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FT editor Roula Khalaf has chosen her favorite stories in this weekly newsletter.
The author 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 making a new wave on Wall Street. Banks across all sectors are once again shedding risk from their balance sheets to make room for more risk-taking, in line with the demands of prudential regulators.
These so-called “credit risk transfers” (CRTs) allow banks to transfer only the risks associated with various loans or pools of loans to third parties willing to assume those risks and receive the associated rewards. It can be sold instead of itself. , or so they hope. These are also known as “significant risk transfers” or SRTs. “One of the big growing pains in this market is that no one can decide on a name. The product is known by different names in different places,” said law firm A & O Sherman.
Intermediaries in such deals include companies like Guy Carpenter, a division of insurance giant Marsh McLennan, and even the big Wall Street banks themselves. For a fee, they transfer some of the risk on banks’ balance sheets to companies like Apollo Global Management, Blackstone and Bayview Asset Management. They like to take risks created by others and hope to profit from them.
The global market has grown 20-25% annually since 2017, reaching a record $24 billion in 2023, according to data from credit investment firm Corus Capital. It said that as of September 30 this year, 44 banks were involved in transactions totaling $16.6 billion.
The idea is to free up regulatory capital on loans and make new loans possible. Hopefully, this will become a virtuous cycle that reduces risk for depository financial institutions and stores risk with other large financial institutions.
But just because risk is removed from the balance sheets of the big Wall Street banks doesn’t mean risk is gone from the system. It only means that it is imposed on others who are willing to take it on. Risk remains. The question is always whether we can manage or contain the risk we have taken on, or whether it will soon explode before our eyes.
And this is something that worries people like Sheila Baer, former chair of the Federal Deposit Insurance Corporation, and Simon Johnson, a newly awarded Nobel Prize-winning professor of entrepreneurship at the Massachusetts Institute of Technology. be. An ingenious financial product, the credit default swap, nearly destroyed the financial world in 2008.
Are CRTs such a ticking time bomb? Their proponents, of course, say no, saying that CRTs could not be more different from credit default swaps. In an August interview with Bloomberg, Michael Sciemi, head of North American structured credit at Guy Carpenter & Co., said the collective experience of credit default swaps in 2008 “has influenced the creation of today’s CRT market. I gave it,” he said. The same thing will happen again.
“A lot of the controversy around this goes back to 2008, during the financial crisis,” he says. “And when people hear buzzwords like ‘synthetics’ and ‘derivatives,’ they start getting sick to their stomachs. But this is different in every way.” The difference, he says, is that CRTs are not part of normal lending activities. In contrast, credit default swaps allow investors to speculate with unlimited leverage, regardless of whether they own the underlying assets. “This is about true diversification of credit risk, not concentration of credit risk,” he said.
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But Mr. Baer, Mr. Johnson and others fear we may see a match lit in the next powder keg. “Even if the transfer of credit risk is successful in protecting regulated banks, the risk is transferred to non-bank entities that may be less able to manage and absorb losses,” Baer wrote in an FT article last December. “It will be done,” he wrote.
Johnson followed up in September with a letter to Federal Reserve Chairman Jay Powell, along with Erki Liekkanen, co-chair of the CFA Institute’s Systemic Risk Council. He hoped the Fed would begin to “address growing systemic vulnerabilities” by using cathode ray tubes. Mr. Johnson’s letter to Mr. Powell follows a letter written by Rhode Island Sen. Jack Reed, asking Mr. Powell to “install additional guardrails” around credit risk transfers.
Some opponents of the use of CRTs argue that some of the buyers in these transactions are using leverage, with funds borrowed from the same Wall Street banks that are transferring the risk to them. They are concerned that they are racking up profits from these transactions. Sen. Reed wonders, “Are CRTs really transferring credit risk to outside investors, or are they further concentrating risk in a small number of Wall Street banks?” That’s a very good question.