1
00:00:03,120 --> 00:00:18,480
Speaker 1: Bloomberg Audio Studios, Podcasts, Radio News.

2
00:00:20,840 --> 00:00:24,120
Speaker 2: Hello and welcome to another episode of the Odd Thoughts Podcast.

3
00:00:24,239 --> 00:00:25,600
Speaker 2: I'm Tracy Allaway.

4
00:00:25,440 --> 00:00:26,680
Speaker 3: And I'm Joe Wisenthal.

5
00:00:27,040 --> 00:00:29,440
Speaker 2: Joe, do you ever wonder what this show would have

6
00:00:29,480 --> 00:00:32,200
Speaker 2: been like if we had been doing the podcast before

7
00:00:32,280 --> 00:00:33,040
Speaker 2: two thousand.

8
00:00:32,800 --> 00:00:35,120
Speaker 3: And eight, Well, we would have had plenty to talk

9
00:00:35,159 --> 00:00:36,960
Speaker 3: about it, you know, I actually have it right, It

10
00:00:36,960 --> 00:00:38,760
Speaker 3: would have, man, now, I wish we could. We would

11
00:00:38,800 --> 00:00:42,199
Speaker 3: have had like five bonus episodes every single week, so

12
00:00:42,720 --> 00:00:44,599
Speaker 3: there were just so much content on those days.

13
00:00:44,640 --> 00:00:47,000
Speaker 2: I'm actually glad we weren't doing it back in two

14
00:00:47,000 --> 00:00:48,600
Speaker 2: thousand and eight because I feel like that was a

15
00:00:48,640 --> 00:00:51,720
Speaker 2: time when we, along with everyone else in the market,

16
00:00:51,760 --> 00:00:55,360
Speaker 2: were still learning a lot about how everything works. But

17
00:00:55,440 --> 00:00:58,200
Speaker 2: the one thing I'm kind of sad about is, uh,

18
00:00:58,600 --> 00:01:00,520
Speaker 2: you know, there was a lot of interesting stuff happening

19
00:01:00,720 --> 00:01:05,080
Speaker 2: in structured finance in the securitization market back then, lots

20
00:01:05,080 --> 00:01:10,119
Speaker 2: of interesting deal structures, and there aren't that many of

21
00:01:10,160 --> 00:01:13,320
Speaker 2: those since two thousan and eight for obvious reasons.

22
00:01:13,760 --> 00:01:15,560
Speaker 3: No, you're totally right, Like, you know, we don't do

23
00:01:15,640 --> 00:01:20,399
Speaker 3: many like credit credit default swaps episodes or CDOs or

24
00:01:20,480 --> 00:01:23,400
Speaker 3: various other versions of structured finance, which I know that

25
00:01:23,760 --> 00:01:26,080
Speaker 3: you know, you've covered quite a bit. You know, you

26
00:01:26,160 --> 00:01:29,000
Speaker 3: hear about that stuff a little bit less. But yes,

27
00:01:29,080 --> 00:01:31,720
Speaker 3: that would have been a buffet of topics for us

28
00:01:31,720 --> 00:01:32,720
Speaker 3: to choose from back then.

29
00:01:32,840 --> 00:01:35,039
Speaker 2: A buffet is a good way of putting it, okay,

30
00:01:35,200 --> 00:01:37,679
Speaker 2: So I'm very happy to say this is an episode

31
00:01:37,720 --> 00:01:39,959
Speaker 2: I have wanted to do for a while.

32
00:01:40,040 --> 00:01:40,759
Speaker 4: We are going to.

33
00:01:40,760 --> 00:01:44,720
Speaker 2: Gorge ourselves on a particular type of structured finance deal,

34
00:01:45,200 --> 00:01:48,320
Speaker 2: something that's been happening in the market for a number

35
00:01:48,360 --> 00:01:51,280
Speaker 2: of years now, but it really seems to be booming

36
00:01:51,480 --> 00:01:53,880
Speaker 2: in some respects in recent years. We're going to be

37
00:01:53,880 --> 00:01:57,800
Speaker 2: talking about synthetic risk transfers or SRTs.

38
00:01:58,240 --> 00:02:00,920
Speaker 3: I have to admit that up until like two days ago,

39
00:02:01,160 --> 00:02:04,080
Speaker 3: I had no idea what a synthetic risk transfer is.

40
00:02:04,680 --> 00:02:06,920
Speaker 3: I also still don't have any idea what a synthetic

41
00:02:07,000 --> 00:02:09,880
Speaker 3: risk transfer is. But I, like, you know, get the

42
00:02:09,919 --> 00:02:13,360
Speaker 3: impression that basically this is what I seem to know

43
00:02:13,400 --> 00:02:15,760
Speaker 3: based on a couple of things I've read. There's only

44
00:02:15,840 --> 00:02:20,400
Speaker 3: so much risk or balance sheet that regulated financial institution

45
00:02:20,560 --> 00:02:24,040
Speaker 3: like a bank is supposed to take, and at some point,

46
00:02:24,120 --> 00:02:26,799
Speaker 3: if they want to continue to make loans and continue

47
00:02:26,840 --> 00:02:30,000
Speaker 3: to maintain a relationship with a client, whoever it is,

48
00:02:30,600 --> 00:02:33,720
Speaker 3: some of that risk in order for regulatory balance sheet

49
00:02:33,800 --> 00:02:37,760
Speaker 3: purposes whatever has to be unloaded to some third party entity.

50
00:02:38,240 --> 00:02:38,440
Speaker 5: Right.

51
00:02:38,720 --> 00:02:42,480
Speaker 2: So the interesting thing about these transactions is they didn't

52
00:02:42,480 --> 00:02:45,959
Speaker 2: always used to be called synthetic risk transfers. I remember,

53
00:02:46,720 --> 00:02:49,520
Speaker 2: I mean, I am so old that I remember when

54
00:02:49,520 --> 00:02:53,040
Speaker 2: they were just called balance sheet securitizations or synthetic balance

55
00:02:53,040 --> 00:02:57,440
Speaker 2: sheet clos collateralized loan obligations. I remember when they were

56
00:02:57,480 --> 00:03:02,520
Speaker 2: called regulatory capital trades or regular relief trades instead of SRT,

57
00:03:02,919 --> 00:03:05,440
Speaker 2: and I think that name actually gives a much more

58
00:03:05,520 --> 00:03:09,560
Speaker 2: concrete idea of what is happening here. So banks have

59
00:03:09,680 --> 00:03:14,760
Speaker 2: portfolios of loans, they have to hold regulatory capital against

60
00:03:14,840 --> 00:03:18,360
Speaker 2: those loans. Post two thousand and eight and all the

61
00:03:18,400 --> 00:03:21,799
Speaker 2: regulatory reform that we've seen, they have to hold more capital,

62
00:03:22,000 --> 00:03:26,400
Speaker 2: and so they've looked at creative ways of lessening some

63
00:03:26,520 --> 00:03:28,480
Speaker 2: of that burden. And one of the things they've come

64
00:03:28,560 --> 00:03:31,760
Speaker 2: up with is this SRT idea. So this idea that

65
00:03:31,800 --> 00:03:36,400
Speaker 2: you purchase basically insurance protection on a portfolio of loans,

66
00:03:36,600 --> 00:03:38,080
Speaker 2: and then if you do it in the right way,

67
00:03:38,280 --> 00:03:41,080
Speaker 2: you get to hold less capital against it, and it

68
00:03:41,120 --> 00:03:44,520
Speaker 2: frees up your balance sheet allows you to do more lending. Now,

69
00:03:44,560 --> 00:03:47,200
Speaker 2: the interesting thing about these deals is, as I alluded to,

70
00:03:47,920 --> 00:03:51,080
Speaker 2: they actually have a long history, Like in some respects,

71
00:03:51,080 --> 00:03:55,000
Speaker 2: they're sort of the essence of securitization itself, this idea

72
00:03:55,000 --> 00:03:57,320
Speaker 2: of risk transfer, and you can kind of trace the

73
00:03:57,440 --> 00:04:00,400
Speaker 2: history all the way back to JP Morgan and first

74
00:04:00,440 --> 00:04:01,560
Speaker 2: pistro trades and.

75
00:04:01,520 --> 00:04:02,200
Speaker 4: Stuff like that.

76
00:04:02,280 --> 00:04:04,280
Speaker 2: Maybe we'll get all the way back to the nineteen

77
00:04:04,320 --> 00:04:07,480
Speaker 2: nineties and JP Morgan in this conversation. I'm not sure,

78
00:04:07,680 --> 00:04:11,240
Speaker 2: but there's definitely a lot to discuss, primarily why these

79
00:04:11,280 --> 00:04:13,960
Speaker 2: things seem to be growing now. So I think there

80
00:04:14,000 --> 00:04:16,920
Speaker 2: was about twenty five billion worth of SRTs issued in

81
00:04:16,960 --> 00:04:20,080
Speaker 2: twenty twenty three. The average number of banks that have

82
00:04:20,160 --> 00:04:22,560
Speaker 2: been tapping the market has gone from something like eight

83
00:04:22,920 --> 00:04:26,320
Speaker 2: in sort of the twenty fourteen to twenty twenty period

84
00:04:26,480 --> 00:04:31,839
Speaker 2: to something like thirty seven now, So that's.

85
00:04:31,720 --> 00:04:32,320
Speaker 4: A big jump.

86
00:04:32,480 --> 00:04:35,760
Speaker 2: More banks are doing this, investors are getting interested in this.

87
00:04:36,520 --> 00:04:38,920
Speaker 2: One funny thing that I just realized is like some

88
00:04:39,000 --> 00:04:43,159
Speaker 2: of the do you remember the trade press on structured credit?

89
00:04:43,200 --> 00:04:46,159
Speaker 2: Like structured credit investor I used to read them all

90
00:04:46,200 --> 00:04:49,080
Speaker 2: the time, sort of two thousand and eight to twenty ten,

91
00:04:49,440 --> 00:04:52,560
Speaker 2: and it was all about you know, CDOs and rmbs

92
00:04:52,760 --> 00:04:57,160
Speaker 2: and housing reform. It is now all about SRTs. So

93
00:04:57,320 --> 00:05:00,599
Speaker 2: you can see the sort of like transition that of

94
00:05:00,640 --> 00:05:02,360
Speaker 2: the market happening in real time.

95
00:05:02,800 --> 00:05:04,960
Speaker 3: I am really looking forward to this conversation, you know,

96
00:05:05,040 --> 00:05:08,599
Speaker 3: I think to me, conceptually, part of my question what

97
00:05:08,680 --> 00:05:12,719
Speaker 3: I want to learn is like a financial institution hedging

98
00:05:12,760 --> 00:05:16,520
Speaker 3: out some of their credit risk exposure, counterparty exposure, whatever

99
00:05:16,560 --> 00:05:18,520
Speaker 3: it is, is not really new. And we had this

100
00:05:18,560 --> 00:05:20,440
Speaker 3: whole thing, you know that we would have talked about

101
00:05:20,480 --> 00:05:21,800
Speaker 3: a lot in two thousand and eight, which is the

102
00:05:21,839 --> 00:05:25,760
Speaker 3: credit default swaps market. And conceptually, to me, this idea

103
00:05:25,800 --> 00:05:28,280
Speaker 3: of like, okay, here's an entity it wants to use

104
00:05:28,320 --> 00:05:32,440
Speaker 3: someone else's capital, you know, to essentially buy ensure or

105
00:05:32,560 --> 00:05:34,880
Speaker 3: ensure away or risk. That was a thing. Then a

106
00:05:34,920 --> 00:05:36,720
Speaker 3: lot of that market sort of dried up, and now

107
00:05:36,760 --> 00:05:38,880
Speaker 3: there is this new market. So I want to understand

108
00:05:38,880 --> 00:05:41,760
Speaker 3: a little bit more about how this is conceptually different

109
00:05:41,880 --> 00:05:42,800
Speaker 3: or similar to right.

