Inside Wall Street’s ‘SRT’ phenomenon
19:40 Share

If there's one ghost that's haunted Wall Street since the 2008 financial crisis, it would be the three-letter acronym. There's this natural, understandable fear of three-letter acronyms in finance. You know, I've heard people say, beware of bankers and their acronyms. That's Robin Wigglesworth. He's the editor of the FT's financial blog, Alphaville.

I talked to him the other day from our office in London, and what he's referring to are things like CDOs and MBSs, these complex financial products that brought the whole system crashing down. And Robin says that recently, there's a new three-letter specter that's spooking Wall Street's watchers.

Well, it goes by the acronym SRT or synthetic risk transfer. And, you know, SRTs, it almost sounds tragic, comically obtuse and dangerous, right? It even has synthetic in there, which definitely in finance historically has always been a code word for head to the hills. Right. It's like synthetic. It's not real. Yeah, exactly. It sounds like this is like the fever dream of some financial engineer and no good will ever come of it.

Robbins says that SRTs are so hot right now that they're in the process of moving from a wonky niche trend into the broader global financial system. But their popularity is also causing organizations like the International Monetary Fund to start raising its eyebrows.

Top line, what do you think of this fear of SRTs? Is it warranted? I think it's always warranted. I mean, I'm a financial journalist, so my job is kind of to be a little bit shrill and alarmist. But we've seen many, many times how cool new financial products eventually get, you know, sloppy, bad, lazy, and then maybe actually outright deliberately abused to the point where they cause carnage at some point.

I'm Michaela Tendera from the Financial Times. Today on Behind the Money, we're talking about the intersection of banking, risk, and regulation. Is the SRT fear the real deal? ♪♪

Hey, Robin. Welcome to the show. Hey, how's it going? Glad to be here. Great. Glad to have you here. So let's talk about this particular piece of financial engineering. Again, SRT stands for synthetic risk transfer. But, Robin, what does it actually do?

Yeah, so it's a bank that is essentially buying insurance on some of its loans going bad from an insurance company sometimes or a pension fund. Essentially banks buying insurance from investment funds against some of its loans going kablooey.

So as part of the name states, synthetic risk transfer is banks transferring their risk, a.k.a. their loans, from themselves and over to, well, elsewhere in the financial system.

So I started by asking Robin, where do these come from and what's their backstory? Well, the fun thing is that obviously America dominates the world in so many areas, and especially some financial innovation. But this is pretty much the only area maybe in finance where Europe is dominant over the U.S. And it's partially because the European banking regulators and politicians have been that much stricter with banks in Europe.

If you can remember back after both the financial crisis and the eurozone crisis, banks in Europe were in pretty bad shape. They had a lot of regulations slapped on them in the aftermath. And to avoid future bank failures, European regulators took a hard line.

We're going to make them hold way more capital and we're going to basically make a lot of stuff that they do less profitable and we'll basically push markets to do more of that heavy lifting. And ever since the financial crisis, we've been sort of finessing the rules, tightening them, plugging holes. And broadly speaking, that's worked out really well.

So today, banks have to hold a lot more in capital thanks to those post-crisis regulations. And so in case the bank's loans go south, the bank doesn't totally collapse. Yeah, so let's say one of these banks has like a billion dollars worth of grab bag of loans. You know, there'll be maybe some mortgages there, but mostly loans to Widget Maker Inc. or Acne Group or whatever. And it has to hold against that at least $100 million worth of capital.

And that is, you know, a bit of a drag. When Robin says "drag," what he means is that the banks have less flexibility. It can't pay its bankers the bigger bonuses that they might want or make new loans to people who need them. And that's where SRTs come in. The idea is that banks can do more of what they're supposed to do — make more loans, move more money around — if they can get insurance from investment funds instead of holding onto all that regulation-required capital themselves.

Now, that insurance is where the investment fund gets involved. I'm talking about like a hedge fund, a pension fund or some kind of asset manager. So they go to a club of investors, but let's just say one investor, like an investment fund that we all call generic Greek god capital because they all seem to be named after Greek or Roman gods and says, hey, you know, if you insure this,

The first $100 million worth of loss on this loan pool will pay you 10% a year. That's pretty juicy for what should be a pretty decent chunk of loans. But for the bank, a Citi or Deutsche Bank or Wells Fargo, well, they then have to hold radically less capital. So rather than $100 million of capital, you only have to set aside $10 million worth of capital. So that might be worth paying 10% a year to generic Greek gold capital.

