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Private Credit 

Owen Sanderson

Right now, JP Morgan is marketing a series of transactions which might be the most important deals the capital markets will see this year. That’s a bold claim, but here’s why we think it stacks up.

The deals under discussion are “significant risk transfer” (SRT) securitisation deals on a portfolio of around $25bn, of which the bulk is said to be US investment grade lending. In other words, JP Morgan sells the junior risk of this portfolio off to the market, keeping the low risk senior portion. This cuts the capital requirements associated with the portfolio; instead of a package of risk averaging say, triple-B, JP Morgan remains exposed only to a senior securitisation tranche at triple-A or double-A level.

These risk transfers are unlikely to come in a single deal, but based on US regulations, which require a thicker 12.5% junior tranche to demonstrate risk transfer, this implies some $3.25bn of junior notes being sold.

The bank is said to be asking for minimum ticket sizes in excess of $250m a time, a level that excludes nearly all the funds which have historically played in risk transfer transactions — and underlines the coming revolution in the market.

“In our view, what's likely to happen is that US banks may put an imprimatur of respectability on the SRT market for a broad base of US LPs and asset managers,” said Matthew Moniot, co-head of credit risk sharing at Man GPM. “There's an understandable parochialism to the US capital markets because with 50% of the global capital markets right there in New York, why go anywhere else? With US banks coming into SRT, the US asset management community will likely stop perceiving SRT as a niche European market.” 

This process goes by several names — risk-sharing, significant risk transfer (SRT), credit risk transfer (CRT), synthetic risk transfer (also SRT), balance sheet securitisation. Somewhat less popular post-2008 is “synthetic CLO”.

The mechanics can vary — structures include a bespoke credit default swap, a financial guarantee, or credit insurance on a synthetic tranche. These risk-transferring contracts can face a collateralised SPV, be packaged into a variable notional credit-linked note, or structured as an uncollateralised reinsurance contract.

The effect is the same — some outside investor bears the junior risk of a portfolio. As losses hit the portfolio, these are borne by the investor, rather than the bank that originated the assets, until the protection tranche is exhausted. In return, the investor gets a coupon payment, usually in the low double digits over a floating benchmark. From the bank’s perspective, they start out holding a pool of whole loans, and end up holding the senior tranche in a (synthetic) securitisation.

These structural variants don’t really change the economics, but they matter a lot for what follows. US banks have only just received regulatory authorisation to treat a credit-linked note (CLN) as equivalent to a synthetic securitisation, a change that makes it far easier for banks to issue risk transfer deals, and potentially heralds a “tectonic shift” in SRT.

Selling the junior risk in corporate loan portfolios this way has long been dominated by the big European banks.

Exact numbers are hard to come by (there are limited disclosures in bank Pillar 3 reports), but some of the largest issuers in the market are the big European corporate and investment banks — Barclays, BNP Paribas, Deutsche Bank, Santander are some of the largest, with Crédit Agricole, Société Générale, HSBC, Standard Chartered, NatWest all active. Throw in Intesa Sanpaolo, UniCredit, Lloyds, and until earlier this year, Credit Suisse, and you get the picture.

The market has been going from strength to strength. According to the European Central Bank’s supervisory arm, 2022 brought a market record of 118 SRT deals from 30 banks, with a total notional of more than €170bn. As this records only the ECB-supervised banks, the total market is likely considerably larger.

European banks drive issuance in the market, which is matched by a more international but highly specialist investor base — most of which would struggle to do $250m or $500m tickets. This includes specialist funds focused on SRT deals, such as Chorus Capital and ArrowMark, as well as specific funds for capital relief raised by firms such as Chenavari, Polus Capital, Pemberton, DE Shaw and Axa Investment Management.

Christofferson Robb, the hedge fund that practically invented the market and which may well have a market share north of 20%, said it invested a record $2.8bn in 2022 — so it could probably do $250m in one hit. Most accounts specialising in risk sharing do far less. Until recently, the only investor in the space regularly speaking for more than €300m at a time was PGGM, the pension fund of the Dutch healthcare system, which already did an SRT on a $2.5bn portfolio with JP Morgan (if the junior transferred tranche detaches at 12.5%, this would be a $312.5m placed note).

