WEBVTT - The Hottest Way for Banks to Get Risk Off Their Balance Sheets 0:00:03.120 --> 0:00:18.480 Bloomberg Audio Studios, Podcasts, Radio News. 0:00:20.840 --> 0:00:24.120 Hello and welcome to another episode of the Odd Thoughts Podcast. 0:00:24.239 --> 0:00:25.600 I'm Tracy Allaway. 0:00:25.440 --> 0:00:26.680 And I'm Joe Wisenthal. 0:00:27.040 --> 0:00:29.440 Joe, do you ever wonder what this show would have 0:00:29.480 --> 0:00:32.200 been like if we had been doing the podcast before 0:00:32.280 --> 0:00:33.040 two thousand. 0:00:32.800 --> 0:00:35.120 And eight, Well, we would have had plenty to talk 0:00:35.159 --> 0:00:36.960 about it, you know, I actually have it right, It 0:00:36.960 --> 0:00:38.760 would have, man, now, I wish we could. We would 0:00:38.800 --> 0:00:42.199 have had like five bonus episodes every single week, so 0:00:42.720 --> 0:00:44.599 there were just so much content on those days. 0:00:44.640 --> 0:00:47.000 I'm actually glad we weren't doing it back in two 0:00:47.000 --> 0:00:48.600 thousand and eight because I feel like that was a 0:00:48.640 --> 0:00:51.720 time when we, along with everyone else in the market, 0:00:51.760 --> 0:00:55.360 were still learning a lot about how everything works. But 0:00:55.440 --> 0:00:58.200 the one thing I'm kind of sad about is, uh, 0:00:58.600 --> 0:01:00.520 you know, there was a lot of interesting stuff happening 0:01:00.720 --> 0:01:05.080 in structured finance in the securitization market back then, lots 0:01:05.080 --> 0:01:10.119 of interesting deal structures, and there aren't that many of 0:01:10.160 --> 0:01:13.320 those since two thousan and eight for obvious reasons. 0:01:13.760 --> 0:01:15.560 No, you're totally right, Like, you know, we don't do 0:01:15.640 --> 0:01:20.399 many like credit credit default swaps episodes or CDOs or 0:01:20.480 --> 0:01:23.400 various other versions of structured finance, which I know that 0:01:23.760 --> 0:01:26.080 you know, you've covered quite a bit. You know, you 0:01:26.160 --> 0:01:29.000 hear about that stuff a little bit less. But yes, 0:01:29.080 --> 0:01:31.720 that would have been a buffet of topics for us 0:01:31.720 --> 0:01:32.720 to choose from back then. 0:01:32.840 --> 0:01:35.039 A buffet is a good way of putting it, okay, 0:01:35.200 --> 0:01:37.679 So I'm very happy to say this is an episode 0:01:37.720 --> 0:01:39.959 I have wanted to do for a while. 0:01:40.040 --> 0:01:40.759 We are going to. 0:01:40.760 --> 0:01:44.720 Gorge ourselves on a particular type of structured finance deal, 0:01:45.200 --> 0:01:48.320 something that's been happening in the market for a number 0:01:48.360 --> 0:01:51.280 of years now, but it really seems to be booming 0:01:51.480 --> 0:01:53.880 in some respects in recent years. We're going to be 0:01:53.880 --> 0:01:57.800 talking about synthetic risk transfers or SRTs. 0:01:58.240 --> 0:02:00.920 I have to admit that up until like two days ago, 0:02:01.160 --> 0:02:04.080 I had no idea what a synthetic risk transfer is. 0:02:04.680 --> 0:02:06.920 I also still don't have any idea what a synthetic 0:02:07.000 --> 0:02:09.880 risk transfer is. But I, like, you know, get the 0:02:09.919 --> 0:02:13.360 impression that basically this is what I seem to know 0:02:13.400 --> 0:02:15.760 based on a couple of things I've read. There's only 0:02:15.840 --> 0:02:20.400 so much risk or balance sheet that regulated financial institution 0:02:20.560 --> 0:02:24.040 like a bank is supposed to take, and at some point, 0:02:24.120 --> 0:02:26.799 if they want to continue to make loans and continue 0:02:26.840 --> 0:02:30.000 to maintain a relationship with a client, whoever it is, 0:02:30.600 --> 0:02:33.720 some of that risk in order for regulatory balance sheet 0:02:33.800 --> 0:02:37.760 purposes whatever has to be unloaded to some third party entity. 0:02:38.240 --> 0:02:38.440 Right. 