Two words excite me like no others.
They are synthetic securitisation (or, for the truly old-school, they are three words: regulatory capital trades). These deals usually involve repackaging loans on a bank’s balance sheet, then slicing them up into different tranches, and selling the exposure to a non-bank entity like an insurer, hedge fund, or asset manager through the use of credit derivatives.
In many respects, they hark back to the early days of securitisation, when JPMorgan first put together its BISTRO trades, otherwise known as the first synthetic CDOs. Banks may be genuinely offloading risk here, and the deals were called reg-cap trades precisely because they offered capital relief that’s so far been genuinely sanctioned by regulators. On the other hand, they seem to speak to some of the worst of the current environment: a pervasive search-for-yield that may see investors put their money in silly things at silly prices (for this reason, you will sometimes hear reg-cap specialists – usually hedge funds – gripe about the non-expertise of new entrants and the need to price the deals perfectly), as well as nagging concern that in fortifying the banking system post the financial crisis, we’ve simply offloaded a bunch of balance sheet risks onto other entities in a classic case of regulatory arbitrage.
In any case, I bring it up because in less than a week we’ve seen two stories published on the market, now said to be booming, first in the Financial Times and then in the Wall Street Journal. Both detail the rise of the market, with issuance described as having jumped by anywhere from 5.6 percent in the first quarter to at least 33 percent so far this year.
Those looking for a graphical representation of the recent rise of synthetic CDOs, could do worse than this chart from Deutsche Bank. It shows European deals only, but the direction of the trajectory is pretty obvious. The WSJ story also references some interesting figures from consultancy Coalition, pointing out that structured credit revenues at the top 12 investment banks more than doubled year-on-year to $1.5 billion the first quarter of 2017, exceeding the growth rate in more conventional trading businesses in the same period.
Growth in the business is not exactly a surprise, though.
More than five years ago I wrote in the FT about some of the bigger banks working hard to get the business going as a way of securing some new fees at a time when many of their other revenue streams were sluggish. In retrospect, that story’s now looking pretty prescient.
Big banks seek regulatory capital trades
Big banks are aiming to help smaller lenders cut the amount of regulatory capital they need to hold against loans in an attempt to make money from deals similar to those first created in the early days of securitisation more than a decade ago.
The big banks want to create so-called regulatory capital trades for smaller lenders as they expect demand for these kind of securitisation structures will rise ahead of regulations designed to provide more stability in the financial system.
Such trades, also known as synthetic securitisations, involve repackaging loans on a bank’s balance sheet, then slicing them up into different tranches.
The bank typically then buys protection on the riskiest or mid-level tranche from an outside investor such as a hedge fund, insurance company or private equity firm.
Doing so allows a bank to reduce the amount of regulatory capital it has to hold against the loans – a tempting prospect as banking groups are forced to hold more capital ahead of new regulation such as the forthcoming Basel III rules.
Some of the biggest global and European banks, including Barclays and Standard Chartered, are known to have recently built and used the structures to reduce the amount of capital they need to hold against corporate or trade finance loans.
But some large banks are now hoping to sell their structuring expertise and help distribute the resulting trades to buyers, investors in the trades say.
“The holy grail for some of the investment banks is to try to get some of the second and third tier banks involved, to get structuring fees,” said one investor. The trades hark back to the early days of securitisation in the late 1990s, which helped fuel the financial crisis.
“It’s almost as if you’re seeing the start of the securitisation market coming back in a very modest way,” said Walter Gontarek, chief executive of Channel Advisors, which operates Channel Capital Plc, a vehicle with $10bn in portfolio credit transactions with banks and has started a new fund dedicated to these structures.
Investors such as Channel Advisors say the yields on the deals are attractive compared with other debt securities on offer, and they are able to gain exposure to a specific portion of a bank’s balance sheet rather than invest in the entire thing. The insurers, hedge funds or private equity firms are not bound by the same, relatively onerous capital regulations as the banks. That makes it easier for them to write protection on the underlying loans in a classic case of regulatory arbitrage.”
Some more early coverage below, for those interested.
Synthetic tranches anyone? – FT Alphaville
Anti-Abacus, anti-BISTRO and anti-balance sheet synthetic securitisation – FT Alphaville
Big banks seek regulatory capital trades – FT, April 2012
Banks share risk with investors – FT, September 2011
Balance sheet optimisation – BOOM! – FT Alphaville, 2010