PGGM, though, has some idiosyncratic requirements from its risk sharing deals, including a 20% risk retention requirement, above and beyond the European regulatory minimum of 5%.

The list of active firms in the market, however, does not include many of the top 20 asset management shops — no BlackRock, Fidelity, T Rowe Price, State Street, Capital Group, BNY Mellon. Pimco has hired a PM with experience in risk transfer last year, Mark Kruzel, but market participants have not heard of many deals closed by Pimco so far.

Recently, risk sharing has attracted more attention from the world-conquering private credit funds.

Several market participants said that Blackstone had been becoming more active in the space, while others cited Ares, and KKR. Dan Pietrzak, head of private credit at KKR, highlighted risk sharing deals as a good opportunity in a recent video interview with 9fin. Elliott Management has been active in the space for a long time (doing a deal with fintech Klarna last year, for example) and can also speak for size.

It’s unlikely, however, that these institutions have raised specific risk transfer funds in large enough size to drop $250m+ on a single transaction. If we assume that you’d want at least 20 positions and you’re holding them unlevered, that implies a $5bn fund; a very chunky capital raising for a market that, until now, has been placing <$20bn per year.

It’s more likely that these commitments are coming from the giant (and under-invested) private credit or asset-backed private credit commitments recently notched up. These deals are basically levered exposures to diversified pools of investment grade borrowers, which can often only be accessed in SRT format.

Several sources also suggested that the funds could structure these big ticket investments as co-investments with their fund LPs — two sources mentioned the large Canadian pension funds as a potential capital pool. It’s a proven strategy in classic private equity, where it’s common to see the likes of CDPQ or OMERS join a traditional private equity GP as a co-sponsor in buying a company, and it’s also been seen in larger private credit investments such as Adevinta.

Several securitisation investors mentioned a wave of inbound enquiries from LPs about the “new” risk transfer market opening up in the US — high profile articles in the Wall Street Journal and Financial Times have encouraged conservative investors such as US public pension funds to open up to the possibilities of risk transfer, and ask the funds they invest in to look at this new opportunity.

Economically, SRT can be considered part of a broader long term trend for banks to concentrate on only the safest assets, with non-banks bearing the risk in ever-increasing proportions of economic activity.

A private credit fund like Blackstone or KKR buying the junior risk in an SRT portfolio on US investment grade is signalling that the capital of choice for lending to US Inc doesn’t come from JP Morgan’s shareholders any more — it comes from private credit LPs. It’s a handing on of the baton in one of the core areas of banking.

It’s the same trend that’s behind the broader rise of specialty finance firms and capital markets funding for all kinds of loan origination. Commercial real estate debt, shipping loans, aviation finance, energy finance, corporate lending, and large portions of personal finance are all now, in the US, dominated by non-bank institutions.

The major banks are still involved, but they have moved up the capital structure, offering back leverage to funds, CLO warehousing, loan on loan financing, warehouse facilities and other forms of portfolio leverage. Just as in an SRT deal, the actual first loss exposures are borne by origination platforms, or their backers in the alternative asset management industry.

“The increase in regulatory capital requirements following the financial crisis made it clear that regulators don't want banks to take credit risk, and, and even more importantly, that banks are not competitive in high credit risk markets,” said Moniot. “Banks need other capital to stand between them and credit risky borrowers, so you have specialty finance companies in shipping and aircraft, leveraged finance, consumer credit and everything else. Unlike 20 years ago, the banks lend to these companies, but don't own them. They're in the senior financing position. SRT just recreates the same structure for assets that specialty finance companies are not well suited to address.”

SRT has several special advantages that make it suitable for a far broader range of banking assets. Because it’s a synthetic hedging technique, it separates the earnings of the portfolio from the cost of hedging — the spread from the underlying loans is not going directly into a securitisation waterfall.

Selling assets through cash securitisation only works when the assets yield enough to make securitisation worthwhile. Triple-A CLO tranches yield roughly the same as triple-B corporate bonds, so it’s impossible to structure a deal to finance investment grade lending in CLO format; you need the high spreads on offer in leveraged finance to make it work.

Large parts of bank lending — the classic example is the corporate revolving credit facility (RCF) — are non-economic on a strictly return-on-capital basis, but remain essential elements of a broader business.