0:02:38.720 --> 0:02:42.480 So the interesting thing about these transactions is they didn't 0:02:42.480 --> 0:02:45.959 always used to be called synthetic risk transfers. I remember, 0:02:46.720 --> 0:02:49.520 I mean, I am so old that I remember when 0:02:49.520 --> 0:02:53.040 they were just called balance sheet securitizations or synthetic balance 0:02:53.040 --> 0:02:57.440 sheet clos collateralized loan obligations. I remember when they were 0:02:57.480 --> 0:03:02.520 called regulatory capital trades or regular relief trades instead of SRT, 0:03:02.919 --> 0:03:05.440 and I think that name actually gives a much more 0:03:05.520 --> 0:03:09.560 concrete idea of what is happening here. So banks have 0:03:09.680 --> 0:03:14.760 portfolios of loans, they have to hold regulatory capital against 0:03:14.840 --> 0:03:18.360 those loans. Post two thousand and eight and all the 0:03:18.400 --> 0:03:21.799 regulatory reform that we've seen, they have to hold more capital, 0:03:22.000 --> 0:03:26.400 and so they've looked at creative ways of lessening some 0:03:26.520 --> 0:03:28.480 of that burden. And one of the things they've come 0:03:28.560 --> 0:03:31.760 up with is this SRT idea. So this idea that 0:03:31.800 --> 0:03:36.400 you purchase basically insurance protection on a portfolio of loans, 0:03:36.600 --> 0:03:38.080 and then if you do it in the right way, 0:03:38.280 --> 0:03:41.080 you get to hold less capital against it, and it 0:03:41.120 --> 0:03:44.520 frees up your balance sheet allows you to do more lending. Now, 0:03:44.560 --> 0:03:47.200 the interesting thing about these deals is, as I alluded to, 0:03:47.920 --> 0:03:51.080 they actually have a long history, Like in some respects, 0:03:51.080 --> 0:03:55.000 they're sort of the essence of securitization itself, this idea 0:03:55.000 --> 0:03:57.320 of risk transfer, and you can kind of trace the 0:03:57.440 --> 0:04:00.400 history all the way back to JP Morgan and first 0:04:00.440 --> 0:04:01.560 pistro trades and. 0:04:01.520 --> 0:04:02.200 Stuff like that. 0:04:02.280 --> 0:04:04.280 Maybe we'll get all the way back to the nineteen 0:04:04.320 --> 0:04:07.480 nineties and JP Morgan in this conversation. I'm not sure, 0:04:07.680 --> 0:04:11.240 but there's definitely a lot to discuss, primarily why these 0:04:11.280 --> 0:04:13.960 things seem to be growing now. So I think there 0:04:14.000 --> 0:04:16.920 was about twenty five billion worth of SRTs issued in 0:04:16.960 --> 0:04:20.080 twenty twenty three. The average number of banks that have 0:04:20.160 --> 0:04:22.560 been tapping the market has gone from something like eight 0:04:22.920 --> 0:04:26.320 in sort of the twenty fourteen to twenty twenty period 0:04:26.480 --> 0:04:31.839 to something like thirty seven now, So that's. 0:04:31.720 --> 0:04:32.320 A big jump. 0:04:32.480 --> 0:04:35.760 More banks are doing this, investors are getting interested in this. 0:04:36.520 --> 0:04:38.920 One funny thing that I just realized is like some 0:04:39.000 --> 0:04:43.159 of the do you remember the trade press on structured credit? 0:04:43.200 --> 0:04:46.159 Like structured credit investor I used to read them all 0:04:46.200 --> 0:04:49.080 the time, sort of two thousand and eight to twenty ten, 0:04:49.440 --> 0:04:52.560 and it was all about you know, CDOs and rmbs 0:04:52.760 --> 0:04:57.160 and housing reform. It is now all about SRTs. So 0:04:57.320 --> 0:05:00.599 you can see the sort of like transition that of 0:05:00.640 --> 0:05:02.360 the market happening in real time. 0:05:02.800 --> 0:05:04.960 I am really looking forward to this conversation, you know, 0:05:05.040 --> 0:05:08.599 I think to me, conceptually, part of my question what 0:05:08.680 --> 0:05:12.719 I want to learn is like a financial institution hedging 0:05:12.760 --> 0:05:16.520 out some of their credit risk exposure, counterparty exposure, whatever 0:05:16.560 --> 0:05:18.520 it is, is not really new. And we had this 0:05:18.560 --> 0:05:20.440 whole thing, you know that we would have talked about 0:05:20.480 --> 0:05:21.800 a lot in two thousand and eight, which is the 0:05:21.839 --> 0:05:25.760 credit default swaps market. And conceptually, to me, this idea 0:05:25.800 --> 0:05:28.280 of like, okay, here's an entity it wants to use 0:05:28.320 --> 0:05:32.440 someone else's capital, you know, to essentially buy ensure or 0:05:32.560 --> 0:05:34.880 ensure away or risk. That was a thing. Then a 0:05:34.920 --> 0:05:36.720 lot of that market sort of dried up, and now 0:05:36.760 --> 0:05:38.880 there is this new market. So I want to understand 0:05:38.880 --> 0:05:41.760 a little bit more about how this is conceptually different 0:05:41.880 --> 0:05:42.800 or similar to right. 