A financial tool that has made waves in recent years could resurge with a different purpose.
As scrutiny of lenders with high concentrations in commercial real estate loans continues, credit risk transfers could offer a way out for the banks. Banks have used the financial instruments for years to free up room on their balance sheets, and the transactions became more popular in the U.S. in 2023, when regulators seemed poised to increase capital requirements.
Now, the potential burden of stricter capital rules seems to be in the rearview mirror, but the risks associated with large exposures to commercial real estate loans remain under the regulatory microscope. Credit risk transfers could be a strategy for banks to bring down their concentrations in those assets.
Last month, Third Coast Bank in Texas struck a $200 million securitization secured by interests in a portfolio of loans to finance the construction of 11 residential planned communities across Houston, Dallas and Austin. EJF Capital, a global asset management firm, structured the transaction to transfer the risk from the bank's balance sheet.
Bart Caraway, president and CEO of Third Coast, called the $5 billion-asset company's first securitization "a landmark achievement" in a prepared statement at the time. The transaction should "improve the diversity of the bank's on-balance sheet loan portfolio," the release said.
"By converting a portion of our loan portfolio into marketable securities, we have not only reduced our concentration in commercial real estate, a key focus for regulators and source of potential risk, but also improved our risk-based capital ratios," Caraway said last month during the company's first-quarter earnings call. "The securitization allows us to redeploy capital more effectively into new lending opportunities."
Hundreds of banks, whose bread-and-butter is lending against real estate, have triggered a regulatory benchmark for scrutiny — CRE loans that make up more than 300% of a bank's capital.
Getting below that level "really matters for banks," Bisanz said.
Credit risk transfers have been used in Europe for years, and as they've gained steam in the U.S., have been utilized by national and global institutions like Huntington Bancshares, U.S. Bancorp and Santander Holdings USA, a subsidiary of the Spanish giant Banco Santander. Smaller regional and community banks haven't engaged in as many credit risk transfers, but outsized CRE loan books are more likely to be a problem for those institutions.
Before Third Coast's recent deal, its CRE exposure was around 350% of capital. The transaction brought that ratio down some 10 to 25 basis points, Chief Financial Officer John McWhorter said during last month's earnings call.
Third Coast is also deep in construction and development lending — an area that regulators see as risky if concentrations exceed 100% of total capital. As of the first quarter, the Texas bank's ratio was 146%. The deal with EJF helped reduce that metric to near 130%, Third Coast's CFO said.
The Texas bank may consider future securitizations, depending on investor demand, McWhorter added.
But credit risk transfer deals, especially those focused on bringing down CRE exposures, are far from ubiquitous.
Credit risk transfers focused on CRE aren't as widely considered because of their complexity, according to Bisanz. It took about a year to pull together the Third Coast deal, he said.
"There are a lot of complicated regulations at stake," Bisanz said. "So even compared to a normal CRT, there are a lot of needles you have to thread."
While credit risk transfers have become more common since 2022, a recent Moody's survey of banks found that "despite significant interest," issuance has still been quite modest. Of the 69 respondents, only 15 banks — most of them large regional or global institutions — had issued credit risk transfers.
Warren Kornfeld, senior vice president at Moody's, said in an interview that the number of new transactions has slowed in recent months, as fears of a hike in capital requirements have dissipated.
"We're probably seeing a shift over from capital build or to, with respect to risk, focusing really on risk transfer," Kornfeld said. Banks may ask, "'Where am I a little bit too concentrated in a particular asset class?'" he noted.
Credit risk transfers allow banks to avoid taking losses on commercial real estate loans made when interest rates were low, which are now less valuable, Bisanz said. Selling the loans outright could cause some pain as banks would have to realize mark-to-market hits.
Banks that use credit risk transfers can also keep providing products like payroll servicing and investment banking to the borrowers. Getting rid of the debt entirely can lead to a rift in those client relationships.
With tougher capital requirements looming, a number of regionals including U.S. Bancorp, Huntington and Santander are using these new instruments to share risk with nonbank investors and lighten their capital load. Experts point out the pros and cons.
Bisanz said the logistics of CRE credit risk transfers can be tricky, and they are structurally different from other types of the deals.
CRE assets are more idiosyncratic.
"It's much harder to assess the credit risk if you're an investor," Bisanz said. "If I'm an investor coming into a pool of auto loans or even a pool of corporate loans, I know that they're all within general credit standards. I can get FICO scores or other kinds of ratings on them. I can't really do that with CRE."
Ideally, the credit risk transfers are backed by well-performing, low-risk commercial real estate assets, Bisanz said, so that banks aren't having to mark down unrealized losses on sour debt. But it takes deep knowledge of CRE to gauge the value of these securitizations, he said.
Kornfeld said he thinks credit risk transfers are generally better options for larger companies with more sophisticated risk management frameworks.
These transactions aren't for everyone, Bisanz said.
Many banks have used other strategies to bring down CRE exposures. Some lenders, like First Foundation in Dallas, Valley National Bank in New Jersey and Dime Community Bancshares have raised huge pots of equity to rework their balance sheets as they diversify their loan books. Flagstar Financial in New York got a $1 billion capital infusion last year that came with an all-new management team.
Some banks may sell outright to other banks, Bisanz said. He added that he thinks most banks with high CRE concentrations will either raise equity or be acquired.
"[My strategy] is a little more elaborate, and it requires more attention, but it also lets you keep your bank," he said.
