How “credit risk transfers” could help banks shore up their balance sheets
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Worries over the strength of regional banks have helped former Treasury Steve Mnuchin buy into New York Community Bancorp for a mere $2 per share. That's partly because he knows full well that banks don't have a lot of attractive options right now when they need to strengthen their balance sheets.
Between the lines: NYCB did reportedly look at one alternative, so-called credit risk transfer (CRT) deals, but faced regulatory skepticism.
Why it matters: CRT deals have become an increasingly popular way for banks to offload risk in Europe, where they're called significant risk transfer operations. But U.S. regulators haven't yet gotten entirely comfortable with the structure.
How it works: A bank can sell credit-linked notes that refer to a pool of loans on its balance sheet. It doesn't sell the loans, but it does effectively sell most of the credit risk associated with the loans.
- If the loans perform well, the outside investors make a healthy return; if the loans underperform, then those investors end up with the associated losses.
- The bank sometimes receives a modest amount of new capital from outside investors. More importantly, it avoids having to realize a loss by selling loans that, in the current interest-rate environment, would almost certainly fetch well below par.
The big picture: Once credit risk is moved off a bank's balance sheet, the pool of loans becomes much less risky — and because it's less risky, regulators can require the bank to hold less capital against it.
- That regulatory arbitrage — moving the loans from being treated as high-risk to low-risk — is how the maneuvers free up capital for a bank.
Where it stands: Deals like these remain extremely rare in the U.S.
- The Fed has allowed Huntington Bancshares, Morgan Stanley, Santander, and U.S. Bancorp to do relatively small CRTs on their auto loan portfolios.
- A clear green light from the Fed encouraging more such transactions would help banks shore up their balance sheets more easily and would also reduce some of the pressure on the Federal Home Loan Banks, which currently act as the first place troubled banks go to borrow money.
- Up until now, however, says Greg Hertrich, head of US depository strategy at Nomura, "regulatory thinking has not included a carte blanche CRT for every bank."
Between the lines: NYCB was looking at these structures, but the WSJ reports that "U.S. officials have expressed reservations" about any such deal. In the end, the bank went the old-fashioned route of simply selling equity at a deep discount.
The bottom line: For CRTs to take off in the U.S., they probably need to be pioneered by large, safe banks, rather than one in crisis mode.