0:05:43.000 --> 0:05:45.599 This is a very big debate in this space, like 0:05:45.680 --> 0:05:48.800 to what degree do these potentially pose a risk to 0:05:49.000 --> 0:05:53.160 financial stability? There's been some excellent coverage by our colleagues 0:05:53.200 --> 0:05:56.360 at Bloomberg about one particular aspect of this that seems 0:05:56.440 --> 0:05:58.720 kind of sketchy. We are going to get into that, 0:05:59.200 --> 0:06:01.279 but I have to say we really do have the 0:06:01.279 --> 0:06:04.159 perfect guest to discuss this, someone I've been wanting to 0:06:04.200 --> 0:06:06.680 speak to about this for a long time. We're going 0:06:06.760 --> 0:06:09.800 to be talking to Michael Shemy. He is the North 0:06:09.839 --> 0:06:14.760 America structured credit lead at Guy Carpenter. So, Michael Mickey, 0:06:15.000 --> 0:06:15.839 welcome to the show. 0:06:17.520 --> 0:06:20.159 Thank you Tracy, thank you Joe for having me. Appreciate it. 0:06:20.160 --> 0:06:21.039 It's great to be here. 0:06:21.360 --> 0:06:22.880 What does Guy Carpenter actually do? 0:06:23.279 --> 0:06:28.359 Guy Carpenter is part of the Marsh McLennan family of 0:06:28.440 --> 0:06:33.200 companies that includes risk and insurance services Guy Carpenter Marsh, 0:06:33.560 --> 0:06:39.000 along with consulting Oliver Wyman and Mercer. Guy Carpenter is 0:06:39.160 --> 0:06:44.360 Marsh mcclennan's reinsurance specialist advisor broker. I lead the North 0:06:44.400 --> 0:06:49.280 America Structure credit business within the Global Mortgage and Structured 0:06:49.320 --> 0:06:54.279 Credit segment. I joined Guy Carpenter in late twenty twenty three. 0:06:54.600 --> 0:06:58.680 I've spent my career in ass management and banking, working 0:06:58.720 --> 0:07:04.240 with financial institution on matters related to regulatory capital, capital management, 0:07:04.400 --> 0:07:08.800 risk transfer. Most immediately before my current position, I had 0:07:08.839 --> 0:07:13.640 spent time working at a regulatory agency at FHFA, the 0:07:13.680 --> 0:07:18.400 Federal Housing Finance Agency, working on similar issues but specifically 0:07:18.520 --> 0:07:22.720 related to the GCS. To Fannie May and Freddie Guy 0:07:22.760 --> 0:07:27.080 Carpenter has presence in the Americas, Europe globally structuring and 0:07:27.120 --> 0:07:33.280 placing credit risk transfer synthetic risk transfer for various financial institutions. 0:07:33.760 --> 0:07:38.800 We generally place this risk with multiline reinsurance companies in 0:07:38.880 --> 0:07:43.120 reinsurance format, but also place this risk into the capital markets. 0:07:43.520 --> 0:07:47.200 We recently published with our colleagues at Marsh and Oliver 0:07:47.320 --> 0:07:50.800 Wyman a white paper in June about the potential for 0:07:50.880 --> 0:07:57.360 expanding banks portfolio management toolkit and exploring specific opportunities for 0:07:57.440 --> 0:08:01.920 North America banks to bail themselves of credit risk transfer 0:08:02.000 --> 0:08:05.840 transactions in that space. Much has been written about this recently. 0:08:05.880 --> 0:08:08.880 As you both alluded to, this was a bit different 0:08:09.520 --> 0:08:13.640 geared towards bank issuers discussed as benefits of credit risk transfer, 0:08:14.000 --> 0:08:17.640 give some historic context, and also you know, discusses what 0:08:17.760 --> 0:08:20.480 is required of a bank to launch such a program. 0:08:20.760 --> 0:08:22.800 It's a good paper and I made sure to read 0:08:22.840 --> 0:08:27.520 it before this conversation, So why don't we, given your expertise, 0:08:27.840 --> 0:08:30.680 have you fact check us in real time? Both Joe 0:08:30.720 --> 0:08:32.960 and I sort of explained the way we think of 0:08:33.280 --> 0:08:37.040 SRTs or redcap trades. Talk to us about what's your 0:08:37.240 --> 0:08:40.720 understanding and maybe give us a specific example, like in 0:08:40.800 --> 0:08:43.800 the evolution of one of these deals, how does it 0:08:43.960 --> 0:08:46.600 start and how does it actually come to market? 