The Big Idea
New Fed guidance on credit-linked notes
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.
Banks this week got a clearer picture of how they might use credit-linked notes to transfer risk to outside investors and reduce regulatory capital, thanks to newly released comments from Fed staff. The comments came in a September 28 post on the Fed website and suggest the Fed wants to see specific features in a CLN to grant capital relief. In particular, CLNs issued out of a special purpose vehicle should trigger capital relief while those issued directly by the bank without an SPV may not. A lack of clear guidance from US bank regulators has limited use of CLNs in the past, but the recent comments from the Fed may give new life to the sector.
Credit-linked note transactions
CLNs involve the issuance of notes to external investors in exchange for cash. These transactions are synthetic as the reference assets, usually a pool of loans, remain on the bank’s balance sheet. If there are credit losses on the loans, the principal amount due on the notes is reduced. Because of this external credit protection, banks may be able to reduce the required capital for a given portfolio by 60% to 80%. For residential mortgages carrying a 50% risk weight, this can be reduced to a 20% risk weight, and for other commercial and consumer loan types carrying a 100% risk weight, this may also be reduced to a 20% risk weight. There have been several CLN transactions issued in the U.S. over the past few years (Exhibit 1).
Exhibit 1: CLN transactions by U.S. banks
Source: Bloomberg, Santander US Capital Markets LLC
Structure matters
In some synthetic securitizations, the bank transfers the risk of a reference pool to an SPV, which then issues the CLNs and receives cash. The bank then enters into a guarantee or credit derivative with the SPV, and the cash is viewed as collateral supporting the SPV’s performance of that guarantee or credit derivative (Exhibit 2). This structure generally meets Fed requirements to achieve regulatory capital relief.
Exhibit 2: SPV issuance structure
Source: Santander US Capital Markets LLC
Alternatively, banks may not use an SPV and issue CLNs directly out of the bank. Here, while substantially and economically similar to the SPV structure, it is less clear that bank-issued CLNs meet the definition of a synthetic securitization. To recognize the credit risk mitigation of the synthetic securitization, the credit derivative must be executed under standard industry documentation, which has not always been the case with bank-issued CLNs.
Perhaps more importantly, the credit risk mitigant usually requires collateral such as cash. With a bank-issued CLN, the cash is considered by regulators to be property owned by the bank, but not collateral for the credit derivative as required by the synthetic securitization rules. This is a distinction that some market participants may find to be without economic substance, but regulators view this as very important, and therefore bank-issued CLNs do not automatically qualify for capital relief.
While not meeting the letter of the law, the Fed does recognize that direct-issued CLNs may substantively transfer risk in the same manner as SPV-issued CLNs, and therefore a bank may request a reservation of authority under the capital rules to achieve relief. In this case, better to ask for permission than forgiveness.
This material is intended only for institutional investors and does not carry all of the independence and disclosure standards of retail debt research reports. In the preparation of this material, the author may have consulted or otherwise discussed the matters referenced herein with one or more of SCM’s trading desks, any of which may have accumulated or otherwise taken a position, long or short, in any of the financial instruments discussed in or related to this material. Further, SCM may act as a market maker or principal dealer and may have proprietary interests that differ or conflict with the recipient hereof, in connection with any financial instrument discussed in or related to this material.
This message, including any attachments or links contained herein, is subject to important disclaimers, conditions, and disclosures regarding Electronic Communications, which you can find at https://portfolio-strategy.apsec.com/sancap-disclaimers-and-disclosures.
Important Disclaimers
Copyright © 2024 Santander US Capital Markets LLC and its affiliates (“SCM”). All rights reserved. SCM is a member of FINRA and SIPC. This material is intended for limited distribution to institutions only and is not publicly available. Any unauthorized use or disclosure is prohibited.
In making this material available, SCM (i) is not providing any advice to the recipient, including, without limitation, any advice as to investment, legal, accounting, tax and financial matters, (ii) is not acting as an advisor or fiduciary in respect of the recipient, (iii) is not making any predictions or projections and (iv) intends that any recipient to which SCM has provided this material is an “institutional investor” (as defined under applicable law and regulation, including FINRA Rule 4512 and that this material will not be disseminated, in whole or part, to any third party by the recipient.
The author of this material is an economist, desk strategist or trader. In the preparation of this material, the author may have consulted or otherwise discussed the matters referenced herein with one or more of SCM’s trading desks, any of which may have accumulated or otherwise taken a position, long or short, in any of the financial instruments discussed in or related to this material. Further, SCM or any of its affiliates may act as a market maker or principal dealer and may have proprietary interests that differ or conflict with the recipient hereof, in connection with any financial instrument discussed in or related to this material.
This material (i) has been prepared for information purposes only and does not constitute a solicitation or an offer to buy or sell any securities, related investments or other financial instruments, (ii) is neither research, a “research report” as commonly understood under the securities laws and regulations promulgated thereunder nor the product of a research department, (iii) or parts thereof may have been obtained from various sources, the reliability of which has not been verified and cannot be guaranteed by SCM, (iv) should not be reproduced or disclosed to any other person, without SCM’s prior consent and (v) is not intended for distribution in any jurisdiction in which its distribution would be prohibited.
In connection with this material, SCM (i) makes no representation or warranties as to the appropriateness or reliance for use in any transaction or as to the permissibility or legality of any financial instrument in any jurisdiction, (ii) believes the information in this material to be reliable, has not independently verified such information and makes no representation, express or implied, with regard to the accuracy or completeness of such information, (iii) accepts no responsibility or liability as to any reliance placed, or investment decision made, on the basis of such information by the recipient and (iv) does not undertake, and disclaims any duty to undertake, to update or to revise the information contained in this material.
Unless otherwise stated, the views, opinions, forecasts, valuations, or estimates contained in this material are those solely of the author, as of the date of publication of this material, and are subject to change without notice. The recipient of this material should make an independent evaluation of this information and make such other investigations as the recipient considers necessary (including obtaining independent financial advice), before transacting in any financial market or instrument discussed in or related to this material.
