Firms can take risk off balance sheet by selling the risk associated with assets to third parties, often hedge funds, willing to take on the risk and associated rewards. Banks, for example, can transfer risks in their loans to these third parties. That makes sense for banks wanting to reduce risk to free up regulatory capital and make more loans. The instrument is a “credit risk transfer” or CRT. By 2023, this market for this facility had risen to $24 billion according to credit investor Chorus Capital (Financial Times, December 7, 2024). That makes sense for banks wanting to reduce risk to free up regulatory capital. And it distributes risk throughout the economy rather than have it concentrated in vulnerable firms, a desirable effect.
But beware. The escalation of risk with credit default swaps (CDS) in 2007-2008, also a device to spread the risk around, had unhappy consequences. In 2008 AIG could not honor CDS claims and collapsed, with the defaulting cascading to other firms now without the CDS insurance on the debt of other defaulting firms: Contagion. For these firms, risk was off balance sheet but came back to hit them. A CRT is a little different from a CDS, but the same worry remains: The default by a firm buying the instrument could spread to other firms. Firms taking on the risk are usually not as informed about the risk as (say) banks making loans to their customers, so are in a less favorable position to manage the risk. And, though there is usually no recourse with these instruments, they can come back and hit a bank if the third party is leveraging with loans from the bank when buying them. And, if banks make more risky loans because of freed-up regulatory capital, the cascading could magnify. Another historical event also brings warnings: In 2005-2007, banks sold off loans to third parties who then packaged them into mortgage-backed securities with little ability to monitor or manage the risk. You know what happened in 2008 and to banks…
The value investor has a mantra: When you see complicated transactions and instruments, beware. They can have long tentacles.