Fed green lights more capital relief trades

The US Federal Reserve has given five regional banks permission to treat credit-linked notes (CLNs) that transfer default risk to investors through financial guarantees as synthetic securitisations for capital purposes.

The relief – which was granted in a series of letters sent to Ally Financial, Huntington Bancshares, Santander USA, Truist and US Bancorp between November of last year and the beginning of this month – could add more fuel to an already red-hot market for credit risk transfer (CRT) deals.

The five banks will be allowed to directly issue CLNs referencing up to $100 billion of loans between them without the need for further regulatory approvals.

“The best world is a world where the regulator says you don’t need anything at all, you can just do the transaction,” says Matthew Bisanz, a partner at the law firm Mayer Brown to whom the Ally, Huntington and US Bancorp letters were addressed. “But the next best world is where the regulator says we’ll give you a letter that lets you do it, so this is much better than the prior state where they didn’t know if they could do it.”

The Fed effectively re-opened the US CRT market last September when it wrote to Morgan Stanley and at least five other large banks to clarify the type of deals that qualify for capital relief. That guidance confirmed that CLNs issued directly by a bank that mimic a synthetic credit default swap (CDS) structure would be accepted on a recurrent basis without having to re-approve each transaction.

JP Morgan and Morgan Stanley issued CLNs referencing billions of dollars of loans on their books after the Fed green-lit these types of transactions.

This is much better than the prior state where they didn’t know if they could do it

Matthew Bisanz, Mayer Brown

The latest guidance extends the same relief to CLNs that are structured as if a financial guarantee – rather than a CDS contract – were in place. Bisanz says this structure has a number of advantages and is usually preferred by smaller banks.

“I like the guarantee [structure] because it is more flexible in terms of the language and variations you can introduce,” he says. “You have greater options in terms of how you can structure the deal and greater flexibility in structuring future deals.”

A CLN based on a CDS structure must use the International Swaps and Derivatives Association’s standard contract language to describe the interest and repayment terms of the transaction.

“If I am going to draft a credit derivative, I am going to need stick fairly closely to the Isda template,” says Bisanz. “So if I have a counterparty who maybe wants to negotiate extensively off of the template, I might be more hesitant to do so because it doesn’t look as much like an Isda.”

By contrast, a financial guarantee structure “can really take any form… as long as it has certain concepts in it, like an obligation to pay under defined conditions”, he says.

Bisanz adds that the guarantee language is helpful because in some cases it may allow banks to use historical cost basis instead of mark-to-market when valuing the amount at risk. “This can make it easier for the bank to value for accounting purposes,” he says.

Regulatory filings indicate that none of the five banks have yet issued public CLNs since the Fed sent the letters. Risk.net understands Santander has issued a number of private CLNs pursuant to the Fed letter it received in December. Truist declined to comment on its issuance plans, while Ally, Huntington and US Bancorp did not respond to requests for comment.    

Jumping the Q

The relief granted by the Fed comes with a few strings attached. To qualify for automatic capital relief, future issuance must be “substantially identical” to the initial deals approved by regulators. The Fed did not specify what would amount to a material change, though Bisanz believes the guidance can be interpreted somewhat broadly. 

“I think it’s a subjective term that is specific to this context and specific to securitisation,” he says. “As a concept, when we’re talking about substantially identical, we think of things that affect the bank’s or the investor’s risk in the deal.”

The authorised transactions are funded CLNs – where the investor makes an upfront payment to cover potential losses – referencing pools of auto loans. Bisanz says an unfunded CLN might be considered substantially different but that changing the underlying loan pool from auto loans to commercial real estate would not.

The Fed also capped the amount of loans that the banks can reference in repeat structure direct CLNs at the lower of $20 billion or 100% of total capital. “We tend to think that it is on a revolving basis – that if you issue a CLN and it pays off next year, then you can issue a new one using that same capacity,” says Bisanz. The limit does not apply to indirect deals issued via a special purpose vehicle.

Despite the limits imposed by regulators, the letters are widely seen as a win for banks. Prior to last September’s guidance, the US CRT market was stifled by regulatory uncertainty, with the New York Fed refusing to approve proposed CLNs from the largest US banks, while other regional Feds continued to allow issuances by the lenders they regulated. The confusion centred on the interpretation of Regulation Q, which governs bank capital requirements.

To obtain capital relief from CRTs, banks must get confirmation from their supervisors that the deals comply with the relevant part of the regulation. The hitch was that while Reg Q recognises deals that use credit default swaps or financial guarantees to transfer credit risk, there is no explicit mention of directly issued CLNs. These deals transfer credit risk in the form of a write-down clause that allows principal repayments to be reduced if defaults in the reference loan portfolio exceed a certain threshold.

Banks are automatically granted capital relief on deals that directly match the wording of Reg Q, while those that fall outside the regulatory definitions are reliant on the supervisor’s discretion. The clarifying guidance from the Fed Board effectively puts direct CLNs on the same footing as bilateral CDS and financial guarantees from a capital perspective.

Terry Oznick, general counsel at Merchants Bank of Indiana, which issued a direct CLN referencing an approximately $1.13 billion pool of loans in March 2023, tells Risk.net that direct CLNs are safer than bilateral deals – in part because banks can negotiate to treat the full notional of the transaction as cash on deposit. 

“In our mind, we thought that would be the preferred approach and we’ve considered it to be somewhat the safest and give us the most protections as an organisation, considering the buyer paid cash straight up,” Oznick says.

Update, May 16, 2024: This article was updated with information about Santander's CLN issuance.  

Editing by Kris Devasabai