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Is the Synthetic Risk Transfer Market in the US Heading Towards Risky Leverage?

JPMorgan shifts $20 billion loan risk in landmark SRT deal, raising regulatory concerns over true risk transfer.

6/11, 19:27 EDT
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Key Takeaway

  • JPMorgan executed a major Synthetic Risk Transfer (SRT) deal, shifting $20 billion in loan risk to hedge funds and nonbank investors.
  • Concerns arise as some investors financed their stakes by borrowing from banks like Nomura, Morgan Stanley, and NatWest, potentially keeping risk within the banking system.
  • The SRT market saw $25 billion in deals in 2023, with US banks increasingly using leverage to enhance returns on broader loan portfolios.

JPMorgan's Synthetic Risk Transfer Deal

JPMorgan Chase & Co. recently executed one of the largest Synthetic Risk Transfer (SRT) trades, shifting the risk of losses from $20 billion of its loans. This deal, struck late last year, involved transferring potential loan losses to hedge funds and other nonbank investors. However, some of these investors financed their stakes by borrowing from other banks, including Nomura Holdings Inc., Morgan Stanley, and NatWest Group Plc. This practice has raised concerns among regulators about the true transfer of risk. Sheila Bair, former head of the Federal Deposit Insurance Corp., commented, "If a bank’s lending against the SRT instrument as collateral, you’re clearly not transferring the risk outside the banking system."

Market Dynamics and Participants

The SRT market saw banks issuing about $25 billion in 2023, partially offloading the risk of $300 billion in loans. Market participants estimate that 10% to 50% of the money for these deals could be borrowed. The US Federal Reserve is closely monitoring this trend to ensure that risk is not merely being transferred between banks. Kaelyn Abrell, partner at ArrowMark Partners, noted, "They want to make sure if a bank issues an SRT it doesn’t just end up transferring risk between banks."

The SRT market has been more common in Europe, but it gained traction in the US in 2023 as banks sought to comply with Basel III capital rules. JPMorgan's recent sale, which transferred $2.5 billion of loan risk through synthetic bonds, was described as a "landmark" by Douglas Charleston at TwentyFour Asset Management. Other buyers included Blackstone Inc. and Dutch pension fund PGGM NV.

Financing and Leverage

To finance these trades, some firms seek outside financing, often through repurchase agreements (repos) or net asset-value (NAV) loans. LuminArx Capital Management, for instance, used a non-repo form of borrowing for its JPMorgan deal. Alan Shaffran, senior portfolio manager at Magnetar, stated, "Leverage in various forms has been employed by most investors on recent US SRT deals."

European and Canadian SRTs typically involve only the riskiest portions of a bank’s loans, offering higher returns. In contrast, US SRTs are broader, requiring buyers to insure larger portions of the debt, which yields less. This creates an incentive to use borrowed money to enhance returns. Jason Marlow, a managing director at Barclays Plc, explained, "In the US we’re seeing thicker tranches on potentially higher quality portfolios and the net effect is much lower coupons. So different forms of leverage are necessary."

Street Views

  • Sheila Bair, Former FDIC Chair (Bearish on SRTs with bank-provided leverage):

    "If a bank’s lending against the SRT instrument as collateral, you’re clearly not transferring the risk outside the banking system. Any counterparty investing in SRT using bank-provided leverage should be prohibited, full stop."

  • Kaelyn Abrell, ArrowMark Partners (Cautiously Optimistic on Fed's focus on SRTs):

    "The US Federal Reserve is very focused on this topic. They want to make sure if a bank issues an SRT it doesn’t just end up transferring risk between banks."

  • Douglas Charleston, TwentyFour Asset Management (Bullish on JPMorgan's synthetic bond sale):

    "[JPMorgan’s sale late last year] was a landmark given its scale."

  • Alan Shaffran, Magnetar Capital (Neutral on leveraging in US SRT deals):

    "Leverage in various forms has been employed by most investors [on recent US SRT deals]."

  • Jason Marlow, Barclays Plc (Neutral on leveraging for higher returns in US SRTs):

    "In the US we’re seeing thicker tranches on potentially higher quality portfolios and the net effect is much lower coupons. So different forms of leverage are necessary."

Management Quotes

  • Richard Robb, CEO of Christofferson Robb & Co.:

    "We don’t use repo leverage that could expose our funds or investors to margin calls... We’ll leave that risk for the other guy."