Wall Street gets creative as regulators demand more capital

Earlier this fall, Morgan Stanley bought $300 million worth of protection against losses on some of its loans from Blackstone Group and other investors, two sources familiar with the matter said. The transaction, details of which have not been previously reported, was effectively insurance, structured as a sale of bonds called credit-linked notes, according to the sources and regulatory filings. By transferring the risk to investors, the $1.4 trillion asset bank could reduce the amount of capital it has to hold against those loans to cover for potential losses.

Morgan Stanley and Blackstone declined to comment. The deal is one of several such credit risk transfer transactions that U.S. banks are considering in the aftermath of a March crisis in the sector and as regulators look to increase the capital they have to hold, bankers, lawyers and investors said. Interviews with eight people involved in the deals show different forms of credit-linked notes and insurance contracts are being discussed to free up precious capital.

While it is known that banks have been looking to offload risk through such transactions, these interviews offer new details on the types of deals and their terms, providing a rare window into a market that's shrouded in secrecy.

These deals help banks meet capital requirements more efficiently, allowing them to keep lucrative businesses that would otherwise become unprofitable But they come with risks. Investors in these deals include lightly regulated entities like hedge funds, shifting risk to the shadow banking sector. That raises the prospect that regulators will have less visibility and understanding of the dangers that lurk in the financial system. The ability to shed the risk could also encourage banks to get more aggressive on lending, leading to problems later.

"If a bank didn't manage interest rate risk well, does it appreciate potential risks associated with these transactions?" said Jill Cetina, associate managing director at Moody’s. "It raises the need for better and more fulsome disclosure in banks' regulatory filings."

Over the last few months, banks including JPMorgan Chase, Merchants Bank of Indiana and US Bancorp (USB.N), have sold the risk of losses on billions of dollars of loans for cars, multi-family homes, private funds, junk-rated companies, commercial equipment and consumers, these industry sources said.

Jon-Claude Zucconi, head of tactical situations at Apollo's ATLAS, which structures such deals, said many U.S. banks are setting up programs to issue credit linked notes for the first time. He expects U.S. banks to sell the risk on nearly $100 billion of assets over the next 12 months, freeing up nearly $15 billion of equity capital. Investors get yields ranging from 8 per cent to 15 per cent from such transactions, Zucconi said.

JPMorgan and US Bancorp declined to comment, while Merchants Bank did not respond to requests for comment.

Wall Street's financial engineering is causing concerns among some lawmakers and regulators. The Federal Reserve approved the Morgan Stanley transaction in late September but set limits, including on size, and is watching closely.

"If they perform as intended, then they might be more generally available," said Fed Vice Chair for Supervision Michael Barr in Congressional testimony this month. "If we see risks arising in those transactions, then we would limit their use for capital mitigation."

SIGNIFICANT INCREASE

The surge in interest in these transactions comes after regulators, led by Barr, proposed capital requirements earlier this year that were tougher than what banks had hoped.

Smaller banks not affected by the proposal have also been looking at these deals as a way to free up capital as conditions tightened after the regional banking crisis.

"Banks are spending a lot of time on their loan books and figuring out how to optimize what they have," said Missy Dolski, global head of capital markets at Varde Partners, which invests in such transactions.

Some banks have sold loan portfolios, businesses and cut down their lending, which were not optimal strategies because it reduces their market share and competitiveness, said Sam Graziano, managing director at advisory firm Chatham Financial.

Some considered raising capital by selling shares and preferred equity but it was expensive due to low stock valuations and high interest rates, Graziano said.

Credit risk transfer is another tool for them to pursue after the Fed’s clarification on what is allowed, said Cory Wishengrad, head of fixed income at Guggenheim Securities.

Jed Miller, a partner at Cadwalader, Wickersham & Taft, said often these transactions were structured so that proceeds must be retained by the bank on deposit for the life of the trade. The upfront cash gave Fed comfort in Morgan Stanley's case, according to Barr's testimony.

DIFFERENT DEALS

Credit risk transfers are common in Europe, where banks transfer the loans to off-balance sheet entities, called special purpose vehicles (SPVs), before selling the risk on those loans. Those deals are called synthetic credit linked notes. But SPVs can come with tax and other complexities.

Morgan Stanley's transaction kept the loans, a portfolio of revolving credit lines to private funds, called subscription lines, on its balance sheet, according to the sources and the regulatory filing.

U.S. Bank followed up with a similar deal in late October and received approval from the Fed last week for a similar transaction, according to sources and a regulatory filing.

Reuters could not determine why Morgan Stanley and U.S. Bank chose to do a direct credit-linked note rather than a synthetic one.

Other U.S. banks have been opting for synthetic deals. One of the earlier ones this year was done by Merchants Bank, an Indiana-based lender with $16 billion in assets. The details of its structure shed light on how these deals work.

Merchants priced a $158.14 million credit-linked note on March 24, providing credit protection on some commercial mortgages, including loans to nursing and assisted-living facilities, the deal's terms show. The transaction freed up the Merchant's capital, allowing it to use it to make new loans.

Through the trade, the bank would absorb the first 1 per cent of losses on the portfolio, while the next 14 per cent would be absorbed by investors, according to the term sheet. That means Merchants sold the riskiest tranche of the loan portfolio, maximizing the capital relief it could get on it.

The investors deposited cash in a collateral account as protection to Merchants Bank, the term sheet shows. Merchants did not respond to requests for comment.

Then last month, JPMorgan did one of the largest trades of this kind. It placed synthetic credit linked notes for $2.5 billion with investors, three sources said. They referenced a pool of mortgages and loans totaling about $20 billion, the sources said. Deborah Staudinger, banking and loan finance partner at Hogan Lovells, said banks are also considering transactions to lower risk on a single loan or a portfolio by buying insurance. The deals, which are yet to happen, can be secured by cash or other collateral posted by one or more insurers. Whether U.S. regulators will allow such insurance deals to qualify for capital relief is still untested, Staudinger said.