110
00:05:43,000 --> 00:05:45,599
Speaker 2: This is a very big debate in this space, like

111
00:05:45,680 --> 00:05:48,800
Speaker 2: to what degree do these potentially pose a risk to

112
00:05:49,000 --> 00:05:53,160
Speaker 2: financial stability? There's been some excellent coverage by our colleagues

113
00:05:53,200 --> 00:05:56,360
Speaker 2: at Bloomberg about one particular aspect of this that seems

114
00:05:56,440 --> 00:05:58,720
Speaker 2: kind of sketchy. We are going to get into that,

115
00:05:59,200 --> 00:06:01,279
Speaker 2: but I have to say we really do have the

116
00:06:01,279 --> 00:06:04,159
Speaker 2: perfect guest to discuss this, someone I've been wanting to

117
00:06:04,200 --> 00:06:06,680
Speaker 2: speak to about this for a long time. We're going

118
00:06:06,760 --> 00:06:09,800
Speaker 2: to be talking to Michael Shemy. He is the North

119
00:06:09,839 --> 00:06:14,760
Speaker 2: America structured credit lead at Guy Carpenter. So, Michael Mickey,

120
00:06:15,000 --> 00:06:15,839
Speaker 2: welcome to the show.

121
00:06:17,520 --> 00:06:20,159
Speaker 5: Thank you Tracy, thank you Joe for having me. Appreciate it.

122
00:06:20,160 --> 00:06:21,039
Speaker 5: It's great to be here.

123
00:06:21,360 --> 00:06:22,880
Speaker 4: What does Guy Carpenter actually do?

124
00:06:23,279 --> 00:06:28,359
Speaker 5: Guy Carpenter is part of the Marsh McLennan family of

125
00:06:28,440 --> 00:06:33,200
Speaker 5: companies that includes risk and insurance services Guy Carpenter Marsh,

126
00:06:33,560 --> 00:06:39,000
Speaker 5: along with consulting Oliver Wyman and Mercer. Guy Carpenter is

127
00:06:39,160 --> 00:06:44,360
Speaker 5: Marsh mcclennan's reinsurance specialist advisor broker. I lead the North

128
00:06:44,400 --> 00:06:49,280
Speaker 5: America Structure credit business within the Global Mortgage and Structured

129
00:06:49,320 --> 00:06:54,279
Speaker 5: Credit segment. I joined Guy Carpenter in late twenty twenty three.

130
00:06:54,600 --> 00:06:58,680
Speaker 5: I've spent my career in ass management and banking, working

131
00:06:58,720 --> 00:07:04,240
Speaker 5: with financial institution on matters related to regulatory capital, capital management,

132
00:07:04,400 --> 00:07:08,800
Speaker 5: risk transfer. Most immediately before my current position, I had

133
00:07:08,839 --> 00:07:13,640
Speaker 5: spent time working at a regulatory agency at FHFA, the

134
00:07:13,680 --> 00:07:18,400
Speaker 5: Federal Housing Finance Agency, working on similar issues but specifically

135
00:07:18,520 --> 00:07:22,720
Speaker 5: related to the GCS. To Fannie May and Freddie Guy

136
00:07:22,760 --> 00:07:27,080
Speaker 5: Carpenter has presence in the Americas, Europe globally structuring and

137
00:07:27,120 --> 00:07:33,280
Speaker 5: placing credit risk transfer synthetic risk transfer for various financial institutions.

138
00:07:33,760 --> 00:07:38,800
Speaker 5: We generally place this risk with multiline reinsurance companies in

139
00:07:38,880 --> 00:07:43,120
Speaker 5: reinsurance format, but also place this risk into the capital markets.

140
00:07:43,520 --> 00:07:47,200
Speaker 5: We recently published with our colleagues at Marsh and Oliver

141
00:07:47,320 --> 00:07:50,800
Speaker 5: Wyman a white paper in June about the potential for

142
00:07:50,880 --> 00:07:57,360
Speaker 5: expanding banks portfolio management toolkit and exploring specific opportunities for

143
00:07:57,440 --> 00:08:01,920
Speaker 5: North America banks to bail themselves of credit risk transfer

144
00:08:02,000 --> 00:08:05,840
Speaker 5: transactions in that space. Much has been written about this recently.

145
00:08:05,880 --> 00:08:08,880
Speaker 5: As you both alluded to, this was a bit different

146
00:08:09,520 --> 00:08:13,640
Speaker 5: geared towards bank issuers discussed as benefits of credit risk transfer,

147
00:08:14,000 --> 00:08:17,640
Speaker 5: give some historic context, and also you know, discusses what

148
00:08:17,760 --> 00:08:20,480
Speaker 5: is required of a bank to launch such a program.

149
00:08:20,760 --> 00:08:22,800
Speaker 2: It's a good paper and I made sure to read

150
00:08:22,840 --> 00:08:27,520
Speaker 2: it before this conversation, So why don't we, given your expertise,

151
00:08:27,840 --> 00:08:30,680
Speaker 2: have you fact check us in real time? Both Joe

152
00:08:30,720 --> 00:08:32,960
Speaker 2: and I sort of explained the way we think of

153
00:08:33,280 --> 00:08:37,040
Speaker 2: SRTs or redcap trades. Talk to us about what's your

154
00:08:37,240 --> 00:08:40,720
Speaker 2: understanding and maybe give us a specific example, like in

155
00:08:40,800 --> 00:08:43,800
Speaker 2: the evolution of one of these deals, how does it

156
00:08:43,960 --> 00:08:46,600
Speaker 2: start and how does it actually come to market?

157
00:08:48,000 --> 00:08:50,280
Speaker 5: Yeah, so there are a few things to say upfront.

158
00:08:50,920 --> 00:08:53,160
Speaker 5: I would also say, you know your introduction. I think

159
00:08:53,200 --> 00:08:56,319
Speaker 5: I agreed with basically every word there. Thank you, So

160
00:08:57,000 --> 00:09:02,199
Speaker 5: that's an accomplishment. There are huge differences between what happens

161
00:09:02,240 --> 00:09:05,320
Speaker 5: now in this market versus what happened in two thousand

162
00:09:05,320 --> 00:09:07,280
Speaker 5: and eight, or more specifically in the lead up to

163
00:09:07,320 --> 00:09:10,240
Speaker 5: two thousand and eight. But generally speaking, as you both

164
00:09:10,280 --> 00:09:15,520
Speaker 5: describe banks or regulated institutions, they face a variety of

165
00:09:15,640 --> 00:09:21,160
Speaker 5: constraints on their balance sheets, their business, liquidity, capital, and

166
00:09:21,240 --> 00:09:25,920
Speaker 5: they have developed tools to manage those constraints. There could

167
00:09:25,920 --> 00:09:29,400
Speaker 5: be loan sales, it could be loan participations, that could

168
00:09:29,400 --> 00:09:34,800
Speaker 5: be partnerships and securitizations. Credit risk transfer synthetic risk transfer

169
00:09:34,960 --> 00:09:38,480
Speaker 5: is just one of those tools to manage these constraints

170
00:09:38,679 --> 00:09:43,360
Speaker 5: through a securitization in the banking framework, they're really conceptually

171
00:09:43,960 --> 00:09:48,679
Speaker 5: two sorts of securitizations. There's a traditional securitization that involves

172
00:09:48,800 --> 00:09:53,080
Speaker 5: actual sale of assets out of a financial institution.

173
00:09:52,840 --> 00:09:54,319
Speaker 4: Where you put them in like a trust.

174
00:09:54,400 --> 00:09:57,760
Speaker 5: Basically there's an SPV, there's a trust, there's an actual

175
00:09:57,880 --> 00:10:02,079
Speaker 5: sales and outright sale of the assets. And then there's

176
00:10:02,280 --> 00:10:06,439
Speaker 5: synthetic securitizations, which does not involve actual sale of assets.

177
00:10:06,960 --> 00:10:11,520
Speaker 5: Assets remain on balance sheet, customer relationships aren't interrupted. Only

178
00:10:11,679 --> 00:10:16,160
Speaker 5: credit risk is transferred out of the institution. What's also

179
00:10:16,200 --> 00:10:19,240
Speaker 5: important here in these transactions, you know, people think of

180
00:10:19,360 --> 00:10:22,560
Speaker 5: like two thousand and eight and credit risk and shedding

181
00:10:22,640 --> 00:10:27,040
Speaker 5: credit risk and bad assets. This really is not strictly

182
00:10:27,440 --> 00:10:31,120
Speaker 5: about shedding credit risk. Certainly it's a risk management tools

183
00:10:31,120 --> 00:10:34,240
Speaker 5: and we'll get into the benefits, but it also really

184
00:10:34,280 --> 00:10:37,680
Speaker 5: has become for banks and other regulated financial institutions like

185
00:10:37,760 --> 00:10:42,480
Speaker 5: Fannyman Freddie MAC, more of a capital management tool than

186
00:10:42,520 --> 00:10:45,600
Speaker 5: anything else. And just one thing I'll say in terms

187
00:10:45,640 --> 00:10:49,040
Speaker 5: of nomenclature, because there's a lot of this floating around.

188
00:10:49,240 --> 00:10:53,640
Speaker 5: CRT SRT probably the largest single program for these types

189
00:10:53,679 --> 00:10:58,160
Speaker 5: of transactions is Fanny May and Freddie Mac's program that's

190
00:10:58,200 --> 00:11:01,400
Speaker 5: referred to here in the US as credit risk transfer CRT.

191
00:11:02,120 --> 00:11:05,920
Speaker 5: If you see some of the US regional banks who

192
00:11:05,960 --> 00:11:09,439
Speaker 5: have become inaugural issuers of these transactions, even in two

193
00:11:09,520 --> 00:11:12,959
Speaker 5: Q earnings, they refer to these transactions as credit risk

194
00:11:13,000 --> 00:11:17,920
Speaker 5: transfers CRT. Globally, outside of the US and Europe specifically,

195
00:11:18,160 --> 00:11:21,640
Speaker 5: these are generally referred to as SRT significant risk transfer,

196
00:11:21,800 --> 00:11:27,600
Speaker 5: even synthetic risk transfer, and SRT is really a regulated term.

197
00:11:27,640 --> 00:11:31,160
Speaker 5: It's a formal regulatory term in that context, but ultimately

198
00:11:31,360 --> 00:11:34,560
Speaker 5: it's all the same. Generally speaking, it's the pulling of

199
00:11:34,640 --> 00:11:39,800
Speaker 5: credit exposures by a financial institution, transferring a subordinated portion

200
00:11:39,880 --> 00:11:42,120
Speaker 5: of the risk to a third party, either through a

201
00:11:42,160 --> 00:11:45,760
Speaker 5: synthetic securitization rather than a traditional securitization.

202
00:12:01,840 --> 00:12:06,240
Speaker 2: Joe I did an etymological study of what people are

203
00:12:06,280 --> 00:12:08,600
Speaker 2: calling these deals. I think I published it like a

204
00:12:08,640 --> 00:12:11,360
Speaker 2: month or maybe two months ago because I was bored,

205
00:12:11,720 --> 00:12:14,120
Speaker 2: and it was more than a thousand words long, just

206
00:12:14,800 --> 00:12:19,000
Speaker 2: tracing like the change in the nomenclature or what we

207
00:12:19,080 --> 00:12:21,200
Speaker 2: actually call these things over time.

208
00:12:21,320 --> 00:12:22,640
Speaker 4: It's funny how many.

209
00:12:22,440 --> 00:12:25,120
Speaker 2: Different like phrases and words have fallen in and out

210
00:12:25,120 --> 00:12:26,920
Speaker 2: of fashion to call these things.

211
00:12:27,040 --> 00:12:29,280
Speaker 3: I feel like synthetic is one of those words that

212
00:12:29,360 --> 00:12:33,000
Speaker 3: like raises alarms, Yeah it's not real, or something like that.

213
00:12:33,440 --> 00:12:36,880
Speaker 3: But why do you explain to us from the perspective

214
00:12:37,080 --> 00:12:39,560
Speaker 3: of a bank. You mentioned the two ways that they

215
00:12:39,600 --> 00:12:42,880
Speaker 3: can offload credit risk. One is outright selling it, the

216
00:12:43,000 --> 00:12:45,800
Speaker 3: other one is keeping it on the balance sheet, and

217
00:12:45,840 --> 00:12:48,560
Speaker 3: then you know, offloading some of the credit specific risk.