So there you go. The investment fund offers to take the first hits on some bank loans in exchange for a nice return.

And the banks get to free up some of their capital, which makes me think of a six-letter phrase, win-win. It's actually a great marriage of convenience between banks and investment funds. Banks have, you know, a lot of loans. That's kind of the bread and butter of what they do. But after the financial crisis, we want banks to hold more capital against those loans. And that makes lending a little bit less profitable. And on the other hand, you have investment funds that are desperate for...

Places to put their money gainfully, like pretty safe places ideally, but somewhere they can earn a good risk-adjusted return. So it's actually something that works out pretty well for both parties in this structure. So big picture, when a bank uses an SRT, they're squeezing risk, that is loans, debt, leverage, you know, however you want to say it.

They're squeezing it out of the bank and into markets, which Robin says in a lot of ways can actually be a net positive. And so far, things have been working out pretty well. You know, we want banks to hold more capital and push more risks out of banks and into markets. And markets generally handle this stuff better, they're less leveraged. And when an investment fund goes belly up, it isn't nearly as destructive as when a bank goes belly up.

So we haven't really seen any examples of an SRT go bad. We've seen some that have had some of the loans that they guarantee go bad. And then the investors lose a bit of money. But nobody cries about that. So actually, so far, they're working pretty much as advertised. And that's kind of a good thing. In fact, Robin says that European regulators have given SRTs their stamp of approval.

That's played an important role in ushering in this current boom among banks that are doing deals like this. So, you know, there's a reason why regulators have actually blessed this. Like the European Central Bank, which is pretty hardcore, it does not mess around, it does not want banks to do stupid things, have looked at these things and have blessed them and saying this is genuinely actually a good thing.

But it doesn't take more than a very small leap of the imagination to see also why something that is fundamentally a good idea and a valuable financial innovation could mutate into something less positive over time. Because we've seen how humans do that again and again and again and again throughout history. So you recently reported, Robin, that this SRT trend is growing and becoming a lot bigger. Yes.

More than a trillion dollars worth of assets have been SRT'd, so to speak, since 2016. So why have they become so much more popular just over the last several years? Well, one side of it is just that it's very attractive for the banks and SRT's is a really useful tool. But for a long period, it was pretty expensive. It takes a bit of work to structure these things.

As more and more investment funds realized that you could get pretty attractive returns, and they were pretty safe and well-structured, money is kind of flooded in, especially into these private credit funds that, frankly, have more money than they know what to do with. So they are buying lots of SRT deals. Now, I think there are very few banks in Europe that haven't done at least one of these SRT deals.

In fact, you know, I've spoken to contacts who say if you haven't done one now, you kind of look weird. People will ask, why on earth haven't you done it? So it's kind of all happening right now for SRTs. They're this phenomenon that seems poised to just keep growing. But recently, some skeptics have put their hands up, and that includes the IMF.

Late last year, they put out a report warning about what could go wrong. And Robin took a close look at it. I was intrigued that the IMF gave it what I always call the Global Financial Stability Report treatment.

So this is a big report that the IMF does occasionally looking at everything that can go wrong in the global economy. And it's usually very, very top level stuff. And most of the stuff, touch wood, doesn't actually happen. But it's definitely a job that the IMF has taken more seriously ever since the financial crisis. And quite often, they'll do little breakout boxes and sections on smaller stuff.

as a sort of putting it on the agenda, letting people know, saying, hey, we've looked at this and this could potentially be a problem or this, holy cow, this is a major problem. And the IMF in its latest global financial stability report

So let's explore that a bit.

Robyn says that the IMF laid out a few key concerns. One of them has to do with looking more closely at the kinds of loans that banks are offloading to investment funds.

there's a worry that they're not as high quality as they once were. So, you know, if you go back five years ago, they'd be pretty solid, safe corporate loans. And increasingly now people are putting, I wouldn't say absolute sludge, but they are definitely putting stuff that is slightly risky into these structures because people want greater returns and the costs have come down. So inevitably there's a bit of almost a reach for yield situation where people are...

hungry for risky deals and banks are, let's face it, more than happy to supply them. But the biggest concern that the IMF has flagged has to do with something that Robin refers to as recycling risk. So the IMF's main concern is that banks are lending to investment funds that are investing in these SRTs.

So then in practice, the debt doesn't leave the bank per se. It just kind of gets recycled into the bank in a different form, in the form of loans to these investment funds. That's the IMF's main concern. They think they're getting offloading this risk onto others, but in reality, it hasn't really left their balance sheet. It's still sitting there.

