Are Banks Selling Risk or Holding It?

S&P Ratings says that even with the boom in collateralized and syndicated debt, major banks still haven't lowered their overall risk

There has been a seismic shift in capital markets in the past five or six years that has, in theory, pushed banks in the U.S. farther down the path of being credit-market middlemen and away from being actual holders of credit.

The industry started on this route in the 1970s, which witnessed the ascendency of the commercial paper and public securities markets that eventually superseded bank lending. What is different today is the private pools of hedge fund money available to make loans or to hold the risky pieces of the collateralized debt obligations that buy loans. These nontraditional buyers now purchase 70% of leveraged loans, whereas historically this debt would have been distributed within the banking system.

Many might think that as these loans are removed from the banking system, risk reduces by a proportional amount. With the rise of credit-default swap (CDS) markets that permit hedging of risk, and the continued development of securitization markets, market observers could even say that the effect of future credit cycles on banks would be muted. They would be wrong.

Certain risks associated with underwriting syndicated loans and securitization remain with the banks, so that on balance in the corporate lending business, banks actually have no less risk than in prior years. In addition, liquidity risk is never removed, as we are now witnessing in the capital markets.

What Happened in the Last Cycle?

If the assumption above were true, there would have been evidence of it in the 2000-03 credit cycle for commercial loans. Yet that cycle was worse for the corporate loan books of banks that made these loans than the previous cycle, which ran from 1990 to 1993. For JPMorgan Chase (JPM), Citigroup (C), Bank of America (BAC), and Bank of New York (BK)—as well as for their predecessor banks—net charge-offs for commercial loans were higher in 2000 than in 1990.

These banks made syndicated loans to investors that trade in CDS markets. While CDSs helped ease the banks' pain, the impact was marginal. Even though the more recent cycle was limited to the telecommunications, airline, and merchant energy industries, the severity of the losses was greater per defaulted loan, so loss rates were higher.

The overall impact on the banks was less noticeable in 2000-03 than in prior cycles for two reasons that were unrelated to shifting the risk elsewhere. First, there was no general economic downturn at the time, so other parts of the banks' business did well. Second, banks had become much more consumer-oriented than in the previous cycles, so profits from businesses like wealth management for well-heeled individuals offset weakness in corporate lending.

The proportion of corporate loans to total loans for the large complex U.S. banks was much lower in 2000-03 than a decade earlier, to the point that the higher charge-offs during 2000-03 had much less impact on bottom-line results.

Shedding Risk

The CDS markets' growth has been phenomenal since that time, and the market for investing in speculative-grade ("junk") names has grown. Yet U.S. banks active in the CDS market underwrite the majority of contracts as dealers. The CDSs that the corporate-lending commercial banks use for hedging their corporate books are relatively small. Lehman Brothers Holdings (LEH), UBS (UBS), Deutsche Bank (DB), and JPMorgan control the bulk of the CDS market. JPMorgan alone has a 30% share (based on company data).

The primary purpose of the CDS market is not to hedge bank credit risk but to enable nonbank players to take positions on credit strategies without the large funding costs associated with bonds or loans.

Credit has become a traded product, complete with a full range of arbitrage strategies beyond simple default probabilities.

Thus, hedge funds have become almost as large a presence in the CDS markets as banks. Neither banks nor hedge funds are markedly committed one way or the other on the market; instead, they tend to balance protection brought with protection sold. The net protection sellers remain the insurance companies and pension funds. The banks are net protection buyers in their hedging books.

Package Deals

Selling loans still seems the preferred way for banks to shed risk. The major U.S. commercial banks keep a small amount of the large corporate loans they originate. But while desired hold levels are modest and have been relatively easy to achieve because of the market's liquidity, this liquidity has recently raised the bar on the level of financing for the large leveraged buyouts that are dominating leveraged loan markets. The size of those deals has grown dramatically, prompting banks to take on larger pieces of the loans than ever before.

Also, sell-down periods are lengthening because of the additional time required to approve the deals, some of which involve regulated companies. Compounding matters, underwriting standards in these "covenant-lite" times reached a nadir, and the level of equity in deals stands at an all-time low.

Most recently, the market has soured on the loose terms and tight pricing of many of these deals, resulting in "hung" loans that the banks have not been able to sell and now have to hold on their books. Until they can restructure them and mark them to a market-clearing price, banks will have large, concentrated holdings on their balance sheets. The danger is that if the credit cycle turns abruptly, banks will get caught with larger write-downs.

It's No Panacea

Another tool that banks use to transfer risk is securitization, which broadens and diversifies the liquidity availability to the banks. In fact, the large banks have securitized more credit risk than they hold on their balance sheets. But securitization is no panacea—and it does not mean all risks are gone.

Indeed, investors in revolving asset classes cover only the most catastrophic levels of credit loss. In some cases, partial risk is transferred, but banks often retain speculative-grade tranches of the structures, so they will experience a portion of the credit losses that the entire pool of assets generates. Such retained interests generally make up about 3% of the assets securitized.

Banks Sell or Securitize More Loans Than They Keep
  Balance-sheet loans ($B) Loans sold and securitized ($B)*
JPMorgan 427 1,494
Citigroup 679 1,356
Bank of America 706 1,145
Wachovia 428 612
Wells Fargo 319 2,552

*Two years of syndication, mortgages on which banks retained servicing, commercial paper conduits, own loans securitized.

When considering the three broad methods of credit risk transfer—CDSs, loan sales, and securitization—the main benefit to banks has been an increase in asset turnover. By offloading more risks, banks can free capital to invest in their businesses. But they haven't really reduced their overall risk in comparison to previous periods.