‘Blind’ Wagers on a Buzzy Bank Risk Transfer Trade Have Never Been So Popular

‘Blind’ Wagers on a Buzzy Bank Risk Transfer Trade Have Never Been So Popular

It might be the ultimate risky bet. Pension funds, insurers and hedge funds are taking on the first losses of loan failures of banks around the world — without even knowing the identities of the borrowers behind those loans.

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(Bloomberg) — It might be the ultimate risky bet. Pension funds, insurers and hedge funds are taking on the first losses of loan failures of banks around the world — without even knowing the identities of the borrowers behind those loans.

Yet the trade has never been so popular. Investors are lining up to insure hundreds of billions of dollars of bank portfolios for the likes of Citigroup Inc. to BNP Paribas. These synthetic risk transfers typically pay double-digit returns, and they’re increasingly being tied to so-called blind loan pools.

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Blind pools have cropped up on SRTs since they began proliferating in Europe in the aftermath of the financial crisis to help cash-strapped banks meet capital requirements. The difference now is that these pools are being expanded to include loans to consumers, as well as to industries such as defense and types of energy that don’t meet many investors’ environmental and social criteria. 

The deals work like this: banks create credit-linked notes to insure losses up to about 12% of a group of loans. They sell these notes to private investors who collect quarterly or monthly payments. That frees up capital that can be used for more profitable business.

PGGM, which has been buying SRTs since 2006, is no stranger to their risks. Managers at the Dutch pension fund say buyers who are new to the deals need to take more care as defaults start to spread amid the highest interest rates in a generation. 

“These are investments in first loss, so of course it is risky by nature and we’ve advertised it as such. We think it’s irresponsible for anyone to think otherwise,” Mascha Canio, who oversees risk-sharing transactions at the firm, said in a phone interview. “When the cycle is turning, people will be taking more credit risk on the chin.”

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Banks eager for capital relief are turning to SRTs to insure more and more of their loans, including to small businesses and to consumers on cars and homes. These are the main fodder for blind pools, which are said by investors to make up about 50% of the €200 billion ($217 billion) of loans pledged to synthetic risk transfers last year.

Read more: D.E. Shaw Among Hedge Funds Buying Blind Pools of Bank Risk

Demand for SRTs is so strong that buyers of blind pools get just a negligible premium for the extra risk. In the US, where the notes pay 9.5% to 12% of all-in interest, blind pools pay as little as 0.2% more than deals where borrowers are disclosed, according to people with direct knowledge of the deals who asked not to be identified discussing confidential information.

SRTs are privately negotiated and it’s often up to buyers to work out their likelihood of default, as well as determine whether the loans are within ESG guidelines. 

That’s no small task, according to Richard Robb, the co-founder of New York-based hedge fund Christofferson Robb, which has specialized in risk-sharing transactions with European banks for two decades.

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“I don’t believe it,” Robb said of those who claim to perform SRT credit work on investment-grade borrowers name-by-name. “I think it’s show business.”

His firm is invested in €6 billion of risk-sharing deals referencing €75 billion of loans, and has focused on small and medium sized European companies. Knowing the underlying names in the portfolio doesn’t make much of a difference, he said, adding that the firm draws comfort from the bank’s internal models and selection process.

Fund managers at PGGM, which buys only blind-pool SRTs, use the loss-based assumptions and ratings devised by the bank issuing the SRT. The firm targets portfolios of mid to large companies that are rated from investment-grade to single B minus, Canio said. It also buys loans tied to project and trade finance.

Black Lists

PGGM submits criteria that exclude certain industries such as tobacco and in some cases weapons makers. For oil and gas, the firm can follow guidelines set by its bank partners. As of the end of 2022, the firm had invested in sharing transactions worth €7 billion insuring €71 billion of loans, according to its website.

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Such “black lists” banning specific industries as well as borrowers are one way for buyers to shield themselves, and they’re becoming more common, according to people familiar with the transactions who didn’t want to be identified because they are private. 

Scant information means “you generally can’t adhere to your own ESG standards,” said Marcel Hörauf, a counsel specializing in SRTs at law firm Mayer Brown.

They’re also a way for some buyers to avoid pools with default-prone commercial real estate.

SRTs grew more commonplace after the financial crisis, providing an alternative for banks in Europe that faced punitive costs raising equity. Lenders also use them to hedge against future credit losses.

They’ve been less popular among US banks, but that changed last year in the wake of the regional banking crisis, when the Federal Reserve helped kickstart the market after it released guidance in September on what types of transactions can be eligible for capital relief. That opened the door to regional banks, as well as bigger lenders.

Banks including BNP Paribas SA and Citigroup are said to be among sellers of so-called blind pools of risk, said some of the people who didn’t want to be identified. Representatives for the banks declined to comment.

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Podcast: Man Group’s Moniot on Rise of Credit Risk Sharing 

As more prospective buyers rush into the market, spreads on deals have tightened by at least 1.5 percentage points since 2022, according to participants. 

Banks use blind pools to offload risk for portfolios where the borrowers’ privacy needs to be protected, Jed Miller, a partner at Cadwalader Wickersham & Taft, said in an interview. Subscription lines secured by capital commitments to investment funds are among some of the most commonly securitized and these feature low loss rates, he said.  

Also common, but perceived to be less safe, are loans to consumers. Overall US household debt reached a record level in the first quarter while more consumers are falling behind on their credit card payments, according to the Federal Reserve.

“We need to see enough data,” said Jody Gunderson, managing principal at alternative asset manager AB CarVal. “The level of information we get is critical for any asset class but in particular for consumer portfolios, where we are choosing our spots very carefully. We ask for as much as we can to get comfortable with the risk, and we don’t always get there.”

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