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No, Risk Reduction by Banks Will Not Cause the Next Crisis

There has been increasing discussion among commentators and certain policy-makers regarding perceived risk factors related to “synthetic risk transfer” (SRT) or “credit risk transfer” (CRT) transactions by banks. Some have suggested that these transactions are harbingers of unchecked risk build up similar to the lead up of the 2008 financial crisis. While these risk management tools have three letter acronyms, and one of those acronyms even starts with a ‘C’, they do not represent a return to the excesses of the 2000s. In fact, reality is quite the opposite!

What is a CRT?

CRTs are a relatively new addition to the risk management toolbox in the U.S., whereas they have been commonly used in Europe for many years (where they have been labeled SRTs). Issuance of a CRT allows a bank holding a pool of assets (such as a portfolio of mortgage loans, consumer loans or business loans) to transfer a portion of the credit risk of that pool to investors who desire exposure to that risk. The investor agrees to bear that portion of losses should they occur, thereby reducing the risk exposure of the bank.

These risk transfers can be accomplished in a few different ways, sometimes using derivatives, sometimes using instruments called credit-linked notes, and sometimes using insurance structures. Investors receive a coupon in return for their taking on a portion of the risk of loss on the referenced collateral pool. Typically, the portion of risk transferred to the investors is the first-loss on the portfolio (i.e. all credit losses on the portfolio up to a certain amount) or junior mezzanine exposure to the portfolio (i.e. all credit losses on the portfolio exceeding a certain amount up to a maximum amount).

In the U.S., the most prolific participants in the CRT markets are the housing-related government sponsored enterprises (GSEs), Fannie Mae and Freddie Mac. Since 2013, the GSEs have sold or transferred risk on over $6.7 trillion of residential mortgage loans, with a combined risk in force (essentially, risk shared into the markets) of over $200 billion. They also transfer risk on commercial mortgages. The Federal Housing Finance Agency, their regulator, requires them to do this.1

In Europe, banks have been active participants in CRT or SRT transactions since it was integrated into the European regulatory framework in 2006, following Basel II.2 In the U.S., in recent years banks have made growing use of this risk management tool. The Federal Reserve has begun to formalize its views on this form of risk management.3

Apropos of the title of this article, there are a few common characteristics that differentiate CRT from CDOs and other transactions that caused problems in the past:

  • Assets stay on banks’ balance sheet – In contrast to 2007/2008 era CDOs, the assets for which banks are transferring risk (e.g. mortgages) remain on the banks’ balance sheet and are included in their financial statements. In other words, CRT are not “originate to distribute” transactions where the lenders could be argued to have less “skin in the game” and therefore less incentive to worry about the quality of the underlying assets that the risks are being transferred to investors.
  • Protection is paid in full, up front – CRTs are typically fully funded; in other words, the investors pay the full value of the protection amount up front, and losses on the underlying pool of assets result in write downs of the repayment to investor.
  • Banks’ retention of risk – CRTs typically transfer only a portion of the risk of the underlying assets, and banks retain a significant amount of risk. For example, a bank might transfer the first 5% of losses on the underlying pool of assets and retain the risk of loss above and beyond 5%. In some cases where the transactions are structured as securitizations, this risk retention is required by law. In all cases, this means the originating bank still has “skin in the game”.

Why are they done?

There are two primary reasons why CRT transactions are executed. First, and most obviously, risk exposure is transferred away from the originating institution to an investor who wants that exposure. Secondly, and following from this risk transfer, banks may be able to reduce their capital requirements, given that capital requirements correlate with risk held by the bank. Third, and specific to the GSEs, this CRT is required by their regulator.

On the other side of the trade, the investors can take on risk/return profiles that they desire, and they may prefer the counterparty risk presented by a bank or GSE to a traditional securitization or other type of securities transaction. For this reason among others, GSE CRT transactions became a primary source of investor exposure to mortgage credit risk following the decline of the non-agency mortgage-backed securities market after the 2000s.

 Are you sure these aren’t just CDOs in fancy clothes?

We explained some of the reasons they aren’t already, but we will do a lightning round here:

  • Why will banks care about risk if they transfer it?
    • The banks still must care about the quality of the loans they underwrite because CRT is a risk management tool, not a risk erasing tool. With CRT, banks are reducing concentrations of risk to certain sectors or credits, but that doesn’t mean they are totally out of the exposure.
  • Don’t we want banks holding on to risk?
    • No, actually we don’t beyond a certain point. Risk transfer is essential for banks to be able to fund business and consumer credit needs and the broader economy. When banks transfer risk, they can make new loans. This is how limited capital is recycled through the economy. Bank balance sheets alone cannot support mortgage and other credit needs; in fact, the capital markets provide almost 75% of the financing for U.S. non-financial corporations.4
  • Who is in charge of these things?
    • For the GSEs, the Federal Housing Finance Agency mandates the issuance of and oversees these transactions. For banks, regulators at the Federal Reserve, FDIC, and OCC oversee bank risk management activities. For CLN structures, which are viewed as the most efficient form of CRT, regulatory approval is required for banks to obtain capital relief which is an impediment to their rapid expansion (in contrast to FHFA’s mandate for their issuance). Thus, there are limits to the scalability of these transactions. There will never be $500BN of these issued in a year (like CDOs in 2007); it’s simply not possible.
  • Is it appropriate for banks to provide financing for CRTs? Doesn’t this mean the risk doesn’t leave the system?
    • Banks provide financing for all manner of securities (and other things) in the ordinary course of business. Indeed, it is what banks are designed to do – help channel financial capital to where it needs to be in the economy, whether it is to assist an investor with the purchase of a security or to provide funding to a company that wants to build a new factory. Specific to CRT, financing provided will typically involve recourse, and of course there is a broader regulatory framework around banks’ risk management enforced by the banking regulators.

So what’s the bottom line?

CRT transactions are a way to manage risk. They are overseen by regulators, and they are limited in scale and scope. Rather than mask risk, CRTs help banks avoid concentrations of risk on their balance sheets and can help markets persevere through times of stress.

Authors

Chris Killian is Managing Director, Corporate Credit and Securitization for SIFMA.

Dr. Guowei Zhang is Managing Director and Head of Capital Policy at SIFMA.

Footnotes

  1. See “Credit Risk Transfer Report 4q2023”, Federal Housing Finance Agency, available here: https://www.fhfa.gov/sites/default/files/2024-04/CRT-Progress-Report-4Q23.pdf. [↩]
  2. See “The European significant risk transfer market”, Occasional Papers Series No 23, European Systemic Risk Board, available here: https://www.esrb.europa.eu/pub/pdf/occasional/esrb.op23~07d5c3eef2.en.pdf. [↩]
  3. See “Frequently Asked Questions about Regulation Q”, Federal Reserve Board of Governors, available here: https://www.federalreserve.gov/supervisionreg/legalinterpretations/reg-q-frequently-asked-questions.htm. [↩]
  4. See SIFMA, Capital Markets Factbook (July 2024), available here: https://www.sifma.org/wp-content/uploads/2023/07/2024-SIFMA-Capital-Markets-Factbook.pdf. [↩]

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