Historically, synthetic trades were also used to replicate arbitrage deals (or even to give investors exposure to multiple arbitrage deals on a leveraged basis), but this sort of transaction has been regulated out of existence following the global financial crisis.
However, it is for purposes of capital relief that CRT trades really come into their own. Understanding how this works is paramount for both issuers and investors, given the extent to which the applicable capital rules drive structures and transaction features.
Issuer motivations
The prudential rules applicable to banks worldwide stem from the Basel framework, an internationally agreed set of measures developed by the Basel Committee on Banking Supervision (BCBS). These rules are translated into the local rules of the bank’s home jurisdiction with varying degrees of fidelity.
Amongst the various requirements relating to capital adequacy, banks must (as a base requirement, before capital buffers and regulatory add-ons) hold capital for credit risk in an amount equal to 8% of the risk weighted asset amount associated with each of their banking book assets.
The risk weighted asset amount can be determined in a variety of different ways, but fundamentally reflects the risk that the asset will not perform. The risk weighted asset amount associated with an asset can be reduced by purchasing credit protection on it (this is called “credit risk mitigation”):
- A bank can purchase protection on a single asset (or group of assets), whereby the protection seller simply compensates the bank for all, or a pro rata share, of its losses in the event that the asset(s) default. For example, for every dollar I lose on the asset(s), you pay me 40 cents. Subject to meeting the applicable local regulatory requirements, this allows the bank to (broadly) substitute the risk weight of the protection provider (or any collateral that it provides) for the risk weight of the underlying borrower(s).
- Alternatively, a bank can take a portfolio of assets, segment it into two or more credit tranches (thus creating a securitization from a Basel perspective), and purchase credit protection on one or more tranches. If one of the loans defaults, the losses which the originator suffers in relation to the default are notionally allocated to the tranches, starting from the bottom up. So, if the junior tranche is placed with an investor, it (and hence the investor) will absorb the first losses suffered by the portfolio. Each tranche will have a defined attachment and detachment point, i.e. a percentage at which it starts and stops absorbing losses. The structure results in risk weighted asset amounts for the securitization tranches that differ markedly from the risk weighted asset amounts that would be associated with an equal nominal amount of investment in the underlying assets.
Junior securitization positions are associated with much higher risk weighted asset amounts, while senior tranches are associated with much lower risk weighted asset amounts (because the junior tranches create a “buffer” against losses being incurred on the senior tranche). By purchasing credit protection on junior and/ or mezzanine securitization tranches, the originator can, subject to meeting the applicable regulatory requirements: (1) de-recognize the securitized assets altogether from a prudential perspective, instead recognizing securitization positions; and (2) broadly, substitute the risk weight of the protection provider (or in funded protection the collateral) for the risk weight of the securitization positions that are placed with investors.
This technique is known as “significant risk transfer” in Europe, and achieving a preferential risk waiting for a retained senior tranche is often the main aim for CRT trades. Alternatively, the originator can (subject to meeting the applicable, somewhat less onerous, regulatory requirements) de-recognize the securitized assets altogether from a prudential perspective and instead effectively deduct from capital the entire amount of its retained securitization positions (this technique is known as the “full deduction option”, it will only be economically efficient if the retained tranches are small).
Ultimately, the entry into the transaction reduces the amount of capital that the originator will have to hold against the portfolio going forwards. In very simple terms, the trade makes sense for the originator if the cost of funding the securitization, taking into account its capital saving, is cheaper than funding the assets on balance sheet
CRT trades can be generally useful for any bank looking for non-dilutive tools to manage its risk weighted assets, but can be particularly important for banks who cannot easily access other balance sheet optimization tools (for example, privately owned challenger banks, who may not be able to issue more conventional capital instruments), or where it is difficult or inconvenient for the bank to actually transfer the assets.
CRT can also be advantageous over other forms of securitization and syndication more generally, as it allows the bank to transfer credit risk only, rather than all risks and rewards associated with the assets, and to transfer certain tranches only, which means that you do not have to find investors to take the “full stack”. If the issuing bank is principally interested in capital relief on the relevant portfolio, and is de-prioritizing other aims such as funding, then a CRT trade can be a sharper tool.
Investor motivations
From an investor perspective, a CRT trade allows participation in a portfolio on a leveraged basis. By taking the first loss or mezzanine position, the investor is able to amplify the return on its investment, and is taking a view that the premium it receives for its credit protection will outweigh any losses allocated to it following defaults. Put another way, the regulatory risk weights of the pre-securitization positions for the bank do not, in the eyes of the investor, reflect the actual likelihood that they will default.
CRT trades can represent an attractive focus for specialist investors, or an opportunity to diversify within a wider strategy. Investors can also use CRT trades to access portfolios that are otherwise hard to syndicate, and there are a number of synthetic deals on “green” collateral (e.g. wind farm loans) that would not have been possible using traditional techniques.
