Demand for high-yield products and shadow banking growth bring back intricate financial products
Earlier this year, Bayview Asset Management structured two trades totaling $642 million, reminiscent of financial instruments last seen during the 2008 crisis. This hedge fund sold insurance against losses on a loan portfolio to two U.S. lenders and subsequently distributed much of that risk to investors.
The transactions, a form of re-securitization, involved Bayview selling credit default swaps (CDS) to Huntington and Sofi late last year. These trades echo pre-crisis practices, modeled on transactions by a major U.S. bank before the financial meltdown, according to Moody’s reports and a source familiar with the deals.
Huntington conducted the trade as part of a “capital optimization strategy” in the fourth quarter, though it declined further comment on the specifics of the transactions. Similarly, Sofi only disclosed that it entered a CDS on student loans, enhancing its risk-based capital ratios by over 1%.
These re-securitizations share the complexity and opacity of financial products like collateralized debt obligations, which exacerbated the 2008 financial crisis. Their resurgence highlights how Wall Street practices that once dispersed risk in misunderstood ways are returning, albeit in new forms. The growing demand for high-yield products, amid expectations of an easing Federal Reserve rate cycle and the rise of shadow banking and private markets, is driving this trend.
Experts argue that these contemporary trades offer more protections than their crisis-era predecessors, such as upfront cash requirements to mitigate counterparty risk. However, they caution that these structures might conceal systemic banking issues, potentially making balance sheets appear healthier than they are.
Jill Cetina, a finance professor at Texas A&M University, emphasized the need for regulatory oversight, suggesting banks disclose more about their use of credit risk transfers (CRTs). She noted that while these transactions transform risk, they do not eliminate it, posing potential issues during a credit downturn.
Deal Mechanics
Bayview, managing $18.5 billion, sold CDS to Huntington National Bank, Sofi Bank, and Sofi Lending in late 2023. These lenders insured against up to 12.5% of losses on a $5.2 billion portfolio of auto and student loans. By March and April 2024, Bayview had securitized these CDS, creating bonds and selling portions of the risk to other investors.
These investors, whose identities remain undisclosed, will receive part of a 7.5% annual insurance premium paid monthly by Huntington. Sofi’s deal involves monthly fixed and floating premium payments. Bayview profits from the arbitrage between the transaction structuring costs and the received premiums, while retaining some risk on its books.
Structural Safeguards
The Bayview transactions include several protections absent in pre-crisis deals. Raised funds are deposited into a cash collateral account, and insurance buyers’ premium payments are backed by letters of credit from institutions like Wells Fargo, Federal Home Loan Banks, and Goldman Sachs.
Moody’s estimates the net loss for Huntington’s loan pool at 0.50%, with 4.5% as maximum net losses in a stressed scenario, both below the 12.5% protection threshold. This indicates banks are addressing capital, not asset problems, making such high-quality asset risk attractive to investors.
Scott Kenney, a senior analyst at Columbia Threadneedle Investments, indicated that more such deals are likely, with Columbia Threadneedle already in discussions with a bank for a similar transaction. This suggests a growing trend of returning to complex financial structures, driven by evolving market demands and financial strategies.