These are the usual price of entry to a corporate banking group, allowing access to lucrative M&A and underwriting work. But in investment grade, they usually remain undrawn (and don’t pay anything except a tiny commitment fee) while requiring a full capital allocation held against them.

Cash securitisation is also a problem for assets which need to be discreet. Cash securitisations can be executed in quite a private format (lots of private US deals use the Section 4(a)2 private placement exemption), but most US deals are 144A, and generally involve more disclosure than the frequently bilateral SRT transactions.

Particularly sensitive asset classes might include lending to other asset management firms — warehouse facilities, for example. Western Alliance Bank, a Phoenix-headquartered US regional, and Texas Capital Bank have both done SRT deals referencing mortgage warehouses.

This could cut both ways, as the private credit giants move into the risk transfer market — specialty finance sponsors might not want Ares or Blackstone to have full transparency into their portfolios, and would prefer a traditional SRT investor unlikely to compete with them.

Although a cash deal, the Ares purchase of PacWest’s specialty finance portfolio is said to be amortising extremely quickly, improving the returns on the trade, as sponsors of the facilities shy away from having Ares, rather than a bank, as their senior lender.

There are several factors that go into figuring out whether these transactions make economic sense.

The point of selling this risk is generally to save regulatory capital. So if the following are true, it’s a good time to do SRT.

1) The deals save a lot of regulatory capital

2) Regulatory capital is expensive or constrained

All of these points are now true, or increasingly true, in the US banking system.

Point 1 is mostly determined by the risk density of the assets and their suitability for securitisation (plus securitisation capital treatment itself).

So if you have a pool of risky assets that will securitise very nicely, and favourable treatment for securitisation bonds, you have yourself a winner. Diverse books of corporate exposures tend to work out well; the diversity helps the structure to work properly, and the risk density for low IG and sub IG corporate exposures is high. US regulation gives a flat 100% risk weighting for most corporate lending. Securitisation leaves a senior tranche with 20% risk weight, for the price of placing a 0-12.5% junior tranche.

Point 2 is determined by regulation, and by the market backdrop.

The post-GFC re-regulation of the banking system is still coming down the tracks, known variously as “Basel IV”, “Basel III.1”, “Basel X” or most dramatically, the “Basel Endgame”. This increases bank capital requirements, increasing the incentive to seek alternative routes to improving capital ratios. This is unlikely to impair JP Morgan, with its 14.5% CET1 ratio, but it still hurts.

From the bank’s third quarter earnings call:

“The pace of buybacks will likely remain modest in light of the Basel III Endgame proposal… on the topic of the Basel III endgame, you'll see that we added a couple of pages on it, so let's cover that now starting on page 4. Given the significance of this proposal for us, the broader industry, as well as households and businesses as end-users, we thought it was important to spend time discussing it. And while we know there's interest in having us quantify the expected impact of this proposal in a lot of granular detail, it's important to start by asking why the proposed increase is so large given the repeated statement over time by policymakers that banks are well-capitalized and well-positioned to deal with stress. Given that context, the absence of detailed analysis supporting a capital increase of this magnitude is disconcerting and there's a lot that does not make sense to us. Starting with RWA, we've already said we expect the firm's RWA to increase by around 30% or $500bn, which results in capital requirements increasing by about 25% or $50bn.”

In short, JP Morgan is facing a massive capital hike, despite no material change in its business mix or riskiness.

Point 3 is a function of supply meeting demand. Although the US banks could easily double the size of the existing SRT market, theoretically pushing spreads wider, the larger effect is likely to come from rechannelling vast pools of private credit capital and mainstream asset management money into SRT.

It’s a compelling opportunity for these funds. The need for the banks to thread the needle of regulatory capital rules mean they are massively over-hedging to get deals away. The US banks need to place a 0-12.5% tranche to claim capital relief. Investment grade loss ratios are around 1%, so 5% cumulatively over a five year transaction term — so the banks, if unconstrained by regulation, would hedge this with a much smaller tranche than the 12.5% on offer, cutting the costs of transferring the risk. As one investor put it, “if 12.5% of the IG universe defaults over five years, don’t worry about the SRT market, buy tinned food”.