0:08:48.000 --> 0:08:50.280 Yeah, so there are a few things to say upfront. 0:08:50.920 --> 0:08:53.160 I would also say, you know your introduction. I think 0:08:53.200 --> 0:08:56.319 I agreed with basically every word there. Thank you, So 0:08:57.000 --> 0:09:02.199 that's an accomplishment. There are huge differences between what happens 0:09:02.240 --> 0:09:05.320 now in this market versus what happened in two thousand 0:09:05.320 --> 0:09:07.280 and eight, or more specifically in the lead up to 0:09:07.320 --> 0:09:10.240 two thousand and eight. But generally speaking, as you both 0:09:10.280 --> 0:09:15.520 describe banks or regulated institutions, they face a variety of 0:09:15.640 --> 0:09:21.160 constraints on their balance sheets, their business, liquidity, capital, and 0:09:21.240 --> 0:09:25.920 they have developed tools to manage those constraints. There could 0:09:25.920 --> 0:09:29.400 be loan sales, it could be loan participations, that could 0:09:29.400 --> 0:09:34.800 be partnerships and securitizations. Credit risk transfer synthetic risk transfer 0:09:34.960 --> 0:09:38.480 is just one of those tools to manage these constraints 0:09:38.679 --> 0:09:43.360 through a securitization in the banking framework, they're really conceptually 0:09:43.960 --> 0:09:48.679 two sorts of securitizations. There's a traditional securitization that involves 0:09:48.800 --> 0:09:53.080 actual sale of assets out of a financial institution. 0:09:52.840 --> 0:09:54.319 Where you put them in like a trust. 0:09:54.400 --> 0:09:57.760 Basically there's an SPV, there's a trust, there's an actual 0:09:57.880 --> 0:10:02.079 sales and outright sale of the assets. And then there's 0:10:02.280 --> 0:10:06.439 synthetic securitizations, which does not involve actual sale of assets. 0:10:06.960 --> 0:10:11.520 Assets remain on balance sheet, customer relationships aren't interrupted. Only 0:10:11.679 --> 0:10:16.160 credit risk is transferred out of the institution. What's also 0:10:16.200 --> 0:10:19.240 important here in these transactions, you know, people think of 0:10:19.360 --> 0:10:22.560 like two thousand and eight and credit risk and shedding 0:10:22.640 --> 0:10:27.040 credit risk and bad assets. This really is not strictly 0:10:27.440 --> 0:10:31.120 about shedding credit risk. Certainly it's a risk management tools 0:10:31.120 --> 0:10:34.240 and we'll get into the benefits, but it also really 0:10:34.280 --> 0:10:37.680 has become for banks and other regulated financial institutions like 0:10:37.760 --> 0:10:42.480 Fannyman Freddie MAC, more of a capital management tool than 0:10:42.520 --> 0:10:45.600 anything else. And just one thing I'll say in terms 0:10:45.640 --> 0:10:49.040 of nomenclature, because there's a lot of this floating around. 0:10:49.240 --> 0:10:53.640 CRT SRT probably the largest single program for these types 0:10:53.679 --> 0:10:58.160 of transactions is Fanny May and Freddie Mac's program that's 0:10:58.200 --> 0:11:01.400 referred to here in the US as credit risk transfer CRT. 0:11:02.120 --> 0:11:05.920 If you see some of the US regional banks who 0:11:05.960 --> 0:11:09.439 have become inaugural issuers of these transactions, even in two 0:11:09.520 --> 0:11:12.959 Q earnings, they refer to these transactions as credit risk 0:11:13.000 --> 0:11:17.920 transfers CRT. Globally, outside of the US and Europe specifically, 0:11:18.160 --> 0:11:21.640 these are generally referred to as SRT significant risk transfer, 0:11:21.800 --> 0:11:27.600 even synthetic risk transfer, and SRT is really a regulated term. 0:11:27.640 --> 0:11:31.160 It's a formal regulatory term in that context, but ultimately 0:11:31.360 --> 0:11:34.560 it's all the same. Generally speaking, it's the pulling of 0:11:34.640 --> 0:11:39.800 credit exposures by a financial institution, transferring a subordinated portion 0:11:39.880 --> 0:11:42.120 of the risk to a third party, either through a 0:11:42.160 --> 0:11:45.760 synthetic securitization rather than a traditional securitization. 