Private Equity and Hedge Funds Buying US Bank Bonds Amid Surge in Loan Losses

Investment in 'Credit Risk Sharing Transactions'
Private Equity and Hedge Funds Expect Returns
Banks Maintain Customer Relationships
Mutual Understanding Aligns Interests

Private equity and hedge funds are buying bonds issued by U.S. banks, such as auto loans and mortgage-backed securities, Bloomberg reported on the 23rd (local time).

Due to the impact of interest rate hikes, banks experienced unrealized losses amounting to $683.9 billion (approximately 916 trillion KRW) on securities in the third quarter of last year. Additionally, small lending institutions are also facing difficulties due to commercial real estate. Bank credit related to commercial real estate, maturing by 2028, amounts to about $1.5 trillion (approximately 2,008 trillion KRW).

[Image source=Reuters Yonhap News]

The unrealized losses on investment securities held by U.S. banks have rapidly increased since the first quarter of 2022 due to the Federal Reserve's (Fed) interest rate hikes. Kaelin Abrell, Financial Partner and Portfolio Manager at ArrowMark Financial, stated, "It has increased significantly compared to before," adding, "Over the past two years, banks in the U.S. and Canada have executed various loans ranging from revolving credit to auto loans."

Private equity and hedge funds are investing their capital in such 'credit risk-sharing transactions' expecting to generate double-digit returns at most. Moreover, banks and these funds have aligned interests as banks can maintain relationships with their customers. Bob O'Leary, Director at private equity firm Oaktree Capital Management, said, "Both regional and large banks are carrying significant losses on their balance sheets," adding, "There is no need to recognize the losses immediately, but risk managers are likely feeling quite uncomfortable and will try to avoid the risks."

Furthermore, Basel III regulations have influenced the increase in such transactions. U.S. banks revived the sale of credit-linked notes last year ahead of the introduction of Basel III regulations, which require banks to hold more capital to strengthen capital adequacy. Bloomberg explained, "Using credit default swaps on bonds essentially means that the issuer transfers credit risk to investors."

Major clients include hedge fund Magnetar Capital, private equity firms Ares Management and KKR & Co., and Blackstone. Bloomberg reported, citing sources, that hedge fund GoldenTree Asset Management earned a 15% profit last year from a $10.7 billion (approximately 14 trillion KRW) master fund because it held synthetic risk transfer products from European banks. It also added that Man Group, the world's largest publicly traded hedge fund, is entering this field. Eric Burl, Head of Discretionary Investments at Man Group, said last month, "Banks worldwide are looking at risk transfer methods more than ever."

Some express concerns about the increasing transactions transferring bank risks. Sheila Bair, former Chair of the U.S. Federal Deposit Insurance Corporation, pointed out in an interview with major media last month, "Non-bank buyers may lack the ability to manage losses, which could make the financial system less stable." On the other hand, the International Credit Portfolio Managers Association rebutted this claim, stating that even if credit deteriorates, counterparties do not disappear and act as long-term partners to banks. O'Leary said, "More banks interested in discussing risk transfer transactions with us are emerging. These are simply mispriced high-quality assets."

This content was produced with the assistance of AI translation services.