218
00:12:49,160 --> 00:12:51,400
Speaker 3: We'll get to how that's structured and who's buying and

219
00:12:51,440 --> 00:12:53,880
Speaker 3: who's on the other side. But what do you explain

220
00:12:53,960 --> 00:12:59,120
Speaker 3: from a regulatory or bank capital efficiency standpoint, why the

221
00:12:59,280 --> 00:13:02,920
Speaker 3: risk is attractive rather than the outright sale dyes.

222
00:13:03,160 --> 00:13:05,720
Speaker 2: Oh, and just to add on to that, because it's related,

223
00:13:05,760 --> 00:13:08,959
Speaker 2: but why don't banks just raise more capital for their loans?

224
00:13:09,400 --> 00:13:11,240
Speaker 5: So I think it's important to understand some of the

225
00:13:11,280 --> 00:13:16,320
Speaker 5: conceptual foundations for bank regulatory capital, what it's designed to

226
00:13:16,400 --> 00:13:19,400
Speaker 5: achieve and what it isn't designed to achieve. At the

227
00:13:19,520 --> 00:13:22,760
Speaker 5: very highest level, financial institutions, again, whether you're a bank

228
00:13:22,880 --> 00:13:27,160
Speaker 5: or a GSE or anything in between, generally face expected

229
00:13:27,160 --> 00:13:33,120
Speaker 5: losses and they face unexpected losses. Expected losses perceived as

230
00:13:33,120 --> 00:13:36,720
Speaker 5: a cost of doing business, bank's price for expected losses

231
00:13:36,760 --> 00:13:41,839
Speaker 5: through lending an account for expected losses also through loan

232
00:13:41,920 --> 00:13:46,800
Speaker 5: loss provisioning. In their normal course of business, banks don't

233
00:13:46,840 --> 00:13:51,679
Speaker 5: hold regulatory capital for expected losses. In essence, what concerns

234
00:13:52,320 --> 00:13:57,520
Speaker 5: bank regulators is unexpected losses, the losses above expected losses,

235
00:13:57,760 --> 00:14:02,120
Speaker 5: and regulatory capital is there to absorb these unexpected losses

236
00:14:02,400 --> 00:14:06,080
Speaker 5: as defined by regulators. And so you can really see

237
00:14:06,120 --> 00:14:10,840
Speaker 5: bank capital as a proxy for those unexpected levels of

238
00:14:10,920 --> 00:14:15,720
Speaker 5: loss above expected loss for which banks provision and price for. Now,

239
00:14:16,200 --> 00:14:20,960
Speaker 5: how do bank regulators sort of transcribe that sort of

240
00:14:22,120 --> 00:14:26,760
Speaker 5: philosophically into capital requirements while they look at two general

241
00:14:26,760 --> 00:14:30,680
Speaker 5: frameworks right now, there's a risk based capital requirement and

242
00:14:30,720 --> 00:14:35,640
Speaker 5: then there's a leverage capital requirement. Leverage capital requirements sort

243
00:14:35,640 --> 00:14:40,080
Speaker 5: of assign same requirements to different asset classes, no matter

244
00:14:40,160 --> 00:14:43,280
Speaker 5: the risk, same amount of capital. So whether you have

245
00:14:43,320 --> 00:14:46,480
Speaker 5: one hundred dollars of a treasury security of cash on

246
00:14:46,560 --> 00:14:49,680
Speaker 5: balance sheet, a mortgage, a corporate loan, you know that

247
00:14:49,760 --> 00:14:52,600
Speaker 5: same hundred dollars of exposure will attract the same level

248
00:14:52,640 --> 00:15:01,320
Speaker 5: of capital. For risk based capital requirements, the RBC assigns

249
00:15:01,520 --> 00:15:05,880
Speaker 5: different capital requirements to different exposures based on the perceived

250
00:15:06,000 --> 00:15:09,440
Speaker 5: risk they post to the bank by assigning different risk

251
00:15:09,520 --> 00:15:14,000
Speaker 5: quits risk based capital. Oh yes, excuse me, yes, yeah, yeah,

252
00:15:14,000 --> 00:15:15,440
Speaker 5: we're diving.

253
00:15:15,160 --> 00:15:18,400
Speaker 2: Into the episode with a lot of acronyms.

254
00:15:18,440 --> 00:15:20,080
Speaker 3: I keep going.

255
00:15:20,560 --> 00:15:24,360
Speaker 5: So, unlike the leverage framework, right, cash on balance sheet

256
00:15:24,520 --> 00:15:28,000
Speaker 5: right will attract far less than capital requirements than a

257
00:15:28,080 --> 00:15:32,040
Speaker 5: mortgage loan or corporate loan or a consumer loan. And

258
00:15:32,120 --> 00:15:35,920
Speaker 5: because of this differentiation in riskiness under the risk based

259
00:15:35,960 --> 00:15:40,280
Speaker 5: capital framework, not the leverage capital requirements, banks seek to

260
00:15:40,320 --> 00:15:48,000
Speaker 5: execute these transactions. So bringing this together, right, credit risk

261
00:15:48,000 --> 00:15:51,720
Speaker 5: transfer transactions transfer a portion of the credit risk, typically

262
00:15:52,400 --> 00:15:56,240
Speaker 5: the unexpected levels of loss as defined by regulators for

263
00:15:56,320 --> 00:16:01,280
Speaker 5: an identified pool of assets at the bank. And so

264
00:16:01,520 --> 00:16:05,440
Speaker 5: as a result, for the risk based capital framework, the

265
00:16:05,480 --> 00:16:08,840
Speaker 5: bank can demonstrate to its regulator that the bank faces

266
00:16:09,160 --> 00:16:13,440
Speaker 5: a significantly lower level of unexpected loss and thus is

267
00:16:13,960 --> 00:16:18,960
Speaker 5: permitted to hold less and regulatory capital. Less regulatory capital,

268
00:16:19,080 --> 00:16:22,600
Speaker 5: not no regulatory capital, right right, And the bank is

269
00:16:22,720 --> 00:16:26,520
Speaker 5: relieved of some of this capital it held pre transaction.

270
00:16:26,640 --> 00:16:28,720
Speaker 5: And that's sort of where the concept r trace you

271
00:16:28,760 --> 00:16:32,760
Speaker 5: mentioned before, where the concept of capital relief trades comes in.

272
00:16:33,040 --> 00:16:35,120
Speaker 5: And I think From there, we can talk about some

273
00:16:35,200 --> 00:16:38,160
Speaker 5: of the more specific structures that we're seeing.

274
00:16:38,360 --> 00:16:40,320
Speaker 2: I definitely want to get into structures. I want to

275
00:16:40,360 --> 00:16:43,960
Speaker 2: ask one question before we move to that, though, and

276
00:16:44,040 --> 00:16:46,480
Speaker 2: it's sort of I think it fills out the regulatory

277
00:16:46,760 --> 00:16:51,200
Speaker 2: aspect of this, But why is it that the market

278
00:16:51,560 --> 00:16:55,920
Speaker 2: for these things seems to be much more mature and

279
00:16:56,080 --> 00:17:00,440
Speaker 2: larger in Europe, so for European bank issuers then in

280
00:17:00,480 --> 00:17:04,280
Speaker 2: the US. In the US it's really only begun to

281
00:17:04,400 --> 00:17:07,919
Speaker 2: take off in the past year or so, despite a

282
00:17:07,960 --> 00:17:11,800
Speaker 2: lot of bankers. I remember in like twenty thirteen or

283
00:17:11,840 --> 00:17:14,199
Speaker 2: something having conversations with I think it was someone at

284
00:17:14,280 --> 00:17:16,679
Speaker 2: City Group talking about how they wanted to structure a

285
00:17:16,720 --> 00:17:19,440
Speaker 2: bunch of red cap trades for smaller banks and then

286
00:17:19,880 --> 00:17:22,679
Speaker 2: lo and behold. Ten years later, it feels like the

287
00:17:22,800 --> 00:17:26,120
Speaker 2: US market is actually starting to do something. So why

288
00:17:26,240 --> 00:17:28,760
Speaker 2: was there that discrepancy?

289
00:17:28,880 --> 00:17:32,840
Speaker 5: So you're absolutely right, in contrast to the global experience,

290
00:17:33,560 --> 00:17:37,840
Speaker 5: credit risk transfer never expanded meaningfully in the US beyond

291
00:17:37,880 --> 00:17:42,080
Speaker 5: the GSCs in any programmatic way. And there's several reasons

292
00:17:42,280 --> 00:17:45,240
Speaker 5: for that. We just hit on one of them. Regulatory

293
00:17:45,280 --> 00:17:49,359
Speaker 5: capital differences are one. You know, we talked about the

294
00:17:49,359 --> 00:17:53,760
Speaker 5: capital requirements risk based capital versus leverage. These transactions were

295
00:17:53,760 --> 00:17:57,720
Speaker 5: more embedded in Europe already pre two thousand and eight,

296
00:17:58,200 --> 00:18:01,320
Speaker 5: because banks had already adopted did what's known as the

297
00:18:01,359 --> 00:18:06,320
Speaker 5: BOZEL two framework that had a lot more risk sensitive

298
00:18:06,960 --> 00:18:11,320
Speaker 5: risk base capital requirements. The US, on the other hand,

299
00:18:11,480 --> 00:18:15,640
Speaker 5: was delayed in that process in transitioning from BOZEL one

300
00:18:15,920 --> 00:18:19,840
Speaker 5: to BOZL two, continue to operate under BASIL one for

301
00:18:19,960 --> 00:18:24,360
Speaker 5: a while, and then in around twenty twelve thirteen sort

302
00:18:24,359 --> 00:18:28,760
Speaker 5: of leapfrog straight to BASL three from BOZEL one. And

303
00:18:28,960 --> 00:18:31,679
Speaker 5: another aspect of this, I think that's important to note.

304
00:18:32,200 --> 00:18:37,879
Speaker 5: One of the post GFC, post Global Financial Crisis reforms

305
00:18:37,960 --> 00:18:41,359
Speaker 5: in BOSL three and the bank capital reforms was the

306
00:18:41,400 --> 00:18:45,320
Speaker 5: introduction of this leverage ratio requirement, right, So it was

307
00:18:45,359 --> 00:18:49,680
Speaker 5: all sort of risk base capital based beforehand, and now

308
00:18:49,720 --> 00:18:52,679
Speaker 5: the leverage ratio requirement is supposed to be sort of

309
00:18:52,720 --> 00:18:57,240
Speaker 5: a backstop. But interestingly, in the US, and earlier than

310
00:18:57,320 --> 00:18:59,920
Speaker 5: two thousand and eight and earlier than BASIL three reforms,

311
00:19:00,200 --> 00:19:04,720
Speaker 5: the US banking regulators already subjected banks to a leverage

312
00:19:04,880 --> 00:19:08,880
Speaker 5: capital requirement unlike their global peers, and in that regime,

313
00:19:09,480 --> 00:19:12,600
Speaker 5: banks don't benefit from the impacts of credit risk transfer,

314
00:19:12,800 --> 00:19:15,919
Speaker 5: since all risks are treated equally, and so there was

315
00:19:15,960 --> 00:19:19,760
Speaker 5: also just up until now, less of a focus historically

316
00:19:19,840 --> 00:19:23,320
Speaker 5: on risk based capital requirements in the US, so implicitly

317
00:19:23,680 --> 00:19:25,679
Speaker 5: less of a focus on credit risk transfer. You know.

318
00:19:25,760 --> 00:19:28,840
Speaker 5: On top of that, during this transition into Basel three,

319
00:19:29,200 --> 00:19:32,920
Speaker 5: there wasn't much regulatory clarity about the treatment of these

320
00:19:32,960 --> 00:19:36,560
Speaker 5: transactions here in the US. So it's real, there's real

321
00:19:36,640 --> 00:19:41,160
Speaker 5: regulatory capital regime differences between the US VERSUS Europe, even

322
00:19:41,200 --> 00:19:44,120
Speaker 5: between the US and say Canada. But I also don't

323
00:19:44,119 --> 00:19:46,960
Speaker 5: want to put this all at the feet of regulators

324
00:19:47,240 --> 00:19:50,440
Speaker 5: because in my view, you know, Tracy, you mentioned having

325
00:19:50,520 --> 00:19:54,000
Speaker 5: conversations in twenty twelve and twenty thirteen around this for

326
00:19:54,160 --> 00:19:56,960
Speaker 5: US banks. In my view, and maybe this is a

327
00:19:57,080 --> 00:20:00,280
Speaker 5: minority view, but I think it's been born out. Credit

328
00:20:00,359 --> 00:20:03,560
Speaker 5: risk transfer for US banks in the years following the

329
00:20:03,560 --> 00:20:06,800
Speaker 5: financial crisis was a solution in search of a problem.

