The second of five essays compiled in SCI's inaugural SRT Journal explores US regional bank CRT activity

CRTs are becoming increasingly attractive to US regional banks, having historically remained almost exclusively the preserve of the so-called global systemically important banks (G-SIBs) in the country. Yet a much anticipated wave of issuance in 2024 has not fully materialised, with players entering the market more gradually and deliberately as they negotiate various challenges.

The growing interest had been partly attributed in some quarters to Basel 3 Endgame and the touted lowering to US$100bn of the total assets threshold over which the sternest capital adequacy measures were expected to apply to US banks. In September, this incentive was diminished when Federal Reserve vice chair of supervision Michael Barr announced banks with between US$100bn and US$250bn would no longer be subject to some of those measures (SCI 10 September). Yet, as SCI reported at the time, sources close to the market believe the relaxations will not bring regionals’ use of CRT to a halt, with only around 20 institutions falling within that bracket.

Another – arguably key – catalyst for issuance has been the Fed FAQ of September 2023 (SCI 29 September 2023), which included Regulation Q clarifications over the recognition of directly issued CLNs under the capital rule. Under the FAQ, a Fed-regulated institution can recognise the credit risk mitigation of the collateral on a reference portfolio within the rules for synthetic securitisations, provided that the operational and due diligence requirements are met and that the transaction satisfies the definition of ‘synthetic securitisation’.

The direct CLN route potentially offers a more straightforward pathway to CRT for banks compared with structures requiring execution of a credit default swap or financial guarantee with a counterparty – often an SPV, which will then issue CLNs. This clarification has proven, at least to some extent, to be a driver of activity. Issuance by regional banks has since grown, with Huntington, Merchants and Ally among those receiving approval for direct CLNs to be treated as synthetic securitisations.

Yet many investors will likely look at the bank risk associated with direct CLNs – which is more pronounced with smaller regional banks compared with G-SIBs – and conclude that it is not for them.

In July this year, Pinnacle Financial Partners and Valley National Bank entered the market with transactions – notably both SPV CLN or CDS-based, rather than direct CLN-based deals – referencing mortgage and auto loan assets respectively (SCI 29 July and 29 July). Both banks have below US$100bn in assets, meaning they would have fallen below even the formerly anticipated threshold for Basel 3. 

Matthew Bisanz, a partner in Mayer Brown’s regulatory practice, says regional banks have the same need for capital enhancement as larger banks – if not greater. However, many are still negotiating the various barriers to entry into what is a complex arena.

Bisanz explains that regionals have a lower level of familiarity with the product. Typically, those that have used CRT have done so because they hired or were advised by somebody who happens to have the relevant expertise. While they have needed capital relief, he says, it has almost been by “happenstance” that they stumbled into CRT.

“For many of these regional banks, it is difficult to access capital markets in other ways,” says Bisanz. “The two other main options are selling equity and selling assets. If you are a small regional bank in Illinois, for example, there isn’t a high demand for your equity – you’re not going to get a premium on it and it will be dilutive to existing shareholders. If you sell assets, you will take a lot of losses because of the change in interest rate and potentially lose control of part of the customer relationship. Your two go-to strategies right now probably aren’t going to work.” This makes CRT very appealing.

The relative lack of CRT activity in the US – compared with the European market – is partly due to a lack of historical need. Indeed the development and growth of synthetic securitisations in Europe was largely driven by banks' requirement to recapitalise in the aftermath of the global financial crash. US banks, as a whole, did not face the same scale of task in having to develop such instruments to build up capital.

It is also partly due to a lack of awareness of the product, says Angela Ulum, partner and co-leader of the banking and finance practice at Mayer Brown. US players with a financial markets focus have been conscious of activity in the space, she says. However, awareness among regional banks only started growing recently, accelerated by coverage of the topic creeping into mainstream financial news outlets.

“To somebody with a structured finance background, CRT is one option for banking seeking capital optimisation,” says Ulum. “Many investors are agnostic as to whether they acquire exposure to a portion of assets through a credit risk transfer, a portfolio sale or an off-balance-sheet securitisation, all of which can have the effect of reducing a bank’s required capital. Looking at these as various tools, some of the benefits of CRT aren’t present with portfolio sales, off-balance-sheet securitisations or by reducing origination flow. So we’re likely to see CRT used more strategically.”

Barriers to entry
Nonetheless, Ulum says the wider industry had expected to see significantly more CRT issuance from regional banks in 2024 than there has been to date. In part, she attributes this to challenges banks face in putting together portfolios that could both benefit from capital relief and offer an attractive risk profile for investors. Portfolios of commercial real estate, for instance, would prove challenging.

Additionally, selecting among direct CLNs and eligible CDS structures – which may or may not include the issuance of SPV CLNs – can prove intimidating, as can navigating any resultant regulatory questions and operational challenges. Questions remain as to whether banks have the required historical loss and delinquency information and whether they are able to track losses and recoveries as required in CRTs. Reporting systems as a whole may require significant investment. There are challenges for banks to produce the loan-level information required and to evaluate and confirm eligibility criteria for reference assets that matter to investors.  