0:12:01.840 --> 0:12:06.240 Joe I did an etymological study of what people are 0:12:06.280 --> 0:12:08.600 calling these deals. I think I published it like a 0:12:08.640 --> 0:12:11.360 month or maybe two months ago because I was bored, 0:12:11.720 --> 0:12:14.120 and it was more than a thousand words long, just 0:12:14.800 --> 0:12:19.000 tracing like the change in the nomenclature or what we 0:12:19.080 --> 0:12:21.200 actually call these things over time. 0:12:21.320 --> 0:12:22.640 It's funny how many. 0:12:22.440 --> 0:12:25.120 Different like phrases and words have fallen in and out 0:12:25.120 --> 0:12:26.920 of fashion to call these things. 0:12:27.040 --> 0:12:29.280 I feel like synthetic is one of those words that 0:12:29.360 --> 0:12:33.000 like raises alarms, Yeah it's not real, or something like that. 0:12:33.440 --> 0:12:36.880 But why do you explain to us from the perspective 0:12:37.080 --> 0:12:39.560 of a bank. You mentioned the two ways that they 0:12:39.600 --> 0:12:42.880 can offload credit risk. One is outright selling it, the 0:12:43.000 --> 0:12:45.800 other one is keeping it on the balance sheet, and 0:12:45.840 --> 0:12:48.560 then you know, offloading some of the credit specific risk. 0:12:49.160 --> 0:12:51.400 We'll get to how that's structured and who's buying and 0:12:51.440 --> 0:12:53.880 who's on the other side. But what do you explain 0:12:53.960 --> 0:12:59.120 from a regulatory or bank capital efficiency standpoint, why the 0:12:59.280 --> 0:13:02.920 risk is attractive rather than the outright sale dyes. 0:13:03.160 --> 0:13:05.720 Oh, and just to add on to that, because it's related, 0:13:05.760 --> 0:13:08.959 but why don't banks just raise more capital for their loans? 0:13:09.400 --> 0:13:11.240 So I think it's important to understand some of the 0:13:11.280 --> 0:13:16.320 conceptual foundations for bank regulatory capital, what it's designed to 0:13:16.400 --> 0:13:19.400 achieve and what it isn't designed to achieve. At the 0:13:19.520 --> 0:13:22.760 very highest level, financial institutions, again, whether you're a bank 0:13:22.880 --> 0:13:27.160 or a GSE or anything in between, generally face expected 0:13:27.160 --> 0:13:33.120 losses and they face unexpected losses. Expected losses perceived as 0:13:33.120 --> 0:13:36.720 a cost of doing business, bank's price for expected losses 0:13:36.760 --> 0:13:41.839 through lending an account for expected losses also through loan 0:13:41.920 --> 0:13:46.800 loss provisioning. In their normal course of business, banks don't 0:13:46.840 --> 0:13:51.679 hold regulatory capital for expected losses. In essence, what concerns 0:13:52.320 --> 0:13:57.520 bank regulators is unexpected losses, the losses above expected losses, 0:13:57.760 --> 0:14:02.120 and regulatory capital is there to absorb these unexpected losses 0:14:02.400 --> 0:14:06.080 as defined by regulators. And so you can really see 0:14:06.120 --> 0:14:10.840 bank capital as a proxy for those unexpected levels of 0:14:10.920 --> 0:14:15.720 loss above expected loss for which banks provision and price for. Now, 0:14:16.200 --> 0:14:20.960 how do bank regulators sort of transcribe that sort of 0:14:22.120 --> 0:14:26.760 philosophically into capital requirements while they look at two general 0:14:26.760 --> 0:14:30.680 frameworks right now, there's a risk based capital requirement and 0:14:30.720 --> 0:14:35.640 then there's a leverage capital requirement. Leverage capital requirements sort 0:14:35.640 --> 0:14:40.080 of assign same requirements to different asset classes, no matter 0:14:40.160 --> 0:14:43.280 the risk, same amount of capital. So whether you have 0:14:43.320 --> 0:14:46.480 one hundred dollars of a treasury security of cash on 0:14:46.560 --> 0:14:49.680 balance sheet, a mortgage, a corporate loan, you know that 0:14:49.760 --> 0:14:52.600 same hundred dollars of exposure will attract the same level 0:14:52.640 --> 0:15:01.320 of capital. For risk based capital requirements, the RBC assigns 0:15:01.520 --> 0:15:05.880 different capital requirements to different exposures based on the perceived 0:15:06.000 --> 0:15:09.440 risk they post to the bank by assigning different risk 0:15:09.520 --> 0:15:14.000 quits risk based capital. Oh yes, excuse me, yes, yeah, yeah, 0:15:14.000 --> 0:15:15.440 we're diving. 