Synthetic risk transfers

When I read the phrase “synthetic risk transfer” my mind went back to the many novel derivatives that helped spread the 2008 financial crisis by supposedly diluting risk. What could possibly go wrong?

Big Banks Cook Up New Way to Unload Risk

Banks are selling risk to hedge funds, private-equity firms through so-called synthetic risk transfers

By Matt Wirz and Peter Rudegeair, The Wall Street Journal, Nov. 7, 2023

U.S. banks have found a new way to unload risk as they scramble to adapt to tighter regulations and rising interest rates.

JPMorgan Chase, Morgan Stanley, U.S. Bank and others are selling complex debt instruments to private-fund managers as a way to reduce regulatory capital charges on the loans they make, people familiar with the transactions said.

These so-called synthetic risk transfers are expensive for banks but less costly than taking the full capital charges on the underlying assets. They are lucrative for the investors, who can typically get returns of around 15% or more, according to the people familiar with the transactions…

In most of these risk transfers, investors pay cash for credit-linked notes or credit derivatives issued by the banks. The notes and derivatives amount to roughly 10% of the loan portfolios being de-risked. Investors collect interest in exchange for shouldering losses if borrowers of up to about 10% of the pooled loans default… [end quote]

Banks are using this as a way of getting around rules that require the banks to hold more capital. It’s a form of insurance, similar to the credit default swaps that propagated the 2008 financial crisis.

Banks globally will likely transfer risk tied to about $200 billion of loans this year. It’s hard to say whether this is a large number because it isn’t spread evenly. In 2008 the collapse of Lehman Brothers and AIG were pressure points whose failure could have dragged down the entire financial system, according to the Federal Reserve and Treasury.

The bank capital rules were put in place after 2008. There’s a darn good reason they are there and the TBTF banks are regularly stress tested.

Risk may be transferred but it’s always there. Attempts to transfer risk can boomerang if the entities that accept the risk aren’t regulated and take on too much.

I continue to watch the Control Panel for signs of financial crisis. There’s a qualitative difference between a garden-variety recession and a financial crisis. The recession is relatively common, usually gradual and doesn’t cause huge volatility in the markets. The crisis is rare and causes extreme moves in VIX and the Financial Stress Index. The stock market may crash without a financial crisis (e.g. 2001) but the financial crisis threatens stocks, bonds and the whole financial system.

This rare event causes VIX > 50 and Financial Stress Index > 5.

There’s no sign of such a crisis today. But I’m uneasy when I read about growing use of a financial technique which is supposed to reduce risk but actually resembles techniques that increased risk in the past.

Wendy

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As far as macro risks, I’d keep a very close eye on this number. If the notional number starts rising, or starts rising rapidly, then we need to become much more cautious. Right now at $200B worldwide, it’s not likely to become a systemic problem, but if the number gets closer to $1T then who knows? Something could trigger cascading failures, that would be “something” that we don’t know about today obviously (“black swan”-like?)

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For a scale comparison, a couple of years ago global net worth was over $600 trillion, so you’re talking about three hundredths of one percent.

DB2

Any bets the buyers of the “risk” will be running infomertials touting some “new, innovative, product” to the unsuspecting, to fob off the risk, while skimming a profit off the scheme?

Back before the bubble popped, First Union published a glossary in it’s annual report offering definitions of all the “innovative” products that were circulating in the market.

Steve

Almost. There is no obvious/detectable sign of such a crisis–yet.

So you’re saying there are undetectable signs? How would you know? Are they some of those Rumsfeld “unknown unknowns”?

DB2

TANSTAAFL. If you don’t know what to look for, how do you know it is not a scam? Essentially, a “pig butcher” operation, which we have seen a number of times. Enron, 2008 economy, supply-side economics, and so on.

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