Markets

Lisa Abramowicz is a Bloomberg Gadfly columnist covering the debt markets. She has written about debt markets for Bloomberg News since 2010.

Regulators have a tough balancing act.

They want a safer financial system, but they don't want to kill bank profitability. They want more lending, but they've required banks to have more cash and equity to buffer against unexpected losses. They've sought to standardize trading, but they don't want to stymie innovation.

These conflicting desires have led regulators, particularly in Europe, to sign off on banks selling some of the risk tied to the loans they make to hedge funds and other investors using derivatives. This lowers the amount of capital that banks have to hold to buffer against loan losses. Last year, they sold about $6 billion of such synthetic risk-transfer notes, protecting as much as $100 billion of debt on their books, Himesh Shah, a managing director at Christofferson Robb & Co., said in a Bloomberg News article on Thursday.   

Hedge Fund Favorite
Hedge funds account for the bulk of the demand for European synthetic securitizations
Source: European Banking Authority
The data was taken from a 2015 EBA report

But that risk doesn't magically disappear. These individually crafted transactions look a lot like the synthetic collateralized debt obligations made infamous amid the 2008 financial meltdown. And here's where things start to get more interesting: Some of these hedge funds and others want to earn more money on these deals than, say, just a mere 11 or 12 percent coupon payment. So they're borrowing money from banks to juice their profits. In other words, banks are lending money to hedge funds to invest in derivatives that guarantee losses on loans held by banks. It's all pretty dizzying. 

Hunting for Yield
Investors have turned to more esoteric investments as riskier public debt yields drop
Source: Bloomberg Barclays US Corporate High Yield Index

Nomura and Credit Suisse are among the most active banks providing leverage to hedge funds for this purpose, according to Bloomberg News reporters Alastair Marsh and Donal Griffin, who cited confidential sources. These firms are also reportedly trying to make it easier for investors to buy and sell these notes.

From the banks' perspective it makes sense. Regulators have handed them a paradox -- they want banks to lend more but take less risk. The answer for many firms has been these synthetic risk-transfer agreements. 

As the adage goes, when something looks too good to be true, it usually is. To be clear, these transactions don't seem as dangerous as many derivatives crafted in the run-up to the 2008 crisis. They're generally fully funded, meaning that investors have to put cash aside to cover any potential losses on loans that are still held by the issuing bank. (In the past, investors often promised to cover losses without having to prove that they'd be able to do so.) 

But the fact that investors are embracing these securities  -- and that banks are helping leverage them up -- should be sounding alarms. This is a risky market, even in the post-crisis era. Recall Banco Espirito Santo, the Portuguese bank that was forced to restructure in 2014, which sold credit-linked notes tied to a 2 billion euro pool of commercial loans. Investors in those notes appeared to wake up to the risk way too late.

Complicated derivatives aren't inherently bad, but financial sleight of hand doesn't truly make risk disappear. It simply moves it out of direct sight. The introduction of leverage into the mix only makes it more dangerous. 

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Lisa Abramowicz in New York at labramowicz@bloomberg.net

To contact the editor responsible for this story:
Daniel Niemi at dniemi1@bloomberg.net