330
00:20:07,480 --> 00:20:11,400
Speaker 5: Coming out of the financial crisis, US banks race capital

331
00:20:11,480 --> 00:20:13,680
Speaker 5: to shore up balance sheet. You know, maybe they were

332
00:20:13,680 --> 00:20:15,840
Speaker 5: forced to do so. Actually, I think I think you

333
00:20:15,840 --> 00:20:18,719
Speaker 5: would ask certain bank bank bank managements. You know, they

334
00:20:18,720 --> 00:20:22,480
Speaker 5: were subjected to regulatory stress tests early on. They have

335
00:20:22,680 --> 00:20:26,320
Speaker 5: been were and have been perceived to be better capitalized

336
00:20:26,359 --> 00:20:29,439
Speaker 5: with stronger balance sheets than their global peers. They were

337
00:20:29,440 --> 00:20:32,320
Speaker 5: never really balance sheet constrained in the years coming out

338
00:20:32,359 --> 00:20:35,800
Speaker 5: of QE, and this is also reflected in their valuations

339
00:20:36,280 --> 00:20:38,679
Speaker 5: across their capital structure. I mean, most of these banks

340
00:20:38,720 --> 00:20:41,600
Speaker 5: traded a premium to book value. So if a bank

341
00:20:41,720 --> 00:20:44,520
Speaker 5: and tracy you pose this question earlier. So if a

342
00:20:44,560 --> 00:20:48,040
Speaker 5: bank did need to raise capital for something, you know,

343
00:20:48,119 --> 00:20:53,719
Speaker 5: it was relatively easy to do, you know, at attractive valuations.

344
00:20:54,040 --> 00:20:57,679
Speaker 5: So the business need wasn't clear for US banks in

345
00:20:57,720 --> 00:21:00,280
Speaker 5: my opinion, as it was for European banks who did

346
00:21:00,320 --> 00:21:03,200
Speaker 5: not recapitalize in the same way as US banks did

347
00:21:03,280 --> 00:21:07,879
Speaker 5: post GFC. They were and are risk based capital constrained,

348
00:21:08,119 --> 00:21:10,760
Speaker 5: and again that was reflected in their valuations where most

349
00:21:10,800 --> 00:21:14,639
Speaker 5: of these banks still trade at a discount to book value.

350
00:21:14,920 --> 00:21:16,880
Speaker 5: And I just think, you know, sort of post two

351
00:21:16,920 --> 00:21:19,880
Speaker 5: thousand and eight around like the lingering sagas for banks

352
00:21:20,160 --> 00:21:24,480
Speaker 5: across the continent right in the European sovereign debt crisis,

353
00:21:24,520 --> 00:21:27,639
Speaker 5: but even even beyond, I would also say, you know,

354
00:21:27,760 --> 00:21:29,960
Speaker 5: moving out of the banks a little bit, the gcs

355
00:21:30,480 --> 00:21:33,320
Speaker 5: like European banks in a way you know, similar but

356
00:21:33,359 --> 00:21:37,560
Speaker 5: not the same. The use case was clear there as well,

357
00:21:37,840 --> 00:21:39,439
Speaker 5: you know, the need to sort of de risk the

358
00:21:39,560 --> 00:21:42,960
Speaker 5: tax payer during the conservatorship and going through the capital

359
00:21:43,000 --> 00:21:46,240
Speaker 5: build process. But you know, in any event, you know, ultimately,

360
00:21:46,240 --> 00:21:49,760
Speaker 5: in addition to regulatory uncertainty here in the US, banks

361
00:21:49,960 --> 00:21:53,560
Speaker 5: and bank managements generally didn't really prioritize active balance sheet

362
00:21:53,640 --> 00:21:55,520
Speaker 5: management as as they are now.

363
00:21:55,640 --> 00:21:58,720
Speaker 3: That was a fantastic and very clear answer, and it

364
00:21:58,760 --> 00:22:01,840
Speaker 3: makes a lot of sense why setting aside regulations, why

365
00:22:01,920 --> 00:22:05,600
Speaker 3: economically there wasn't much need to prioritize these sort of

366
00:22:05,600 --> 00:22:24,320
Speaker 3: balance sheet trades. All right, let's talk about how these

367
00:22:24,359 --> 00:22:28,120
Speaker 3: are structured. So I'm the first bank of Joe, and

368
00:22:28,240 --> 00:22:30,760
Speaker 3: I want to take off some of my books, some

369
00:22:30,800 --> 00:22:34,720
Speaker 3: of my credit risk, and you're some other entity. What's

370
00:22:34,760 --> 00:22:36,919
Speaker 3: our deal? First of all, two, I guess there's two questions.

371
00:22:36,920 --> 00:22:39,000
Speaker 3: Who are you? Are you like a hedge fund, are

372
00:22:39,000 --> 00:22:40,000
Speaker 3: you a pension fund?

373
00:22:40,119 --> 00:22:40,199
Speaker 5: Like?

374
00:22:40,560 --> 00:22:43,119
Speaker 3: Who is taking sure an insurer? Who is taking on

375
00:22:43,119 --> 00:22:46,600
Speaker 3: this credit risk? And then, in the most vanilla example,

376
00:22:46,640 --> 00:22:47,960
Speaker 3: what is the deal that we're striking?

377
00:22:48,880 --> 00:22:50,960
Speaker 5: Right? I think that's an important question also to to

378
00:22:51,200 --> 00:22:55,199
Speaker 5: sort of think about who the counterparty is. Generally in

379
00:22:55,240 --> 00:22:57,840
Speaker 5: these transactions. These are done in what's sort of known

380
00:22:57,880 --> 00:23:04,119
Speaker 5: as fully funded format. There's a synthetic securitization. We're taking

381
00:23:04,240 --> 00:23:08,760
Speaker 5: a loan pool, and a bank typically hedges the mezzanine

382
00:23:09,040 --> 00:23:13,920
Speaker 5: level of risk while retaining the first loss. Right, that's

383
00:23:13,960 --> 00:23:15,960
Speaker 5: really the expected loss we were talking about a few

384
00:23:15,960 --> 00:23:19,200
Speaker 5: minutes ago, and retain then the senior.

385
00:23:18,880 --> 00:23:22,120
Speaker 4: Trunch, So mezzanine is like the middle, that's right.

386
00:23:22,160 --> 00:23:23,879
Speaker 2: The clue is in the name. But also this is

387
00:23:23,960 --> 00:23:28,240
Speaker 2: kind of different to the securitizations, the synthetic securitizations of old,

388
00:23:28,240 --> 00:23:31,520
Speaker 2: where I think they were mostly selling the senior right.

389
00:23:31,680 --> 00:23:34,840
Speaker 5: Yeah, and those were even selling full stack securitizations, right,

390
00:23:35,119 --> 00:23:37,080
Speaker 5: And I mean one of the key differences, and we

391
00:23:37,080 --> 00:23:39,040
Speaker 5: can get into this as well, right, One of the

392
00:23:39,119 --> 00:23:44,080
Speaker 5: key differences then was really to sort of allow uncapped

393
00:23:44,320 --> 00:23:48,199
Speaker 5: leverage speculation. Where we're here. What we're talking about is

394
00:23:48,440 --> 00:23:52,840
Speaker 5: a bank, first Bank of Joe, having actual credit exposure

395
00:23:53,080 --> 00:23:56,400
Speaker 5: on their balance sheet through normal course of lending operations,

396
00:23:56,720 --> 00:23:59,320
Speaker 5: and then seeking to hedge a portion of that risk

397
00:24:00,080 --> 00:24:04,000
Speaker 5: capital purposes for risk management purposes. And so the whole

398
00:24:04,680 --> 00:24:08,160
Speaker 5: point of departure for this transaction is not speculation, it's

399
00:24:08,200 --> 00:24:12,320
Speaker 5: actual hedging, right, and there's there's actually but going back.

400
00:24:12,200 --> 00:24:14,879
Speaker 3: To you on the other end of this trade, I

401
00:24:14,880 --> 00:24:16,679
Speaker 3: don't know if it's right to say you're a speculator,

402
00:24:16,680 --> 00:24:19,080
Speaker 3: but you're looking to make money on this trade. I'm

403
00:24:19,080 --> 00:24:21,680
Speaker 3: looking to hedge risk or I'm looking to deal with

404
00:24:21,720 --> 00:24:23,520
Speaker 3: some balance sheet and you're looking.

405
00:24:23,320 --> 00:24:25,120
Speaker 4: To collect you get paid a premium.

406
00:24:25,240 --> 00:24:26,800
Speaker 3: Right, So what's the deal that we do?

407
00:24:27,040 --> 00:24:31,120
Speaker 5: Right? So so so again, A financial institution pools credit

408
00:24:31,200 --> 00:24:34,920
Speaker 5: risk together transfers a portion of the risk out of

409
00:24:34,960 --> 00:24:37,679
Speaker 5: the bank. The loans remain on balance sheet. You know,

410
00:24:37,840 --> 00:24:41,439
Speaker 5: assets are not sold, only credit risk trans is transferred.

411
00:24:42,280 --> 00:24:45,240
Speaker 5: We've we gather a loan pool in what we've seen

412
00:24:45,280 --> 00:24:47,239
Speaker 5: here in the US, just to just to take up

413
00:24:47,280 --> 00:24:50,840
Speaker 5: sort of a hypothetical transaction. A in what's become a

414
00:24:50,880 --> 00:24:54,879
Speaker 5: popular asset class is auto loans, and so a bank

415
00:24:55,040 --> 00:24:58,600
Speaker 5: has a certain amount of auto loan lending exposures on

416
00:24:58,720 --> 00:25:01,760
Speaker 5: balance sheet, they have have to risk weight that according

417
00:25:01,800 --> 00:25:06,080
Speaker 5: to current regulation at one hundred percent. They take an

418
00:25:06,119 --> 00:25:10,399
Speaker 5: identified subset of that pool and put it into a

419
00:25:10,760 --> 00:25:17,880
Speaker 5: synthetic securitization. They trunch up securitize that risk. Generally speaking, right,

420
00:25:18,119 --> 00:25:20,200
Speaker 5: they retain the first one or one and a half

421
00:25:20,280 --> 00:25:24,960
Speaker 5: percent of cumulative portfolio losses, that's the expected losses. They

422
00:25:25,160 --> 00:25:29,440
Speaker 5: sell the mezzanine tranch that references the next levels of loss,

423
00:25:29,440 --> 00:25:31,960
Speaker 5: the unexpected loss You can say, maybe that's next ten

424
00:25:32,040 --> 00:25:35,920
Speaker 5: or eleven percent of losses, and then they retain again

425
00:25:36,040 --> 00:25:39,840
Speaker 5: the very remote senior levels of loss, referencing the remaining

426
00:25:40,040 --> 00:25:42,679
Speaker 5: whatever it is, eighty seven eighty eight percent of loans

427
00:25:42,720 --> 00:25:48,000
Speaker 5: after credit protection is exhausted. Different act classes, different geographies

428
00:25:48,040 --> 00:25:51,640
Speaker 5: will have different tranching, but that's the basic capital structure

429
00:25:51,720 --> 00:25:55,119
Speaker 5: that generally stays the same. There are instances where banks

430
00:25:55,160 --> 00:25:59,000
Speaker 5: also buy first loss protection. A bank can demonstrate to

431
00:25:59,200 --> 00:26:02,720
Speaker 5: the regulator that the bulk of the unexpected losses transferred

432
00:26:02,760 --> 00:26:06,879
Speaker 5: out of the bank. Regulatory capital treatment is then transformed

433
00:26:06,880 --> 00:26:10,359
Speaker 5: from just a normal loan pool to a synthetic securitization

434
00:26:10,480 --> 00:26:13,320
Speaker 5: with different tranches of risk being risk weighted according to

435
00:26:13,359 --> 00:26:16,399
Speaker 5: the risk they represent to the bank. Now that's the

436
00:26:16,480 --> 00:26:19,720
Speaker 5: capital structure, Joe, I think more specifically to your questions, like,

437
00:26:20,000 --> 00:26:24,680
Speaker 5: what is the actual mechanism that transfer? Is this exactly that?