0:15:15.160 --> 0:15:18.400 Into the episode with a lot of acronyms. 0:15:18.440 --> 0:15:20.080 I keep going. 0:15:20.560 --> 0:15:24.360 So, unlike the leverage framework, right, cash on balance sheet 0:15:24.520 --> 0:15:28.000 right will attract far less than capital requirements than a 0:15:28.080 --> 0:15:32.040 mortgage loan or corporate loan or a consumer loan. And 0:15:32.120 --> 0:15:35.920 because of this differentiation in riskiness under the risk based 0:15:35.960 --> 0:15:40.280 capital framework, not the leverage capital requirements, banks seek to 0:15:40.320 --> 0:15:48.000 execute these transactions. So bringing this together, right, credit risk 0:15:48.000 --> 0:15:51.720 transfer transactions transfer a portion of the credit risk, typically 0:15:52.400 --> 0:15:56.240 the unexpected levels of loss as defined by regulators for 0:15:56.320 --> 0:16:01.280 an identified pool of assets at the bank. And so 0:16:01.520 --> 0:16:05.440 as a result, for the risk based capital framework, the 0:16:05.480 --> 0:16:08.840 bank can demonstrate to its regulator that the bank faces 0:16:09.160 --> 0:16:13.440 a significantly lower level of unexpected loss and thus is 0:16:13.960 --> 0:16:18.960 permitted to hold less and regulatory capital. Less regulatory capital, 0:16:19.080 --> 0:16:22.600 not no regulatory capital, right right, And the bank is 0:16:22.720 --> 0:16:26.520 relieved of some of this capital it held pre transaction. 0:16:26.640 --> 0:16:28.720 And that's sort of where the concept r trace you 0:16:28.760 --> 0:16:32.760 mentioned before, where the concept of capital relief trades comes in. 0:16:33.040 --> 0:16:35.120 And I think From there, we can talk about some 0:16:35.200 --> 0:16:38.160 of the more specific structures that we're seeing. 0:16:38.360 --> 0:16:40.320 I definitely want to get into structures. I want to 0:16:40.360 --> 0:16:43.960 ask one question before we move to that, though, and 0:16:44.040 --> 0:16:46.480 it's sort of I think it fills out the regulatory 0:16:46.760 --> 0:16:51.200 aspect of this, But why is it that the market 0:16:51.560 --> 0:16:55.920 for these things seems to be much more mature and 0:16:56.080 --> 0:17:00.440 larger in Europe, so for European bank issuers then in 0:17:00.480 --> 0:17:04.280 the US. In the US it's really only begun to 0:17:04.400 --> 0:17:07.919 take off in the past year or so, despite a 0:17:07.960 --> 0:17:11.800 lot of bankers. I remember in like twenty thirteen or 0:17:11.840 --> 0:17:14.199 something having conversations with I think it was someone at 0:17:14.280 --> 0:17:16.679 City Group talking about how they wanted to structure a 0:17:16.720 --> 0:17:19.440 bunch of red cap trades for smaller banks and then 0:17:19.880 --> 0:17:22.679 lo and behold. Ten years later, it feels like the 0:17:22.800 --> 0:17:26.120 US market is actually starting to do something. So why 0:17:26.240 --> 0:17:28.760 was there that discrepancy? 0:17:28.880 --> 0:17:32.840 So you're absolutely right, in contrast to the global experience, 0:17:33.560 --> 0:17:37.840 credit risk transfer never expanded meaningfully in the US beyond 0:17:37.880 --> 0:17:42.080 the GSCs in any programmatic way. And there's several reasons 0:17:42.280 --> 0:17:45.240 for that. We just hit on one of them. Regulatory 0:17:45.280 --> 0:17:49.359 capital differences are one. You know, we talked about the 0:17:49.359 --> 0:17:53.760 capital requirements risk based capital versus leverage. These transactions were 0:17:53.760 --> 0:17:57.720 more embedded in Europe already pre two thousand and eight, 0:17:58.200 --> 0:18:01.320 because banks had already adopted did what's known as the 0:18:01.359 --> 0:18:06.320 BOZEL two framework that had a lot more risk sensitive 0:18:06.960 --> 0:18:11.320 risk base capital requirements. The US, on the other hand, 0:18:11.480 --> 0:18:15.640 was delayed in that process in transitioning from BOZEL one 0:18:15.920 --> 0:18:19.840 to BOZL two, continue to operate