Banks Are Teeing Up a New Financial Crisis

Shah Gilani|February 16, 2024

Banks are up to their old tricks…

Their latest round of financial engineering is poised to create a new crisis… and we’ll be left holding the bag.

Our credit crisis is spiraling. Consumer debt just ballooned to $17.5 trillion. Nearly a trillion dollars of real estate debt comes due this year.

And now banks are offsetting their risk with the help of synthetic risk transfers, or SRTs.

If you’ve never heard of them, you’re not alone.

They’re a lot like their better-known cousins, credit default swaps (CDS) – infamous for blowing up banks in the financial crisis – but safer.

At least that what we’re being told.

Risk On

Synthetic risk transfers are derivatives.

Banks package a pool of assets – think automobile loans, credit card debt, commercial real estate loans or mortgages – in synthetic or “reference” form, into a special-purpose entity or SPE. They then issue credit-linked notes against those SPEs that investors can buy.

Those investors include private equity firms, hedge funds, private credit funds… and the likes of Blackstone, D.E. Shaw, Ares Management, Magnetar Capital and ArrowMark Partners.

If SRTs sound complicated… that’s because they are.

First of all, the special purpose entities that bank “sponsors” set up do not hold real assets. The SPEs “mirror” the bank’s assets, whose risk is being sold to investors. That’s why they’re called synthetic assets. They only “reference” a pool of real assets (loans) the bank keeps on its balance sheet.

The beauty of SRTs is banks keep their assets… but get to transfer the credit risk inherent in them.

Wouldn’t that be nice if you could own a house… but give the risk of your mortgage to someone else?

Banks prefer to keep those assets on their books instead of selling them outright. After all… if they were to sell them, and there were losses on any of the assets, they’d have to “realize” those losses. That of course would hit their earnings and profits and credibility.

They don’t want that.

But with these SRTs, they can transfer the risk that those referenced assets might underperform or default.

A sweet deal… that gets even sweeter.

By transferring the credit risk on balance sheet assets to outside investors, banks get to lower the capital reserves they have to pony up against those assets.

How Interesting

Here’s why investors like SRTs…

In a “funded” SRT, the proceeds from those note sales go to the banks. It’s usually a cash payment that can offset potential losses on the pool. The bank pays interest on the notes and returns the principal, or what’s left of it, when the term ends.

In an “unfunded” SRT, the note holders pay to cover losses on the references pool as they are marked to market.

The interest note holders are paid these days amounts to close to 15%.

That’s not a bad return for holding credit risk, especially if the portfolio of referenced assets keeps performing and paying interest.

Banks get a break on how much capital they have to reserve, which means they can make more loans with that capital. Investors willing to take the credit risk get an above market yield on their investment.

The interest investors make comes from the interest banks collect on their performing assets, plus and money they pony up toward that juicy yield. It’s cheaper to pay credit note investors than it is to have to set aside capital to meet reserve requirements.

It’s a win-win… right?

Hardly.

A Dangerous Game

SRTs are essentially “regulatory arbitrage.”

It’s a way for banks to get around reserve requirements. Yet those requirements are there for a reason. They protect banks from overextending themselves, taking losses and having to get bailed out or – if they’re too small for the “too big to fail” club – liquidated.

Another problem with SRTs is they don’t absorb all the bank’s potential losses. Only about 10% of them.

That’s because referenced pools are “tranched” or divided into super-senior, senior, mezzanine and first-loss tranches. The risk transfer takes place mostly in the mezzanine space… but can cover some risk in more senior and junior tranches.

That’s a little too much smoke and mirrors for me. It looks like banks are covering potential losses… but covering 10% of a pool still leaves them holding a big bag.

Investors in credit-linked notes aren’t required to post reserves. They aren’t even regulated for the most part. And, as counterparties, they have risk.

During the financial crisis, counterparties to the credit default swaps banks entered into as insurance against their subprime mortgages and mortgage derivatives portfolios had to be bailed out themselves.

AIG, the giant insurance company, was one of those counterparties that had to be bailed out. So was Goldman Sachs (but that story’s been buried).

In other words, it doesn’t matter how big counterparties are. They can leverage themselves to death.

Synthetic risk transfers were frowned upon after the financial crisis.

But they’re back.

Last March’s mini-banking crisis brought stiffer regulations. Tougher Basel requirements are coming in 2025.

Big banks are seeking and getting approval from regulators to transact SRTs. JPMorgan, Morgan Stanley, U.S. Bank and others recently executed SRTs with the Fed’s approval.

I don’t know about you… but my spidey senses are tingling.

Suspicious Activity

Why are banks trying to transfer risk? Why are regulators letting them?

What don’t we know?

Are big banks in trouble? Are regulators afraid “higher for longer” rates will force banks to take huge losses on sunk portfolios of commercial real estate loans, auto loans, consumer credit loans and mortgages?

Are nonbanks – shadow banks – taking risk from banks because they’ve got too much cash they’re not able to invest in their traditional hunting grounds?

This leverage upon leverage of derivatives, especially insurance-type credit default swaps, brought us the 2008 financial crisis.

SRTs are helping banks who are asset constrained and looking to offload risk they’ve loaded up on.

What could possibly go wrong?

History knows best.

Note: Look… this kind of complicated financial wheeling and dealing got past the mainstream media before. It’s not something you’re going to hear about on the nightly news. That’s why I’ve put together an action plan to protect my subscribers from this coming credit crisis. It contains seven hot targets all locked, loaded and ready to trade. Get all the details here… before the banking dominoes start to fall.