438
00:26:25,040 --> 00:26:27,120
Speaker 5: What is the actual mechanism for a bank to actually

439
00:26:27,160 --> 00:26:32,080
Speaker 5: transact and acquire credit protection. Generally, what happens is that

440
00:26:32,160 --> 00:26:37,680
Speaker 5: a bank enters a derivative or a financial guarantee that's

441
00:26:37,760 --> 00:26:41,560
Speaker 5: transformed into a credit link note, which is a bond. Right.

442
00:26:41,600 --> 00:26:45,639
Speaker 5: An investor hedge fund, pension fund, buys a bond from

443
00:26:45,720 --> 00:26:49,120
Speaker 5: the bank, a credit link note CLN, and the performance

444
00:26:49,200 --> 00:26:52,040
Speaker 5: of that bond that CLN is linked to the performance

445
00:26:52,119 --> 00:26:56,600
Speaker 5: of the underlying reference polls as losses arise. Should they arise,

446
00:26:56,800 --> 00:27:00,200
Speaker 5: then those losses rather than being allocated to the bank

447
00:27:00,400 --> 00:27:03,960
Speaker 5: or allocated to this bond, right, and what does the

448
00:27:04,000 --> 00:27:07,480
Speaker 5: investor receive, Well, you know, the investor puts up money upfront,

449
00:27:07,600 --> 00:27:11,800
Speaker 5: fully collateralizes the transaction and buying this bond, they get

450
00:27:11,840 --> 00:27:15,159
Speaker 5: interest income over time, and then at the end of

451
00:27:15,160 --> 00:27:20,040
Speaker 5: the transaction they get whatever money remains there less losses.

452
00:27:20,359 --> 00:27:22,040
Speaker 3: Terracy. It reminds me a little bit of like a

453
00:27:22,040 --> 00:27:25,359
Speaker 3: catastrophe bond or something like that, where it's like you

454
00:27:25,400 --> 00:27:27,840
Speaker 3: put up a bunch of money and you get interest,

455
00:27:27,880 --> 00:27:29,920
Speaker 3: and if there's no hurricanes, you get all the money back,

456
00:27:29,960 --> 00:27:31,400
Speaker 3: but if there are some hurricanes, you get a little

457
00:27:31,440 --> 00:27:32,000
Speaker 3: less money back.

458
00:27:32,080 --> 00:27:35,680
Speaker 5: So I can't tell you why. That is a perfect analogy, right,

459
00:27:35,760 --> 00:27:38,960
Speaker 5: and that is really the sort of genesis of many

460
00:27:38,960 --> 00:27:42,000
Speaker 5: of these of these transactions. Maybe genesis isn't the right word,

461
00:27:42,000 --> 00:27:44,760
Speaker 5: but the right parallel. And what we've also seen is that,

462
00:27:44,880 --> 00:27:47,000
Speaker 5: you know, I just described sort of fully funded you know,

463
00:27:47,040 --> 00:27:51,000
Speaker 5: sort of bond format transactions. You know, what we also do,

464
00:27:51,119 --> 00:27:54,640
Speaker 5: this is sort of a Guy Carpenter specialty, is put

465
00:27:54,880 --> 00:27:58,639
Speaker 5: this risk in the form of a reinsurance contract with

466
00:27:58,760 --> 00:28:00,840
Speaker 5: diversified reinsures.

467
00:28:02,040 --> 00:28:03,560
Speaker 4: Interesting, there's another layer.

468
00:28:04,080 --> 00:28:08,359
Speaker 5: There's another layer, or or better yet, a different execution alternative.

469
00:28:09,200 --> 00:28:12,879
Speaker 5: So if you look at globally the bank credit risk

470
00:28:12,960 --> 00:28:15,600
Speaker 5: transfer market, most of it is in this sort of

471
00:28:15,760 --> 00:28:18,639
Speaker 5: credit link note bond format that I just described, probably

472
00:28:18,640 --> 00:28:22,320
Speaker 5: about eighty five ninety percent of it, probably about ten percent,

473
00:28:22,600 --> 00:28:26,760
Speaker 5: and it's growing, is in this reinsurance format with multiline

474
00:28:26,800 --> 00:28:31,480
Speaker 5: diversified reinsures. If you look at Fanny May and Freddie

475
00:28:31,480 --> 00:28:34,680
Speaker 5: Mack right now in terms of outstanding not not volumes

476
00:28:34,760 --> 00:28:38,320
Speaker 5: outstanding credit risk transfer, you know they have about almost

477
00:28:38,360 --> 00:28:42,160
Speaker 5: ninety billion dollars in a risk transfer outstanding right now.

478
00:28:42,520 --> 00:28:46,000
Speaker 5: I would say the latest reporting roughly thirty five percent

479
00:28:46,000 --> 00:28:50,080
Speaker 5: of that is in reinsurance market in about sixty five

480
00:28:50,080 --> 00:28:52,720
Speaker 5: percent of that or so is in this bond credit

481
00:28:52,800 --> 00:28:54,480
Speaker 5: link note like format.

482
00:28:54,680 --> 00:28:58,760
Speaker 2: So I really like the cat bond for banks analogy

483
00:28:59,000 --> 00:29:02,840
Speaker 2: where you're sort of getting insurance on the unexpected lost

484
00:29:02,920 --> 00:29:06,959
Speaker 2: portion of your portfolio. I mean, explain again, who's on

485
00:29:07,000 --> 00:29:10,080
Speaker 2: the other side of me. So you mentioned insurers, but

486
00:29:10,400 --> 00:29:12,960
Speaker 2: I believe there are lots of hedge funds involved as well.

487
00:29:13,440 --> 00:29:17,920
Speaker 2: And then secondly, I'm still unclear on the genesis of

488
00:29:18,000 --> 00:29:21,040
Speaker 2: these trades and who approaches Who is it the bank

489
00:29:21,120 --> 00:29:25,240
Speaker 2: issuer that goes out and talks to a potential counterparty

490
00:29:25,240 --> 00:29:27,240
Speaker 2: and says, hey, we're looking to do this, or.

491
00:29:27,240 --> 00:29:29,440
Speaker 3: Do they approach they approach you and they find us

492
00:29:29,440 --> 00:29:29,960
Speaker 3: a counter part?

493
00:29:30,160 --> 00:29:30,360
Speaker 5: Yeah?

494
00:29:30,360 --> 00:29:34,400
Speaker 2: And then also how do they decide exactly which loans

495
00:29:34,600 --> 00:29:37,720
Speaker 2: to put into these structures? Because my understanding is one

496
00:29:37,760 --> 00:29:40,400
Speaker 2: of the criticism of some of these deals is that

497
00:29:40,440 --> 00:29:43,840
Speaker 2: sometimes hedge funds are just offering to ensure these things

498
00:29:43,840 --> 00:29:47,680
Speaker 2: basically without actually knowing what's in the underlying portfolio.

499
00:29:47,760 --> 00:29:49,520
Speaker 4: It can be opaque at times.

500
00:29:50,160 --> 00:29:51,760
Speaker 5: So there are a lot of questions in this life.

501
00:29:51,800 --> 00:29:53,520
Speaker 4: I know, I'm sorry, I think that might have been

502
00:29:53,520 --> 00:29:54,240
Speaker 4: four questions.

503
00:29:54,480 --> 00:29:57,680
Speaker 5: So let me start off with that last bit tracy

504
00:29:57,920 --> 00:30:00,000
Speaker 5: around sort of what are the typical ask the class

505
00:30:00,240 --> 00:30:02,760
Speaker 5: is the banks put into these transactions, and then we

506
00:30:02,800 --> 00:30:06,320
Speaker 5: can get into you know, part three, four, five, and

507
00:30:06,400 --> 00:30:11,520
Speaker 5: seventeen of your of your multipart question. I think one

508
00:30:11,520 --> 00:30:16,840
Speaker 5: important to make upfront is that generally speaking, these transactions

509
00:30:16,880 --> 00:30:21,840
Speaker 5: are programmatic issuances from from banks that have issued them, right,

510
00:30:21,880 --> 00:30:24,240
Speaker 5: So it's not like there's a one off deal they've

511
00:30:24,240 --> 00:30:27,239
Speaker 5: identified some bad asset on their balance sheet and then

512
00:30:27,280 --> 00:30:28,880
Speaker 5: they want to get rid of it and then they

513
00:30:28,880 --> 00:30:33,960
Speaker 5: go home. No, it's more around programmatic issuances and transactions

514
00:30:34,000 --> 00:30:39,960
Speaker 5: typically reference assets and businesses that the bank likes. Transactions

515
00:30:39,960 --> 00:30:43,320
Speaker 5: reference assets that the banks wants to grow and they're

516
00:30:43,360 --> 00:30:49,480
Speaker 5: looking for tools to support that growth. Now, the assets

517
00:30:49,480 --> 00:30:52,280
Speaker 5: span a whole range of them, and reference pools really

518
00:30:52,400 --> 00:30:58,720
Speaker 5: range from very granular exposures like consumer and mortgage and

519
00:30:58,840 --> 00:31:01,320
Speaker 5: auto loan type of of exposures you know, to to

520
00:31:01,720 --> 00:31:07,560
Speaker 5: single borrowers too much chunkier portfolios like corporate exposures that

521
00:31:07,640 --> 00:31:11,040
Speaker 5: a bank has on balancey, like lending to large corporate corporations.

522
00:31:11,400 --> 00:31:13,960
Speaker 5: And then you have also asset classes somewhere in the

523
00:31:14,000 --> 00:31:15,960
Speaker 5: middle in Europe. You know, these are sort of known

524
00:31:16,000 --> 00:31:19,800
Speaker 5: as SMEs small and medium enterprises here in the US

525
00:31:20,040 --> 00:31:23,120
Speaker 5: more commonly known as just the middle market companies. And

526
00:31:23,160 --> 00:31:25,680
Speaker 5: it's important to just to just bear that in mind.

527
00:31:25,720 --> 00:31:29,720
Speaker 5: You know, that's that's a big part of how reference

528
00:31:29,760 --> 00:31:33,960
Speaker 5: assets are selected, and underlying borrowers may have a much

529
00:31:34,160 --> 00:31:37,320
Speaker 5: broader relationship with the bank rather than just this loan.

530
00:31:37,360 --> 00:31:40,840
Speaker 5: There could be involved in other fee generating activities for

531
00:31:40,920 --> 00:31:42,600
Speaker 5: the bank. They're just looking and the bank is looking

532
00:31:42,640 --> 00:31:48,680
Speaker 5: for ways to protect that borrower relationship another aspect of

533
00:31:48,720 --> 00:31:53,920
Speaker 5: it for a bank. So so in terms of assets selection, right,

534
00:31:53,960 --> 00:31:58,080
Speaker 5: So for the GSCs, they're sort of you know, monoligned guaranteurs, right,

535
00:31:58,120 --> 00:32:02,280
Speaker 5: they do single family and then you know multifamily acquisitions,

536
00:32:02,360 --> 00:32:05,360
Speaker 5: you know, so mortgages are really their business. A bank

537
00:32:05,400 --> 00:32:09,320
Speaker 5: would typically look across its asset portfolio and say, well,

538
00:32:09,320 --> 00:32:13,040
Speaker 5: what's the most capital intense, right, So, from a cost

539
00:32:13,080 --> 00:32:17,080
Speaker 5: of capital perspective, what makes the most sense in terms

540
00:32:17,080 --> 00:32:19,200
Speaker 5: of targeting for capital relief?

541
00:32:19,280 --> 00:32:19,400
Speaker 2: Right.

542
00:32:19,920 --> 00:32:24,200
Speaker 5: So oftentimes exposures like mortgages, conversely to the gcs, may

543
00:32:24,240 --> 00:32:27,000
Speaker 5: not make the most sense for a bank to see

544
00:32:27,000 --> 00:32:30,480
Speaker 5: capital relief on because they have lower capital and they're

545
00:32:30,560 --> 00:32:35,239
Speaker 5: just lower capital requirements on on mortgages versus say a

546
00:32:35,280 --> 00:32:39,120
Speaker 5: corporate or a consumer loan that that draws double in

547
00:32:39,240 --> 00:32:42,320
Speaker 5: the capital requirements a bank is required to hold. And

548
00:32:42,360 --> 00:32:45,600
Speaker 5: so just implicitly, there's also that calculation for a bank,

549
00:32:45,640 --> 00:32:48,160
Speaker 5: you know, what is the most capital intensive asset I

550
00:32:48,200 --> 00:32:50,400
Speaker 5: have on balance sheet? You know, and where does it

551
00:32:50,440 --> 00:32:53,080
Speaker 5: make most sense to seek capital relief?

