sell only the risks associated with various loans or pools of loans (but not the loans themselves) to third parties willing to take on those risks and receive the associated rewards. , or so they hope. They are also known as “significant risk transfer” or SRT. “One of the biggest problems in this market is that no one can decide on a name. The product is known by different names in different places.” grades A & O Shearman Law Firm.
Middlemen for such deals include people like Guy Carpenter, a division of the huge insurer Marsh McLennan, as well as some big Wall Street banks. In exchange for a fee, they transfer some of the risk from banks’ balance sheets to companies like Apollo Global Management, Blackstone, and Bayview Asset Management, among others, who like to take on the risk generated by others, hoping to profit from it. he.
Since 2017, the global market has grown 20 to 25 percent annually, reaching a record $24 billion in 2023, according to data from credit investor Chorus Capital. It says there have been $16.6 billion in deals this year through Sept. 30 involving 44 banks.
The idea is to free up regulatory capital placed against loans to allow new loans to be made. Hopefully, this is a virtuous cycle that reduces risk in depository institutions and houses it in other financial giants.
But just because risk is being removed from the balance sheets of big Wall Street banks doesn’t mean risk is gone from the system; it simply means that it is passed on to others willing to take it on. The risk remains. The question is always whether the risk taken can be managed or contained, or whether it will soon blow up in our faces.
And this is what worries people like Sheila Bair, former president of the Federal Deposit Insurance Corporation, and Simon Johnson, the newly crowned Nobel laureate and MIT entrepreneurship professor, who remembers well how the promise of risk containment, using another creative financial product – “credit default swaps” – nearly blew the financial world to pieces back in 2008.
Are CRTs another time bomb? Their proponents say no, of course, CRTs couldn’t be more different from credit default swaps. in an august interview Speaking to Bloomberg, Michael Shemi, head of North American Structured Credit at Guy Carpenter, said the collective experience of credit default swaps in 2008 “informed” the creation of the current CRT market – the goal is to not let it return. the same thing will happen. .
“A lot of the controversy around this goes back to 2008, with the financial crisis,” he said. “And when people hear buzzwords like ‘synthetics’ and ‘derivatives,’ their stomach turns. But this is different in every way possible.” The difference, he said, is that CRTs hedge risk arising from the normal course of credit activities, while credit default swaps allowed for unlimited leveraged speculation, whether you owned the underlying credit asset or not. “This is a true distribution of credit risk, rather than a concentration of credit risk,” he said.
But Bair and Johnson, among others, worry that we could see the match being lit in the next powder keg. in a article In the Financial Times last December, Bair wrote that “even if credit risk transfer succeeds in protecting regulated banks, the risk is transferred to non-banks that appear less able to manage and absorb losses.”
Johnson followed up in September letter with his colleague co-chair of the CFA Institute Systemic Risk Council, Erkki Liikanen, to Jay Powell, chairman of the Federal Reserve. He wanted the Federal Reserve to begin “addressing the growing systemic vulnerabilities posed” by the use of CRT. Johnson’s letter to Powell followed another written by Senator Jack Reed of Rhode Island, who also urged Powell to “put up additional barriers” around credit risk transfers.
Some opponents of the use of CRT also fear that some of the buyers of these transactions are increasing their returns on these deals using leverage, with money borrowed from the same Wall Street banks that are transferring these risks to them. Senator Reed questions “whether CRTs actually transfer credit risk to outside investors or further concentrate risk among a small number of Wall Street banks.” It’s a very good question.