US Senator Jack Reed urges the Fed to place additional guardrails around CRTs

Senator Jack Reed (D-RI) has called on the Federal Reserve to create stricter regulations on credit risk transfer (CRT) transactions. The US senator made the calls in a letter to the Federal Reserve, in a development that comes nine months after he wrote to the regulator warning that the risks of CRT trades “may not be fully understood”.

This time around, Senator Jack Reed claims that synthetic risk transfer transactions are being overly leveraged. As outlined in the letter, the senator emphasises and questions whether leveraged CRTs truly transfer credit risk, noting: “the use of bank-provided leverage raises serious questions about whether CRTs truly transfer credit risk to outside investors or further concentrate risk among a small number of Wall Street banks.”

Additionally, the senator requests that the Federal Reserve Require public regulatory reporting (through bank call reports and systemic risk reports) of information regarding each bank’s use of CRTs, including the amount of risk transferred, the associated capital relief, the identities of the counterparties, the amount of risk transferred to each counterparty, and the credit quality of assets in each reference pool.

One CRT investor describes the letter as another “shot across the bows” for CRT by US banks. They note: “Fundamentally, there are a few aspects which do not align fully with practitioners’ view of the market. Firstly, you note a the comments around leverage. SRT leverage is usually done by a normal repo instrument the same as any other market  repo which banks carry out on other instruments without any specific limitation. Then, the suggestion that banks have to disclose who their SRT investors are is a significant step – query in what other type of transaction is a bank obliged to disclose publicly who their counterparties are?”

They continue: “He also suggests that banks should required to disclose the amount of capital relief obtained, which is of course required to be disclosed to regulators here in Europe at inception and periodically; the point is that for prudential oversight this is useful, but public disclosure assumes a level of understanding of the complexity of these calculations in the recipient of the information.”

Asked if such assessment and critique of the asset class is slowly gaining momentum in the US, the investor views that Senator Reed’s letter is a “concern.”

They say: “Although Senator Reed is perhaps right in saying that there should be some type of stronger oversight, what strikes me is that there is a suggestion that banks are doing something in the shadows, which is not the case.”

Conceivably, the underlying sentiment of such letter might be viewed as a lobbying case towards a more classical capital market instrument with more broadly syndicated deals. Again, the investor expresses scepticism: “That is sort of what they are implying in this letter. However, why are bilateral transactions a problem? Often deals are closed bilaterally (after a syndication process) because the financial arrangement is such that it's bilateral. If CRTs were to become more of a classic DCM instrument, it then becomes less of a risk-sharing transaction.”

Vincent Nadeau