Regulation shapes this market, and a relaxation in the credit-linked note regulation has lit a fire under it. But it could be a short-lived flowering. As currently drafted, the Basel Endgame will also blow up the nascent US SRT market — the formula for risk-weighting securitisation tranches becomes very inefficient, and will require a much thicker placed tranche, perhaps up to 25%. The securitisation capital formula also becomes much more punitive, thanks to something called the “P Factor”.

That matters because banks are left with a securitisation tranche once the deal is done, so the risk weight of this senior position partly determines the economics.

The P Factor basically cranks up capital requirements for securitisation exposures specifically, on the grounds of opacity and complexity. A “P Factor” of 0.5 puts securitisation capital costs at 150% of the equivalent non-securitised exposure. European banks can apply for a certification called STS (Simple Transparent and Standardised), which brings the P Factor down to 0.25 (125% of equivalent), but no equivalent US regulation exists, and the size and cost of the placed tranche would render any deal prohibitive.

US regulatory bodies have yet to rule on how they will treat the P Factor and on the Basel Endgame generally, with investors watching the market drawing very different conclusions. Some argue the US regulatory system is heavily driven by bank lobbying, and once the US major banks swing into action, lawmakers will fold.

“Lobbyists literally write laws in the US,” said one SRT investor. “It’s not like some random Congressman is going to understand the P factor and securitisation capital treatments; they’re interested in guns, butter, and culture wars. They will just pass on whatever the bank lobbyists want them to.”

Others argued that the Basel Endgame would be fudged, but for a different reason, with the more important factor the undercapitalised US regional banking system, and the possibilities for SRT trades to raise much-needed capital without touching equity markets.

“Once JP Morgan is printing 10 deals a year and running all over the States pitching these trades to the regionals, it will open the floodgates,” said one SRT-focused banker. “It will become a completely standard technology for every mid-sized bank in America. They can’t touch the equity markets at the moment, and this offers a way to get capital in. Once the big asset managers are buying SRT deals, they will be able to manage their underwater equity positions by investing in SRT.”

The Federal Reserve change that opened the door to firing up the market was a Legal Interpretation update to its “Frequently Asked Questions about Regulation Q”.

The key passage was this: “A Board-regulated institution may request a reservation of authority under the capital rule for directly issued credit-linked notes in order to assign a different risk-weighted-asset amount to the reference exposures. To make such a request, a Board-regulated institution should contact supervisory staff at the appropriate Federal Reserve Bank. Board staff will review a request from an individual firm based on the facts and circumstances presented, including a review of the transaction documents that the firm is using.”

In English, the Fed clarified that credit-linked note structures wouldn’t usually qualify as synthetic securitisations (allowing for risk transfer), but that it was willing to look at and approve structures case by case.

In other words, it is not opening the door for CLN-based securitisations from every bank in America — it is just signalling potentially review and approval.

That’s in keeping with how SRT markets work elsewhere — the ECB’s supervisory arm must approve deals, as must the Hong Kong Monetary Authority, Canada’s OSFI, and so on. UK authorities prefer not to approve in advance, but still tick the deals once they’re done.

So far, the Federal Reserve’s disclosures indicate only one approval — a permission granted to Morgan Stanley on 29 September, the day after the publication of the crucial FAQ.

Market participants are divided on how to read the Fed’s cautious endorsement. On the one hand, why grant this waiver (and presumably, signal to other big US banks that it will do similarly) if it also intends to implement the Basel Endgame in full, thus potentially killing the market? On the other, this falls a long way short of an actual endorsement of the US SRT market in CLN format, and seems illogical in places.

Why should a CLN structure (where the bank owns all of the cash used to purchase the CLN) be less effective protection than a collateral interest (where an SPV holds cash collateral to ensure the protection-selling fund covers losses)?

US regulation for SRT is difficult in a number of other respects as well (hence the importance of the CLN structure). Here’s a rundown from Mayer Brown, but as the note points out, “One of the more challenging issues in structuring a CRT is navigating between avoiding insurance regulation on the one hand, and swap regulation on the other.”

Insurance regulation is state-by-state and difficult in its own right, while swaps regulation might take an SRT transaction into regulation by the CFTC and treatment as a “commodity pool operator” (a Dodd-Frank concept).

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