552
00:32:53,320 --> 00:32:56,520
Speaker 2: What about the transparency of the low portfolio? If I

553
00:32:56,520 --> 00:32:58,200
Speaker 2: agree to do this, you know, if I'm a hedge

554
00:32:58,240 --> 00:33:00,720
Speaker 2: fund or an insurer on the other side, how much

555
00:33:00,800 --> 00:33:02,719
Speaker 2: visibility do I get into the loans?

556
00:33:03,000 --> 00:33:07,040
Speaker 5: Right? And so that relates to sort of the granularity

557
00:33:07,320 --> 00:33:10,120
Speaker 5: of the transaction or of the reference pool. So in

558
00:33:10,240 --> 00:33:13,239
Speaker 5: very granular pools, really what you're looking at is more

559
00:33:13,280 --> 00:33:15,920
Speaker 5: of a statistical exercise, right, with not a lot of

560
00:33:16,240 --> 00:33:20,160
Speaker 5: visibility into like the identity of like one individual borrow.

561
00:33:20,400 --> 00:33:22,640
Speaker 5: You'll have a loan tape, You'll have all the relevant

562
00:33:23,120 --> 00:33:27,920
Speaker 5: credit and performance information that you need, but like picking

563
00:33:28,320 --> 00:33:33,200
Speaker 5: one loan out of thousands won't necessarily help you in

564
00:33:33,280 --> 00:33:37,200
Speaker 5: your credit work. It has to sort of be seen together. Conversely,

565
00:33:37,720 --> 00:33:42,280
Speaker 5: in chunk your portfolios, including portfolios that include corporate exposures,

566
00:33:42,640 --> 00:33:48,440
Speaker 5: they're usually individual obligors are identified in their names identified,

567
00:33:48,480 --> 00:33:51,320
Speaker 5: and so the investors on the other side can do

568
00:33:51,400 --> 00:33:54,600
Speaker 5: their own individual credit work on top of what the

569
00:33:54,640 --> 00:33:59,040
Speaker 5: bank already already provides. You know, one can question, you know,

570
00:34:00,320 --> 00:34:03,440
Speaker 5: how much merit that additional credit work actually has or

571
00:34:03,600 --> 00:34:08,520
Speaker 5: provides to the transaction. But there's certain investors that just generally,

572
00:34:08,560 --> 00:34:11,680
Speaker 5: at because of their investment requirements, just require sort of

573
00:34:11,719 --> 00:34:15,160
Speaker 5: full disclosure of all their borrowers in an underlying reference pool,

574
00:34:15,360 --> 00:34:17,840
Speaker 5: that just may not look at more granular sort of

575
00:34:17,840 --> 00:34:20,960
Speaker 5: consumer assets and rather just look at at corporate exposures.

576
00:34:20,960 --> 00:34:25,160
Speaker 3: For example, can you walk me through a sort of

577
00:34:25,320 --> 00:34:29,239
Speaker 3: simplified math, So you're going to take this risk off

578
00:34:29,280 --> 00:34:31,880
Speaker 3: my book, but I'm going to pay you for that service.

579
00:34:31,920 --> 00:34:34,360
Speaker 3: I'm going to pay you some spread over whatever, some

580
00:34:34,600 --> 00:34:37,680
Speaker 3: risk free reference rate, whatever. I don't know, walk us

581
00:34:37,680 --> 00:34:41,239
Speaker 3: through like the really simplified math of how much it's

582
00:34:41,239 --> 00:34:45,000
Speaker 3: worth me to pay you for that, because it frees

583
00:34:45,080 --> 00:34:46,400
Speaker 3: up regulatory capital for me.

584
00:34:46,760 --> 00:34:50,719
Speaker 5: So in the example that that we just discussed a

585
00:34:50,719 --> 00:34:55,319
Speaker 5: few minutes ago, you know, around that hypothetical auto loan transaction,

586
00:34:56,000 --> 00:34:59,800
Speaker 5: now we would probably estimate and that sort of capital structure.

587
00:35:00,120 --> 00:35:03,760
Speaker 5: You know, the capital requirement for the bank just dropped

588
00:35:03,800 --> 00:35:08,239
Speaker 5: by sixty percent. Okay, right, because the risk weighting on

589
00:35:08,239 --> 00:35:10,799
Speaker 5: that portfolio has dropped from one hundred percent and just

590
00:35:10,880 --> 00:35:15,880
Speaker 5: like outright bank holding auto loans to roughly forty percent.

591
00:35:16,080 --> 00:35:23,359
Speaker 5: Under this synthetic securitization framework, typically the different tranches of

592
00:35:23,480 --> 00:35:26,400
Speaker 5: risk you know, will have different different pricing you know

593
00:35:26,440 --> 00:35:30,359
Speaker 5: what we've seen more recently for that type of mes

594
00:35:30,640 --> 00:35:34,560
Speaker 5: tranching on balance right, And this is just this isn't

595
00:35:34,640 --> 00:35:37,200
Speaker 5: just spread. This is sort of all in coupon. We're

596
00:35:37,239 --> 00:35:41,320
Speaker 5: probably talking about, you know, mid to high single digits

597
00:35:42,000 --> 00:35:45,520
Speaker 5: type of payment on the mezzanine tranch. Now, that's sort

598
00:35:45,520 --> 00:35:50,200
Speaker 5: of the headline coupon that a bank has for these transactions.

599
00:35:50,600 --> 00:35:53,080
Speaker 5: A bank, however, won't just look at the headline coupon

600
00:35:53,200 --> 00:35:54,840
Speaker 5: say you know, this is this is what we're paying.

601
00:35:55,200 --> 00:35:57,960
Speaker 5: What the bank will do is say, okay, these are

602
00:35:58,000 --> 00:36:01,360
Speaker 5: our annual costs no on the mes tranch, on the

603
00:36:01,400 --> 00:36:05,759
Speaker 5: mezzanine tranch, and they will compare that relative to the

604
00:36:05,800 --> 00:36:09,600
Speaker 5: amount of capital that's freed up and together they'll take

605
00:36:09,640 --> 00:36:13,360
Speaker 5: a look and say, okay, well that's my cost of capital,

606
00:36:13,400 --> 00:36:16,239
Speaker 5: the amount of paying investors relative to the amount of

607
00:36:16,320 --> 00:36:20,680
Speaker 5: capital I freed up. That's my cost of capital. And

608
00:36:20,719 --> 00:36:23,600
Speaker 5: then they can also look, the bank can look and say, well,

609
00:36:24,480 --> 00:36:28,120
Speaker 5: what are my alternatives. Well, I can go out and

610
00:36:28,160 --> 00:36:31,719
Speaker 5: issue common equity, but the cost of common equity will

611
00:36:31,719 --> 00:36:34,960
Speaker 5: probably be far north of anything I just described. It

612
00:36:35,080 --> 00:36:38,439
Speaker 5: could issue preferred equity, right, but even on yields today

613
00:36:38,480 --> 00:36:40,880
Speaker 5: will probably be far north of what I just described

614
00:36:41,040 --> 00:36:45,239
Speaker 5: without that same sort of common equity benefit. And that's

615
00:36:45,239 --> 00:36:48,520
Speaker 5: sort of like the general approach a bank would take

616
00:36:48,640 --> 00:36:53,440
Speaker 5: to pricing and really sort of assessing the financial viability

617
00:36:53,680 --> 00:36:55,200
Speaker 5: of these of these transactions.

618
00:36:55,560 --> 00:36:58,480
Speaker 2: Okay, so it has to make financial sense for the bank,

619
00:36:58,600 --> 00:37:04,200
Speaker 2: for the issuer. Can't cost more than issuing equity for instance.

620
00:37:04,840 --> 00:37:07,640
Speaker 2: My understanding, and now we're getting into some of the

621
00:37:07,680 --> 00:37:12,439
Speaker 2: financial stability questions around these, is that because of this,

622
00:37:12,880 --> 00:37:15,920
Speaker 2: the yields or returns being paid on these deals to

623
00:37:16,080 --> 00:37:18,760
Speaker 2: investors on the other side of the trade, the hedge funds,

624
00:37:18,760 --> 00:37:23,560
Speaker 2: the insurers whatever, have sometimes been let's just say mediocre,

625
00:37:24,320 --> 00:37:28,360
Speaker 2: and so there has been a temptation in recent years

626
00:37:28,400 --> 00:37:33,320
Speaker 2: for hedge funds to basically juice the returns by using

627
00:37:33,760 --> 00:37:37,840
Speaker 2: the deals the credit link notes as collateral in the

628
00:37:37,880 --> 00:37:41,080
Speaker 2: repo market, so basically borrowing against them and then you

629
00:37:41,160 --> 00:37:45,200
Speaker 2: get cheaper funding and then your return goes up. So

630
00:37:45,320 --> 00:37:47,680
Speaker 2: I don't know, instead of this is totally hypothetical because

631
00:37:47,680 --> 00:37:49,560
Speaker 2: I don't know the exact numbers, but instead of getting

632
00:37:49,600 --> 00:37:53,279
Speaker 2: six percent, you get nine percent or whatever. Is that

633
00:37:54,239 --> 00:37:57,839
Speaker 2: a worry because it seems kind of weird that we're

634
00:37:57,880 --> 00:38:02,000
Speaker 2: offloading risk from the financial system, but then hedge funds

635
00:38:02,080 --> 00:38:06,399
Speaker 2: are turning around and getting leverage on that risk by

636
00:38:06,480 --> 00:38:08,200
Speaker 2: borrowing from another bank.

637
00:38:08,480 --> 00:38:12,160
Speaker 5: It's hard to assess the amounts outstanding here, and it's

638
00:38:12,200 --> 00:38:16,200
Speaker 5: hard to say whether this is a real or perceived risk.

639
00:38:16,480 --> 00:38:20,799
Speaker 5: My experience, including my experience at FHFA, I think, with

640
00:38:20,920 --> 00:38:25,239
Speaker 5: our conversations I had had with our other federal partners,

641
00:38:25,520 --> 00:38:28,160
Speaker 5: call it whether or not the risk is real or perceived.

642
00:38:28,160 --> 00:38:31,799
Speaker 5: The concern is real, like I said, we can't tell

643
00:38:31,840 --> 00:38:35,560
Speaker 5: you exactly how much that actually happens. I saw a

644
00:38:35,600 --> 00:38:38,920
Speaker 5: bit of that in my past professional life, even before FHFA,

645
00:38:39,480 --> 00:38:41,799
Speaker 5: in the early days of the pandemic. In March of

646
00:38:41,840 --> 00:38:45,480
Speaker 5: twenty twenty, you know, for a brief time when bank

647
00:38:45,640 --> 00:38:51,640
Speaker 5: supplied leverage for GSC CRT ZRT for credit risk transfer

648
00:38:51,880 --> 00:38:53,360
Speaker 5: for GC credit risk transfer.

649
00:38:53,520 --> 00:38:58,680
Speaker 3: Keep up with the whole episode. Sorry, there's the whole episode. Sorry.