under BASIL one for 0:18:19.960 --> 0:18:24.360 a while, and then in around twenty twelve thirteen sort 0:18:24.359 --> 0:18:28.760 of leapfrog straight to BASL three from BOZEL one. And 0:18:28.960 --> 0:18:31.679 another aspect of this, I think that's important to note. 0:18:32.200 --> 0:18:37.879 One of the post GFC, post Global Financial Crisis reforms 0:18:37.960 --> 0:18:41.359 in BOSL three and the bank capital reforms was the 0:18:41.400 --> 0:18:45.320 introduction of this leverage ratio requirement, right, So it was 0:18:45.359 --> 0:18:49.680 all sort of risk base capital based beforehand, and now 0:18:49.720 --> 0:18:52.679 the leverage ratio requirement is supposed to be sort of 0:18:52.720 --> 0:18:57.240 a backstop. But interestingly, in the US, and earlier than 0:18:57.320 --> 0:18:59.920 two thousand and eight and earlier than BASIL three reforms, 0:19:00.200 --> 0:19:04.720 the US banking regulators already subjected banks to a leverage 0:19:04.880 --> 0:19:08.880 capital requirement unlike their global peers, and in that regime, 0:19:09.480 --> 0:19:12.600 banks don't benefit from the impacts of credit risk transfer, 0:19:12.800 --> 0:19:15.919 since all risks are treated equally, and so there was 0:19:15.960 --> 0:19:19.760 also just up until now, less of a focus historically 0:19:19.840 --> 0:19:23.320 on risk based capital requirements in the US, so implicitly 0:19:23.680 --> 0:19:25.679 less of a focus on credit risk transfer. You know. 0:19:25.760 --> 0:19:28.840 On top of that, during this transition into Basel three, 0:19:29.200 --> 0:19:32.920 there wasn't much regulatory clarity about the treatment of these 0:19:32.960 --> 0:19:36.560 transactions here in the US. So it's real, there's real 0:19:36.640 --> 0:19:41.160 regulatory capital regime differences between the US VERSUS Europe, even 0:19:41.200 --> 0:19:44.120 between the US and say Canada. But I also don't 0:19:44.119 --> 0:19:46.960 want to put this all at the feet of regulators 0:19:47.240 --> 0:19:50.440 because in my view, you know, Tracy, you mentioned having 0:19:50.520 --> 0:19:54.000 conversations in twenty twelve and twenty thirteen around this for 0:19:54.160 --> 0:19:56.960 US banks. In my view, and maybe this is a 0:19:57.080 --> 0:20:00.280 minority view, but I think it's been born out. Credit 0:20:00.359 --> 0:20:03.560 risk transfer for US banks in the years following the 0:20:03.560 --> 0:20:06.800 financial crisis was a solution in search of a problem. 0:20:07.480 --> 0:20:11.400 Coming out of the financial crisis, US banks race capital 0:20:11.480 --> 0:20:13.680 to shore up balance sheet. You know, maybe they were 0:20:13.680 --> 0:20:15.840 forced to do so. Actually, I think I think you 0:20:15.840 --> 0:20:18.719 would ask certain bank bank bank managements. You know, they 0:20:18.720 --> 0:20:22.480 were subjected to regulatory stress tests early on. They have 0:20:22.680 --> 0:20:26.320 been were and have been perceived to be better capitalized 0:20:26.359 --> 0:20:29.439 with stronger balance sheets than their global peers. They were 0:20:29.440 --> 0:20:32.320 never really balance sheet constrained in the years coming out 0:20:32.359 --> 0:20:35.800 of QE, and this is also reflected in their valuations 0:20:36.280 --> 0:20:38.679 across their capital structure. I mean, most of these banks 0:20:38.720 --> 0:20:41.600 traded a premium to book value. So if a bank 0:20:41.720 --> 0:20:44.520 and tracy you pose this question earlier. So if a 0:20:44.560 --> 0:20:48.040 bank did need to raise capital for something, you know, 0:20:48.119 --> 0:20:53.719 it was relatively easy to do, you know, at attractive valuations. 0:20:54.040 --> 0:20:57.679 So the business need wasn't clear for US banks in 0:20:57.720 --> 0:21:00.280 my opinion, as it was for European banks who did 0:21:00.320 --> 0:21:03.200 not recapitalize in the same way as US banks did 0:21:03.280 --> 0:21:07.879 post GFC. They were and are risk based capital constrained, 0:21:08.119 --> 0:21:10.760 and again that was reflected in their valuations where most 0:21:10.800 --> 0:21:14.639 of these banks still trade at a discount to book value. 