Synthetic Risk Tranfers – July 2024

In the wake of the financial crisis, banks around the world faced stricter rules regarding capital requirements in certain asset types as regulators took measures to reduce systemic risk in the banking sector. Synthetic Risk Transfers (SRT) are derivatives that enable banks to transfer credit risk on a bundle of loans and pays a fee to whoever buys them, while retaining ownership of the loans and receiving interest income on it. SRTs are popular in Europe and are gaining ground in the United States. An example: a bundle of loans worth 100$ is divided into three tranches. The first two tranches are worth typically 5-15% of the loan and are sold to hedge funds or private-credit funds who receive a floating-rate coupon that typically lasts 3-7 years. The bank maintains the last tranche. Therefore, if only half the loans are paid back, the bank would lose roughly 40% (instead of 50% if fully covered), granting exposure while lowering risk. According to the Economist, last year banks issued $25b in SRTs, off-loading perhaps some $300b in risk. Lenders have access to the Federal Reserve who can swap long-term assets (like an SRT) for cash. SRTs are also sometimes recycled and used as collateral against loans (even from the banks who issued the SRTs), potentially causing a leveraged debt doom-loop.