The spread of a new generation of credit protection agreements among US banks is likely to outlive cyclical factors that have spurred their adoption in recent years.

Credit-risk transfers — well-established in Europe — have helped a growing number of US banks strengthen capital during a time when rising interest rates were hammering the fair value of loans and bonds and doing the opposite.

Some banks have said they are not likely to return to the market after meeting capital needs. However, the deals can slash risk-weighted assets (RWAs) at an attractive price, and offer features that can make them more desirable than conventional securitizations or loan sales, including eliminating questions about who controls relationships with borrowers and facilitating bespoke relationships with credit investors.

Activity in the US so far by early movers is creating a template. "As deals start to close, others pay attention," said Sagi Tamir, a partner at Mayer Brown. Matthew Bisanz, also a partner at Mayer Brown said, "There is still more runway with this product."

The deals take a number of forms, but in essence an investor such as an insurer or a private credit fund agrees to absorb potential credit losses on a single corporate loan or pool of loans that a bank continues to control on its balance sheet. The investor can agree to absorb initial losses, or take a second-loss position, where for instance the investor covers losses beyond 2% of a pool of high-quality auto loans through 10%. The idea is that money is available to absorb losses that exceed routine credit provisions, functioning as a substitute for the bank's own capital.

The deals can include elements that create protections against potential breakdowns, such as cash collateral equivalent to the maximum losses an investor might have to absorb — and sometimes held on the bank's balance sheet — that address concerns that a counterparty might not be able to meet its obligations. Still, their complexity and newness in the US can raise comparisons to derivative transactions that underpinned the Great Financial Crisis.

It is reasonable to scrutinize whether these deals represent arbitrage of regulatory capital rules or involve hidden leverage, said Richard Barnes, senior director at S&P Global Ratings. "If we were to see banks becoming dependent on this as a capital management tool such that if this market suddenly went away that they would be left in a difficult position, I think that would be a concern. [However], with the kind of volumes that we're looking at right now, it's more of a tactical play."

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Favorable economics

Ally Financial Inc. and Huntington Bancshares Inc. are among the banks that have issued credit-linked notes (CLNs) recently after receiving specific approval from the Federal Reserve that the transactions could be used in calculating RWAs.

Credit risk transfer (CRT) "really gives us an opportunity to manage the capital load associated with a number of our retail auto loan assets, but maintaining, obviously, our relationships with dealers, maintaining our ability to speak for their volume," Ally CFO Russell Hutchinson said at an investor conference Sept. 10. "We haven't committed to any kind of specific volume or cadence but it's certainly something that we expect to continue to do."

Ally sold $330 million of CLNs representing a mezzanine, or second loss position, on a pool of $3.0 billion of prime auto loans. It said the cost on the debt is about 7%, partially offset by investment income on a corresponding $330 million of collateral it onboarded as an asset, and that the transaction lowered the risk-weighting on the $3.0 billion of auto loans from 100% to 38%, thereby increasing its common equity Tier 1 (CET1) ratio by 11 basis points. The bank's CET1 ratio increased 18 basis points sequentially in the second quarter overall.

Huntington said the $478 million of CLNs it issued in the second quarter reduced the risk-weighting on $4.0 billion of auto loans by 76%, or about $3.0 billion, delivering a CET1 ratio boost of 17 basis points. In the bank's second-quarter earnings call, CFO Zachary Wasserman called the transaction "tactical" and said the "economics are incredibly favorable" at less than a 3% cost of capital.

"Oftentimes, you can take pools that have performed in terms of historical data very, very well, but from a capital reserve standpoint, they are punitive," Tamir said. Banks can execute the deals efficiently "because the risk based on historical data is acceptable in the market, definitely for investors who play at these levels."

Exits from a percolating market

A partial tally of recent CRTs gives a window on activity in the market, with data on issuance by select banks compiled by S&P Global Market Intelligence totaling $3.28 billion, and covering loan pools totaling $35.6 billion.

Some banks have said they are backing away, however.

"We don't have a need for capital, liquidity particularly, right now," Banc of California Inc. President and CEO Jared Wolff said at an investor conference Sept. 10. "So for right now, I think we're open to looking at it, but I don't see another one."

Banc of California bought PacWest Bancorp in 2023 after PacWest was pulled into the turmoil early that year. "PacWest was looking for some capital, some liquidity, when they did that risk transfer," Wolff said. "It absorbs the first 5% loss position on a relatively safe portfolio of single-family loans, but it has a huge benefit in terms of reducing the risk weighting of those assets from 50% to 25% or 20%. ... But it's pretty expensive, especially given how safe those assets are."

Texas Capital Bancshares Inc., which has taken a number of steps to reshape itself and boost its profitability, redeemed its CLNs in full in the second quarter.

Its CET1 ratio declined 76 basis points sequentially, including 46 basis points from the CRT expiration. "We just simply didn't need additional risk-weighted asset benefit and instead are prioritizing improved earnings and associated tangible capital generation," CFO J. Matthew Scurlock said during the bank's second-quarter earnings call.

Systemic concerns

While the expansion of CRTs in the US has attracted scrutiny over resemblances to financial engineering that melted down in the 2000s, market participants say that current structures reflect lessons learned from that era.

Skeptics have noted that leverage credit investors use by borrowing from banks recycles risk to the banking sector. But current arrangements are not characterized by "back leverage [that] is provided on a one-for-one basis" and are not a financing arrangement whereby "the party at the end of the chain has taken the exact same risk as" the lender, Tamir said. Back leverage used by investors in CRT deals "could be collateralized. It could be subject to margin requirement. It is clearly subject to sort of borrowing base, like the regular lending."

"This is really viewed as more of a partnership product where there is risk sharing in the transaction," said Matthew Mitchell, managing director at S&P Global Ratings, with lenders typically absorbing some junior or mezzanine losses. "We view it as a different synthetic product than what we saw in the world of securitization back in 2006, 2007."

"It's not as if there are only a few leverage providers or that they're taking huge outsized risks like you saw with maybe Archegos," Bisanz said. "The regulators are still supervising all of this, even with the banks that are providing leverage, they are still supervised."