The Hottest Way for Banks to Get Risk Off Their Balance Sheets

Joe Weisenthal (0:03)

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Tracy Alloway (0:20)

Hello, and welcome to another episode of the Odd Lots Podcast. I'm Tracy Alloway.

Joe Weisenthal (0:25)

And I'm Joe Weisenthal.

Tracy Alloway (0:27)

Joe, do you ever wonder what this show would have been like if we had been doing the podcast before 2008?

Joe Weisenthal (0:33)

Well, we would have had plenty to talk about. You know, I actually have it right? It would have been, man, now I wish we had. We would have had like five bonus episodes every single week, so there was just so much content on those days.

Tracy Alloway (0:44)

I'm actually glad we weren't doing it back in 2008 because I feel like that was a time when we, along with everyone else in the market, were still learning a lot about how everything works. But the one thing I'm kind of sad about is, there was a lot of interesting stuff happening in structured finance, in the securitization market back then, lots of interesting deal structures. There aren't that many of those since 2008 for obvious reasons.

Joe Weisenthal (1:13)

No, you're totally right. We don't do many credit default swaps episodes, or CDOs, or various other versions of structured finance, which I know that you've covered quite a bit. You hear about that stuff a little bit less. But yes, that would have been a buffet of topics for us to choose from back then.

Tracy Alloway (1:32)

A buffet is a good way of putting it. I'm very happy to say this is an episode I have wanted to do for a while. We are going to gorge ourselves on a particular type of structured finance deal. Something that's been happening in the market for a number of years now, but it really seems to be booming in some respects in recent years. We're going to be talking about Synthetic Risk Transfers or SRTs.

Joe Weisenthal (1:58)

I have to admit that up until like two days ago, I had no idea what a synthetic risk transfer is. I also still don't have any idea what a synthetic risk transfer is. But I get the impression that basically, this is what I seem to know based on a couple of things I've read. There's only so much risk or balance sheet that a regulated financial institution like a bank is supposed to take. And at some point, if they want to continue to make loans and continue to maintain a relationship with a client, whoever it is, some of that risk in order for regulatory balance sheet purposes, whatever, has to be unloaded to some third-party entity.

Tracy Alloway (2:38)

Right. So the interesting thing about these transactions is they didn't always used to be called synthetic risk transfers. I remember, I mean, I am so old that I remember when they were just called balance sheet securitizations or synthetic balance sheet CLOs, collateralized loan obligations. I remember when they were called regulatory capital trades or regulatory relief trades instead of SRT. And I think that name actually gives a much more concrete idea of what is happening here. So banks have portfolios of loans. They have to hold regulatory capital against those loans. Post 2008 and all the regulatory reform that we've seen, they have to hold more capital. And so they've looked at creative ways of lessening some of that burden. And one of the things they've come up with is this SRT idea. So this idea that you purchase basically insurance protection on a portfolio of loans. And then if you do it in the right way, you get to hold less capital against it. And it frees up your balance sheet, allows you to do more lending. Now, the interesting thing about these deals is, as I alluded to, they actually have a long history. Like in some respects, they're sort of the essence of securitization itself. This idea of risk transfer. And you can kind of trace the history all the way back to JP Morgan and the first Bistro trades and stuff like that. Maybe we'll get all the way back to the 1990s and JP Morgan in this conversation, I'm not sure. But there's definitely a lot to discuss, primarily why these things seem to be growing now. So I think there was about 25 billion worth of SRTs issued in 2023 The average number of banks that have been tapping the market has gone from something like eight in sort of the 2014 to 2020 period to something like 37 now. So that's a big jump. More banks are doing this.

Investors are getting interested in this. One funny thing that I just realized is like some of the... Do you remember the trade press on structured credit, like Structured Credit Investor? I used to read them all the time, sort of 2008 to 2010, and it was all about CDOs and RMBS and housing reform. It is now all about SRTs. So you can see the sort of like transition, the evolution of the market happening in real time.