650
00:38:59,160 --> 00:39:00,960
Speaker 5: So I'd seen some of that in the early days

651
00:39:01,000 --> 00:39:03,719
Speaker 5: of the pandemic for a brief time with a bank

652
00:39:03,760 --> 00:39:07,440
Speaker 5: supplied leverage for GSC CRT, given that you know, at

653
00:39:07,480 --> 00:39:10,680
Speaker 5: that time the world was basically hit by a meteor

654
00:39:10,800 --> 00:39:13,600
Speaker 5: or the equivalent thereof. You know, you know, this piece

655
00:39:13,640 --> 00:39:16,520
Speaker 5: of it, you know, was was was hardly systemic. I

656
00:39:16,600 --> 00:39:18,680
Speaker 5: would say this, you know, I happen to know that

657
00:39:18,760 --> 00:39:23,800
Speaker 5: many of the dedicated traditional asset managers in this space

658
00:39:24,160 --> 00:39:27,640
Speaker 5: are really buy and hold investors. You don't really rely

659
00:39:27,920 --> 00:39:30,759
Speaker 5: on that type of leverage to boost sort of short

660
00:39:30,840 --> 00:39:33,799
Speaker 5: term returns. I think this gets Joe to your question

661
00:39:33,800 --> 00:39:35,880
Speaker 5: a little bit. Who are these people on the other side,

662
00:39:36,000 --> 00:39:38,920
Speaker 5: and and and many of these you know, more veteran

663
00:39:39,160 --> 00:39:43,320
Speaker 5: investors really are just relying on on the current coupon

664
00:39:43,480 --> 00:39:47,880
Speaker 5: in the current interest that these deals throw off. Certainly,

665
00:39:48,000 --> 00:39:52,120
Speaker 5: what I know in the reinsurance markets right, reinsurance markets

666
00:39:52,120 --> 00:39:55,640
Speaker 5: are buy and hold investors counterparties, I should say, they're

667
00:39:55,680 --> 00:39:59,080
Speaker 5: not really affected by the vagaries of the secondary market.

668
00:39:59,440 --> 00:40:03,560
Speaker 5: But even to the extent, say that there is bank

669
00:40:03,920 --> 00:40:08,080
Speaker 5: supplied leverage to these transactions. I think trace you mentioned

670
00:40:08,120 --> 00:40:10,400
Speaker 5: at the outset, you know, you had an estimate of

671
00:40:10,400 --> 00:40:12,800
Speaker 5: about twenty five billion or so of these deals getting

672
00:40:12,800 --> 00:40:16,760
Speaker 5: done in twenty twenty three. Even if that number doubles

673
00:40:17,160 --> 00:40:18,839
Speaker 5: this year, I don't know that it will, but let's

674
00:40:18,840 --> 00:40:21,480
Speaker 5: just say that that it does if some of that

675
00:40:22,280 --> 00:40:25,920
Speaker 5: risk transferred has some bank leverage on it. Is that systemic?

676
00:40:27,360 --> 00:40:30,880
Speaker 5: You know, forty fifty twenty twenty three, twenty five billion

677
00:40:31,320 --> 00:40:36,080
Speaker 5: of risk transferred. You know that that could increase this year,

678
00:40:36,280 --> 00:40:38,640
Speaker 5: But is that systemic? You know, for the global banking

679
00:40:38,680 --> 00:40:41,759
Speaker 5: system doesn't seem to be.

680
00:40:42,320 --> 00:40:47,280
Speaker 3: So well, So, speaking of systemic risk, and I mentioned

681
00:40:47,440 --> 00:40:50,399
Speaker 3: in the introduction that if we and Tracy mentioned it too,

682
00:40:50,440 --> 00:40:52,000
Speaker 3: you know, if we've been talking about this in two

683
00:40:52,000 --> 00:40:54,160
Speaker 3: thousand and eight, we would talking about credit default chops,

684
00:40:54,160 --> 00:40:58,800
Speaker 3: et cetera. There are other mechanisms for any financial entity

685
00:40:58,880 --> 00:41:00,960
Speaker 3: to take some credit risk off their book. And so

686
00:41:01,040 --> 00:41:03,799
Speaker 3: for a while, they're buying CDs, and unfortunately a bunch

687
00:41:03,840 --> 00:41:06,280
Speaker 3: of them were all buying it from one company, AIG,

688
00:41:06,480 --> 00:41:09,279
Speaker 3: and then we all know what happened with AIG, et cetera.

689
00:41:09,360 --> 00:41:12,759
Speaker 3: But structuring like what happened to this mark to that

690
00:41:12,920 --> 00:41:16,000
Speaker 3: market and why. From the sort of at the most

691
00:41:16,040 --> 00:41:20,080
Speaker 3: sort of conceptual, abstract level, how do you describe the

692
00:41:20,160 --> 00:41:25,440
Speaker 3: sort of market structure differences between these synthetic risk transfers

693
00:41:25,560 --> 00:41:28,000
Speaker 3: or credit risk transfers and credit default swaps.

694
00:41:29,040 --> 00:41:32,920
Speaker 5: Joe, That's a great question, because I actually happen to

695
00:41:32,960 --> 00:41:39,840
Speaker 5: think that much of the current SRTCRT market is actually

696
00:41:39,880 --> 00:41:42,600
Speaker 5: informed by the experience of two thousand and eight. We

697
00:41:42,680 --> 00:41:44,799
Speaker 5: all saw two thousand and eight. We said, don't let

698
00:41:44,840 --> 00:41:49,879
Speaker 5: that happen. Yeah, right, And much of the i'll call

699
00:41:49,920 --> 00:41:54,279
Speaker 5: it polemic around this harks back to two thousand and

700
00:41:54,320 --> 00:41:57,600
Speaker 5: eight in the financial crisis, and when people hear buzzwords

701
00:41:57,600 --> 00:42:02,240
Speaker 5: like synthetic yeah and derivatives know, their stomach start churning.

702
00:42:03,080 --> 00:42:06,720
Speaker 5: But this is different in in in every possible way.

703
00:42:07,160 --> 00:42:11,880
Speaker 5: This is really about hedging actual credit risk that arises

704
00:42:11,920 --> 00:42:17,319
Speaker 5: out of actual normal course of lending activities, not uncapped

705
00:42:17,520 --> 00:42:22,520
Speaker 5: leveraged speculation that was the hallmark of many synthetic securitizations

706
00:42:22,880 --> 00:42:27,160
Speaker 5: pre two thousand and eight. This is about true distribution

707
00:42:27,239 --> 00:42:30,799
Speaker 5: of credit risk rather than concentration of credit risk at

708
00:42:30,800 --> 00:42:34,759
Speaker 5: a number of highly level counterparts counterparties. I wasn't going

709
00:42:34,800 --> 00:42:38,160
Speaker 5: to mention it, but you mentioned aig FP, right, there

710
00:42:38,239 --> 00:42:44,080
Speaker 5: was the poster child for all of this, and you know,

711
00:42:44,160 --> 00:42:47,840
Speaker 5: we take the aig experience and say this is completely

712
00:42:47,840 --> 00:42:53,200
Speaker 5: different because of this hedging versus speculation point. I would

713
00:42:53,200 --> 00:42:57,239
Speaker 5: also I'd also say this, most of these deals are

714
00:42:57,280 --> 00:43:00,600
Speaker 5: fully funded, like we talked about, so no counter party risk.

715
00:43:00,920 --> 00:43:05,160
Speaker 5: The investor money, the investor puts up cash day one

716
00:43:05,360 --> 00:43:09,840
Speaker 5: fully collateralizes the bank for the life of the transaction.

717
00:43:09,920 --> 00:43:14,000
Speaker 5: So it's not like the bank exchanges the underlying credit

718
00:43:14,120 --> 00:43:18,200
Speaker 5: risk of the portfolio for the counterparty risk of the investor. Now,

719
00:43:18,280 --> 00:43:22,360
Speaker 5: to the extent that these are transacted with the reinsurance market,

720
00:43:22,560 --> 00:43:25,719
Speaker 5: you know, rather than with the capital markets, these reinsurance

721
00:43:25,760 --> 00:43:29,400
Speaker 5: counterparties are exactly the opposite of ai g f P.

722
00:43:29,840 --> 00:43:35,960
Speaker 5: There are highly diversified, highly regulated, highly rated, multiline companies

723
00:43:36,160 --> 00:43:38,719
Speaker 5: where the credit exposure that they take on through these

724
00:43:38,840 --> 00:43:42,799
Speaker 5: deals is actually a diversifier and not correlated to their

725
00:43:42,880 --> 00:43:47,560
Speaker 5: sort of underlying core property and casualty business. Right, AI

726
00:43:47,680 --> 00:43:50,640
Speaker 5: g f P was in the business of selling credit

727
00:43:50,640 --> 00:43:54,439
Speaker 5: protection and that's it. And I think a big part

728
00:43:54,480 --> 00:43:58,480
Speaker 5: of this is also alignment of interest. There is actual

729
00:43:58,560 --> 00:44:01,759
Speaker 5: skin in the game from the issuers, right. So so

730
00:44:01,800 --> 00:44:04,600
Speaker 5: we just talked about some you know, illustrative capital structure.

731
00:44:04,840 --> 00:44:08,120
Speaker 5: You know, the issuer of these transactions, banks or the

732
00:44:08,160 --> 00:44:11,640
Speaker 5: gcs have skin in the game and almost every tranch

733
00:44:11,880 --> 00:44:15,040
Speaker 5: of this of this of these transactions, right. And I

734
00:44:15,080 --> 00:44:18,320
Speaker 5: think that's also a key differentiation in terms of linement

735
00:44:18,400 --> 00:44:20,600
Speaker 5: of interest and risk retention.

736
00:44:21,520 --> 00:44:24,759
Speaker 2: So we kind of came full circle just then back

737
00:44:24,840 --> 00:44:28,080
Speaker 2: to two thousand and eight and the experience there. Given

738
00:44:28,120 --> 00:44:32,040
Speaker 2: that and given your storied career in working with banks

739
00:44:32,040 --> 00:44:35,399
Speaker 2: and advising banks, I have to ask you, what's the

740
00:44:35,480 --> 00:44:38,640
Speaker 2: dumbest thing you've ever seen bank management do?

741
00:44:40,840 --> 00:44:43,239
Speaker 3: And name the individual so I can look them up

742
00:44:43,239 --> 00:44:43,720
Speaker 3: on LinkedIn.

743
00:44:44,040 --> 00:44:44,920
Speaker 4: Just don't do that.

744
00:44:45,800 --> 00:44:48,600
Speaker 5: Maybe we could save this for some off the record conversations.

745
00:44:50,160 --> 00:44:54,120
Speaker 5: I have seen many things in my career, both you know,

746
00:44:54,360 --> 00:44:57,040
Speaker 5: sort of pre two thousand and eight through two thousand

747
00:44:57,040 --> 00:45:02,080
Speaker 5: and eight, and since I don't want to name any individuals,

748
00:45:02,239 --> 00:45:04,600
Speaker 5: of course, of course, but but but but this is

749
00:45:04,600 --> 00:45:05,520
Speaker 5: what I would say.

750
00:45:05,680 --> 00:45:05,839
Speaker 3: Uh.

751
00:45:05,920 --> 00:45:08,399
Speaker 5: And and I really came to even appreciate this more

752
00:45:09,080 --> 00:45:13,440
Speaker 5: during my time in government. Uh And this tracy to

753
00:45:13,480 --> 00:45:19,279
Speaker 5: your point going full circle. Banks face many constraints. They

754
00:45:19,360 --> 00:45:25,520
Speaker 5: have many stakeholders, right, both internally and externally, whether it's

755
00:45:25,800 --> 00:45:28,919
Speaker 5: you know, banks have employees, whether they have shareholders, whether

756
00:45:28,920 --> 00:45:33,399
Speaker 5: they have depositors. There aren't just like normal consumers. Uh uh.

757
00:45:33,440 --> 00:45:36,040
Speaker 5: And then externally they have regulators and this and then

758
00:45:36,120 --> 00:45:39,839
Speaker 5: again this isn't just like you know regulator supervisors, right,

759
00:45:39,840 --> 00:45:41,640
Speaker 5: this is also you know things like the fd I

760
00:45:41,719 --> 00:45:47,560
Speaker 5: C Right, we're actually protecting depositors. Banks face many constraints.

761
00:45:47,719 --> 00:45:52,120
Speaker 5: They have a lot of stakeholders they have to answer to,

762
00:45:52,480 --> 00:45:55,759
Speaker 5: and I think that's just an incredibly difficult job this

763
00:45:55,880 --> 00:45:59,000
Speaker 5: day and age. And I think that these types of

764
00:45:59,040 --> 00:46:02,160
Speaker 5: transactions again just like one tool in their toolkit to

765
00:46:02,760 --> 00:46:07,160
Speaker 5: help manage these these different stakeholders. I've seen I've seen

766
00:46:07,200 --> 00:46:10,680
Speaker 5: bank leaderships and other financial institutions sort of get in

767
00:46:10,760 --> 00:46:13,920
Speaker 5: trouble when they lose sight of all these different stakeholders

768
00:46:13,920 --> 00:46:14,600
Speaker 5: they have to manage.