0:21:14.920 --> 0:21:16.880 And I just think, you know, sort of post two 0:21:16.920 --> 0:21:19.880 thousand and eight around like the lingering sagas for banks 0:21:20.160 --> 0:21:24.480 across the continent right in the European sovereign debt crisis, 0:21:24.520 --> 0:21:27.639 but even even beyond, I would also say, you know, 0:21:27.760 --> 0:21:29.960 moving out of the banks a little bit, the gcs 0:21:30.480 --> 0:21:33.320 like European banks in a way you know, similar but 0:21:33.359 --> 0:21:37.560 not the same. The use case was clear there as well, 0:21:37.840 --> 0:21:39.439 you know, the need to sort of de risk the 0:21:39.560 --> 0:21:42.960 tax payer during the conservatorship and going through the capital 0:21:43.000 --> 0:21:46.240 build process. But you know, in any event, you know, ultimately, 0:21:46.240 --> 0:21:49.760 in addition to regulatory uncertainty here in the US, banks 0:21:49.960 --> 0:21:53.560 and bank managements generally didn't really prioritize active balance sheet 0:21:53.640 --> 0:21:55.520 management as as they are now. 0:21:55.640 --> 0:21:58.720 That was a fantastic and very clear answer, and it 0:21:58.760 --> 0:22:01.840 makes a lot of sense why setting aside regulations, why 0:22:01.920 --> 0:22:05.600 economically there wasn't much need to prioritize these sort of 0:22:05.600 --> 0:22:24.320 balance sheet trades. All right, let's talk about how these 0:22:24.359 --> 0:22:28.120 are structured. So I'm the first bank of Joe, and 0:22:28.240 --> 0:22:30.760 I want to take off some of my books, some 0:22:30.800 --> 0:22:34.720 of my credit risk, and you're some other entity. What's 0:22:34.760 --> 0:22:36.919 our deal? First of all, two, I guess there's two questions. 0:22:36.920 --> 0:22:39.000 Who are you? Are you like a hedge fund, are 0:22:39.000 --> 0:22:40.000 you a pension fund? 0:22:40.119 --> 0:22:40.199 Like? 0:22:40.560 --> 0:22:43.119 Who is taking sure an insurer? Who is taking on 0:22:43.119 --> 0:22:46.600 this credit risk? And then, in the most vanilla example, 0:22:46.640 --> 0:22:47.960 what is the deal that we're striking? 0:22:48.880 --> 0:22:50.960 Right? I think that's an important question also to to 0:22:51.200 --> 0:22:55.199 sort of think about who the counterparty is. Generally in 0:22:55.240 --> 0:22:57.840 these transactions. These are done in what's sort of known 0:22:57.880 --> 0:23:04.119 as fully funded format. There's a synthetic securitization. We're taking 0:23:04.240 --> 0:23:08.760 a loan pool, and a bank typically hedges the mezzanine 0:23:09.040 --> 0:23:13.920 level of risk while retaining the first loss. Right, that's 0:23:13.960 --> 0:23:15.960 really the expected loss we were talking about a few 0:23:15.960 --> 0:23:19.200 minutes ago, and retain then the senior. 0:23:18.880 --> 0:23:22.120 Trunch, So mezzanine is like the middle, that's right. 0:23:22.160 --> 0:23:23.879 The clue is in the name. But also this is 0:23:23.960 --> 0:23:28.240 kind of different to the securitizations, the synthetic securitizations of old, 0:23:28.240 --> 0:23:31.520 where I think they were mostly selling the senior right. 0:23:31.680 --> 0:23:34.840 Yeah, and those were even selling full stack securitizations, right, 0:23:35.119 --> 0:23:37.080 And I mean one of the key differences, and we 0:23:37.080 --> 0:23:39.040 can get into this as well, right, One of the 0:23:39.119 --> 0:23:44.080 key differences then was really to sort of allow uncapped 0:23:44.320 --> 0:23:48.199 leverage speculation. Where we're here. What we're talking about is 0:23:48.440 --> 0:23:52.840 a bank, first Bank of Joe, having actual credit exposure 0:23:53.080 --> 0:23:56.400 on their balance sheet through normal course of lending operations, 0:23:56.720 --> 0:23:59.320 and then seeking to hedge a portion of that risk 0:24:00.080 --> 0:24:04.000 capital purposes for risk management purposes. And so the whole 0:24:04.680 --> 0:24:08.160 point of departure for this transaction is not speculation, it's 0:24:08.200 --> 0:24:12.320 actual hedging, right, and there's there's actually but going back. 0:24:12.200 --> 0:24:14.879 To you on the other end of this trade, I 0:24:14.880 --> 0:24:16.679