“As banks are considering different asset classes and different portfolios, or even getting into the market, it’s important they are on board with investing in the operational challenges to be able to do that,” says Ulum. “There are a number of different companies trying to provide solutions, but that has been one of the more intimidating factors as banks think about getting into this market or expanding into different asset classes – even when they are already out with one asset class.”

There is a temptation among some banks, Bisanz says, to attempt to avoid some of the costs of entering the market – specifically the six-figure sums associated with hiring experienced financial advisors to help structure economic terms. Avoiding such hires is a course he cautions against.

“If you haven’t done one of these before, it’s often prudent to hire a knowledgeable financial advisor or broker,” says Bisanz. “Put aside the fact that you won’t negotiate as good a deal versus a more sophisticated counterparty. How are you going to get the data from your loan portfolio or even pick your loan portfolio [without those expertise]?” Many who look to cut corners may find themselves falling behind their peers, Bisanz fears, in a bid to avoid making a hire that would cost “a few hundred thousand dollars”.

The challenges of transitioning into the CRT market, more often than not, also involve selling the vision and potential benefits within banks themselves – not least to senior management, who themselves may be naturally resistant to a new unfamiliar financial product. A lot of time and energy is required, Ulum explains, in the organising of different stakeholders within the institution to come on board.

“Typically, the people who are worried about capital or cost of equity may be in one department, treasury is in a different department, and the line of business that actually touches the assets is in a third,” Ulum says. “Somebody has to have the vision and the force of personality to get those different groups together to understand the value proposition for CRT – and be able to invest the upfront cost in building the systems and understanding the structure. Once you do the first deal, there are many economies of replicating a transaction multiple times.”

It follows that, for those banks that do reach a consensus in favour of CRT, the benefits could become incrementally more significant over time. Ulum argues that, as more programmatic issuers start providing proof of concept and are able to determine the terms they care about and those they do not, pricing should start to tighten.

Identifying candidates
Once a consensus is reached – or as part of that process – the task is identifying portfolios that are best suited to CRTs. Bisanz highlights that there are a small number of regional US banks with auto loan portfolios that justify a CRT such as that executed by Valley National. That deal, he points out, was issued on US$1.5bn of loans, a strikingly high percentage of the bank’s US$1.8bn total auto loans portfolio. There may be some other regionals in a position – and of an inclination – to follow this lead, according to Bisanz, but not many.

“There are a small handful of regional banks with a significant non-bank lender, fund finance or specialty finance business,” says Bisanz. “That’s a very desirable portfolio. Commercial real estate can also be attractive, but it has to be the right kind. If you have a lot of rent controlled apartments or urban rental office space, for example, that isn’t good. But unregulated multifamily or seasoned owner-occupied are more interesting. A lot of people look at doing resi mortgages, which is a good CRT candidate, although it is less capital efficient because of how US capital rules work.”

Key to selecting a portfolio from the bank’s perspective, Ulum adds, is a reference portfolio with the critical mass required to justify the transaction costs involved. Many regionals are currently in the process of assessing which portfolios meet this criteria while also having losses that are low enough or predictable enough to be attractive to investors, she says.

“A lot of banks are trying to determine what the relative merits are of different portfolios between operational ease, the risk weights they’re holding and how attractive these assets are for investors,” Ulum says. “Some assets – such as auto loans – might be the easiest from an investor perspective, but they require a fair amount of operational systems work. A portfolio that has a hundred commercial loans, on the other hand, is small enough that you could have a human do the reporting manually.”

One touted approach to building portfolios of suitable scale, is that clusters of banks pool their portfolios into larger transactions. Bisanz feels that, as a potential approach, it would not carry many risks. The key challenge, he says, is finding small banks that are willing to work together with investors.

In a typical non-pooled transaction, investors may have to rewrite terms of a deal they have agreed with one bank in order to satisfy the requirements of another bank, or vice versa. In the context of a multi-bank deal these dynamics can become more challenging, as Bisanz explains: “When you get five banks in a room, and say, ‘we are going to do this with one of you and the other four of you are going to have to accept the terms that have been negotiated,’ the others are likely to say they would just rather not do the deal.”

He continues: “It requires five banks who are highly motivated to do a deal to be willing to agree to the same terms. When you find five banks in that position, what is the likelihood that they have some commonality, whereby they all have a multi-family CRE problem, for example? There are only around 100 regional banks in the US that we are talking about. So you quickly stratify them into different categories.”

Bisanz says he believes pooling will happen eventually, but that it will require a level of compromise over terms – a willingness that is yet to become apparent. Ultimately, what is needed is a shift in outlook in order for regionals to embrace the efficiencies of the multi-bank deal.

Despite the challenges or the approaches adopted, recent CRT issuance in the US tells us that momentum is building, albeit more slowly than many anticipated at the start of 2024. Regional banks have a very present need for capital enhancement and CRTs provide a tangible path to achieving this. With a handful of their peers issuing over the past year, the next wave now has case studies that can be presented to investors – once the internal questions have been answered.

Kenny Wastell

 SCI’s SRT Journal is sponsored by Arch MI and Mayer Brown. All five essays can be downloaded, for free, here.