769
00:46:14,760 --> 00:46:18,400
Speaker 2: Very diplomatic answer, that's a very diplomatic answer. We'll have

770
00:46:18,400 --> 00:46:21,640
Speaker 2: to get the real answer, I guess I'll yeah, So

771
00:46:21,719 --> 00:46:25,680
Speaker 2: apologies to the listeners, but Micky, that was a fantastic conversation.

772
00:46:25,840 --> 00:46:29,200
Speaker 2: I feel like I understand these deals a lot better now.

773
00:46:29,280 --> 00:46:31,720
Speaker 2: So thank you so much for coming on all thoughts

774
00:46:31,719 --> 00:46:32,879
Speaker 2: and explaining them to us.

775
00:46:33,680 --> 00:46:36,400
Speaker 5: Tracy, Joe, thank you very much. Appreciate the invitation.

776
00:46:36,680 --> 00:46:37,640
Speaker 3: Yeah, that was very fan.

777
00:46:37,800 --> 00:46:51,680
Speaker 4: That was great, Joe.

778
00:46:51,800 --> 00:46:54,640
Speaker 2: I enjoyed that conversation so much. It just it feels

779
00:46:54,680 --> 00:46:59,080
Speaker 2: good to have a sort of acronym Leyden discussion. I'm

780
00:46:59,120 --> 00:47:00,480
Speaker 2: trying to think of all the one that we hit,

781
00:47:00,520 --> 00:47:06,600
Speaker 2: like CRT, SRT, RWA, RRBC, SME, CDs, CLN, there is

782
00:47:06,600 --> 00:47:07,160
Speaker 2: probably more.

783
00:47:07,280 --> 00:47:10,480
Speaker 3: You know, it was an acronym laden conversation, but he

784
00:47:10,600 --> 00:47:14,759
Speaker 3: was very clear, and I think the two things that

785
00:47:14,800 --> 00:47:17,440
Speaker 3: I really you know, two of the big things that

786
00:47:17,520 --> 00:47:19,800
Speaker 3: I think about, Like is he mentioned we sort of mentioned,

787
00:47:19,800 --> 00:47:22,279
Speaker 3: you know, people's like alarm bells go off and they

788
00:47:22,280 --> 00:47:24,680
Speaker 3: hear things like synthetic ris transfer and all that stuff.

789
00:47:24,719 --> 00:47:28,319
Speaker 3: But the two things that like, this structure, the sort

790
00:47:28,320 --> 00:47:30,880
Speaker 3: of cat bond fully funded. We're going to put the

791
00:47:30,920 --> 00:47:34,960
Speaker 3: money in a pot up front, which we expect to

792
00:47:34,960 --> 00:47:40,160
Speaker 3: take back minus any losses. Inherently I think seems less risky,

793
00:47:40,200 --> 00:47:42,680
Speaker 3: although you mentioned there are ways to transform that risk,

794
00:47:42,719 --> 00:47:45,080
Speaker 3: but it seems less risky than like one where you're

795
00:47:45,120 --> 00:47:48,840
Speaker 3: depending on the credit strength of your car counterparty like

796
00:47:48,880 --> 00:47:53,120
Speaker 3: an AIGFP. And then also there's other big theme that

797
00:47:53,120 --> 00:47:55,520
Speaker 3: we've seen in the post grade financial crisis era of

798
00:47:55,560 --> 00:47:59,839
Speaker 3: like distributed risk. Yes to non regulated institutions like hedge

799
00:47:59,840 --> 00:48:03,520
Speaker 3: f or so forth, which are designed in some level

800
00:48:04,160 --> 00:48:07,160
Speaker 3: to take risk, and if they lose money, that's okay

801
00:48:07,239 --> 00:48:09,359
Speaker 3: because that's part of why they exist and why they

802
00:48:09,360 --> 00:48:09,840
Speaker 3: make money.

803
00:48:09,920 --> 00:48:12,319
Speaker 2: That's exactly what I was going to say, is this

804
00:48:12,560 --> 00:48:16,680
Speaker 2: outcome is kind of what financial regulators would have been

805
00:48:16,800 --> 00:48:19,879
Speaker 2: envisioning PLUS two thousand and eight, where they want to

806
00:48:20,040 --> 00:48:23,000
Speaker 2: shift a lot of the risk of unexpected losses from

807
00:48:23,040 --> 00:48:27,640
Speaker 2: bank loans onto non bank entities who you know, you

808
00:48:27,640 --> 00:48:30,240
Speaker 2: don't have to It's bad if a hedge fund goes under,

809
00:48:30,320 --> 00:48:31,680
Speaker 2: obviously or you.

810
00:48:31,640 --> 00:48:33,640
Speaker 3: Know, but it's less bad than if a banker.

811
00:48:33,880 --> 00:48:36,279
Speaker 2: Yeah, I was going to throw out another acronym, a

812
00:48:36,320 --> 00:48:39,879
Speaker 2: BDC a business development company goes under. But yes, it's

813
00:48:39,960 --> 00:48:42,359
Speaker 2: less bad than if a regulated bank goes under. There's

814
00:48:42,440 --> 00:48:46,840
Speaker 2: less systemic implications. Hopefully that was the thought process, and

815
00:48:46,840 --> 00:48:49,000
Speaker 2: I should just say we didn't actually get to it

816
00:48:49,080 --> 00:48:53,720
Speaker 2: because of time constraints, but the timing of these things

817
00:48:53,719 --> 00:48:55,919
Speaker 2: in the US, at least you can trace that back

818
00:48:55,920 --> 00:48:58,239
Speaker 2: to regulators as well. So last year, I think it

819
00:48:58,320 --> 00:49:02,239
Speaker 2: was September twenty twenty three, the FED basically issued guidance

820
00:49:02,640 --> 00:49:05,640
Speaker 2: on these deals, so sort of gave its blessing to

821
00:49:05,760 --> 00:49:08,760
Speaker 2: these things and said like, okay, if there's a genuine

822
00:49:08,840 --> 00:49:13,240
Speaker 2: risk transfer here, we're okay with the resulting capital relief

823
00:49:13,280 --> 00:49:15,560
Speaker 2: that comes out of it. And again, I think there

824
00:49:15,560 --> 00:49:19,400
Speaker 2: are questions about specific deals and how they're structured.

825
00:49:19,239 --> 00:49:22,399
Speaker 3: And what's in the notes and all, and then the.

826
00:49:22,360 --> 00:49:26,319
Speaker 2: Repo leverage, and there is some irony where if you

827
00:49:26,400 --> 00:49:28,719
Speaker 2: have these deals and you're trying to shift risk out

828
00:49:28,719 --> 00:49:30,719
Speaker 2: of the banking system, and then it comes right back

829
00:49:30,760 --> 00:49:34,600
Speaker 2: into the banking system because the investor is borrowing against

830
00:49:34,640 --> 00:49:38,120
Speaker 2: the deal, Like that doesn't seem to be an ideal outcome.

831
00:49:38,719 --> 00:49:41,160
Speaker 2: But as Mickey was saying, we're probably not at the

832
00:49:41,239 --> 00:49:44,120
Speaker 2: point yet where it's something that people are doing at

833
00:49:44,160 --> 00:49:45,680
Speaker 2: like a massive scale.

834
00:49:45,920 --> 00:49:49,160
Speaker 3: It's nowhere near massive, but it is your point, right, Like,

835
00:49:49,200 --> 00:49:52,280
Speaker 3: if I'm an entity and I buy one of these bonds,

836
00:49:52,520 --> 00:49:54,919
Speaker 3: there's at least some chance that I'm going to try

837
00:49:54,960 --> 00:49:57,440
Speaker 3: to borrow against that bonds to juce my returns. And

838
00:49:57,440 --> 00:50:00,680
Speaker 3: if I'm borrowing from a bank. This is fineancial markets.

839
00:50:00,719 --> 00:50:02,799
Speaker 3: I mean, this is just what financial markets do. They

840
00:50:02,800 --> 00:50:05,080
Speaker 3: find a way to press it. And so I think,

841
00:50:05,239 --> 00:50:08,520
Speaker 3: you know, it sounds like something to watch, not like, oh,

842
00:50:08,520 --> 00:50:10,120
Speaker 3: this is a big red flag and there's like a

843
00:50:10,200 --> 00:50:13,719
Speaker 3: lurking time. But I'm underneath the banking system. But you know,

844
00:50:13,840 --> 00:50:16,040
Speaker 3: like I said, the market is not that big. But

845
00:50:16,120 --> 00:50:19,160
Speaker 3: if I have this bond and it's designed to protect

846
00:50:19,200 --> 00:50:21,719
Speaker 3: the banks from risk, but then I'm borrowing against that

847
00:50:21,840 --> 00:50:24,600
Speaker 3: bond from a bank, you could see how risk should emerge.

848
00:50:24,840 --> 00:50:28,480
Speaker 2: Yeah, that seems not like what was intended. But anyway,

849
00:50:28,560 --> 00:50:30,520
Speaker 2: this was a fun, Yeah it was. This is a

850
00:50:30,560 --> 00:50:34,680
Speaker 2: fun like nibble at structured credit. Yeah. In the interests

851
00:50:34,680 --> 00:50:37,799
Speaker 2: of continuing to gorge ourselves on this, I really want

852
00:50:37,840 --> 00:50:41,359
Speaker 2: to do an episode on the original like JPM Yes Trades,

853
00:50:41,760 --> 00:50:45,360
Speaker 2: Like let's just go back, let's do a financial history

854
00:50:45,520 --> 00:50:47,880
Speaker 2: down for that kind Okay, all right, Well in the meantime,

855
00:50:47,880 --> 00:50:48,640
Speaker 2: shall we leave it there?

856
00:50:48,719 --> 00:50:49,520
Speaker 3: Let's leave it there.

857
00:50:49,760 --> 00:50:52,560
Speaker 2: This has been another episode of the All Thoughts podcast.

858
00:50:52,640 --> 00:50:56,000
Speaker 2: I'm Tracy Alloway. You can follow me at Tracy Alloway.

859
00:50:55,600 --> 00:50:57,560
Speaker 3: And I'm Jill Wisenthal. You can follow me at The

860
00:50:57,560 --> 00:51:01,200
Speaker 3: Stalwart follow our producers Carmen rodrig Is at Carman Ermann

861
00:51:01,280 --> 00:51:04,840
Speaker 3: Dashel Bennett at Dashbot and kill Brooks at Kilbrooks. And

862
00:51:04,880 --> 00:51:07,560
Speaker 3: thank you to our producer Moses Ondam. And for more

863
00:51:07,560 --> 00:51:10,480
Speaker 3: odd Lags content, go to Bloomberg dot com slash odd Lots.

864
00:51:10,600 --> 00:51:13,440
Speaker 3: We have transcripts, a blog, and a newsletter and you

865
00:51:13,440 --> 00:51:15,440
Speaker 3: can talk about all of these topics twenty four to

866
00:51:15,440 --> 00:51:19,000
Speaker 3: seven in the discord discord dot gg slash odd Lots.

867
00:51:19,400 --> 00:51:20,200
Speaker 3: Go there and hang out.

868
00:51:20,239 --> 00:51:22,040
Speaker 2: And if you enjoy odd Lots, if you like it

869
00:51:22,080 --> 00:51:25,239
Speaker 2: when we dive deep into the structured finance market, then

870
00:51:25,280 --> 00:51:28,880
Speaker 2: please leave us a positive review on your favorite podcast platform.

871
00:51:29,200 --> 00:51:31,680
Speaker 2: And remember, if you are a Bloomberg subscriber, you can

872
00:51:31,719 --> 00:51:35,160
Speaker 2: listen to all of our episodes absolutely ad free. All

873
00:51:35,200 --> 00:51:37,400
Speaker 2: you need to do is connect your Bloomberg account with

874
00:51:37,520 --> 00:51:40,120
Speaker 2: Apple Podcasts. In order to do that, just find the

875
00:51:40,120 --> 00:51:43,640
Speaker 2: Bloomberg channel on Apple Podcasts and follow the instructions there.

876
00:51:44,000 --> 00:52:01,680
Speaker 2: Thanks for listening in