It's like if it creates a house of cards of leverage. Yes, exactly. It just meshes every part of this ecosystem in this dance of debt, essentially. So the worry is if banks and investment funds are all intertwined, if one part collapses, it's that much easier for all of it to go down. And then there's the question of would we even know if something was going wrong? Yeah.

How transparent is this market? I mean, how clear can we see into what's really happening with SRTs in the global market? Not well at all, unfortunately.

There is a massive lack of data just on the top level of things, like how many deals. People do tally it, but it is not organized. It's not great. You see different numbers from different people. And unfortunately, the opacity gets worse the closer you look. Finding details of individual deals is very hard. These are bespoke private deals between banks and investors.

And it's very difficult to find out exactly what's gone into them. Yeah. How much does that worry you, I guess? Well, it worries me. I mean, it annoys me as a financial journalist would love to do a bit of like kind of scratching around and digging into and really kind of looking at the guts and the innards of these things. And I'm sure, let's say one bank has a very good idea of what they've done, who they've lent against and so on, but they don't see everybody else's deals.

So like the whole ecosystem and it's wrapped into things like private credit and the private capital ecosystem is not exactly blessed with an abundance of daylight and transparency. And I think that's unfortunate. It's one thing that the IMF also commented that, you know, we just don't know all the details here. So SRTs are here to stay. And as Robin says, they're risky, but also useful.

I wasn't sure what to think. So I asked Robin about three different ways he thought this could go. So, Robin, what would you say is the kind of worst case scenario if things go belly up here? Oh, worst case scenarios. So it's probably that both the structures that have so far, frankly, been pretty conservative, you know, but like are losing maybe a bit of their rigor get increasingly sloppy.

So banks think they're transferring the risk of some bad loans or loans going bad into the markets. Actually, it doesn't work out that way in practice at all, but they're still holding less capital. So they kind of have this horrible, nasty realization when there's a big

nasty recession that actually it had thought it would bought all this insurance against loans going bad. It doesn't work out that way for naughty, annoying legal reasons. And it has less capital and suddenly is looking really, really, really vulnerable.

And then that is compounded by the fact that the bank is lent into these SRT deals itself, in which case it's just problems upon problems upon problems. And they don't have enough capital and the bank goes bankrupt, essentially. Or enough people worry about the health of the bank that there is a bank run and the bank de facto becomes bankrupt. Yeah.

And then if there's enough of that with enough banks at the wrong time, then that could become a real systemic, like a big, nasty, horrible financial crisis. So on the other side of that, what is the best case scenario for these SRTs proliferating more into our financial system?

Well, the fundamental idea is that it is supposed to make banks safer by transferring risk out of the banking system and into capital markets where there's lots of investors who are quite happy and willing and able to take those risks for a fee. So it's kind of like a happy marriage between investment capital and banks, right?

that makes the banks safer and gives investors a healthy return. These structures become more streamlined, plain vanilla, more transparent, but we never lose that discipline. People kind of realize how it can go wrong. Regulators keep an eye on it. And essentially, it ends up being something that genuinely makes the financial system more efficient and safer at the same time, like a real, as Michael Stott from The Office might say, a win-win-win situation.

So give me your best prediction here. Let's say we're back here talking in the studio many years from now. Are we talking about SRTs having caused, you know, the great financial crisis of 2039? Probably not. Though, you know, predictions are very hard, especially about the future, as the cliche goes. I think they might be in the scene of the crime.

They might not be the main perpetrator of the financial crisis of 39, but they might be near the scene of the crime and have played some sort of a betting role, certainly not a helpful role. And that's not based on something I'm seeing now or hearing now at all. It's just the jaundiced view of cynical journalists who has seen how things get used, abused and misused over time as it kind of reaches maturity.

And then, you know, we haul back, realize that was really stupid. We shouldn't have done that. And the good financial inventions, they stick around, like securitization that helped cause the financial crisis of 2008. That's still around and a hugely valuable part of our financial system. We just kind of have to learn from our mistakes. Well, thank you for that prediction, Robin. And thank you for coming on the show. It's been great to talk with you. Yeah, no, thanks for having me on again. I love it.

Behind the Money is hosted by me, Michaela Tendera. This episode was produced by me, Safiya Ahmed, and Katya Kamkova. Sound design and mixing by Sam Giovinko and Joseph Salcedo. Original music is by Hannes Brown. Topher Forges is our executive producer. Cheryl Brumley is the global head of audio. Thanks for listening. See you next week.

Save up to 70% at Mattress Warehouse today and sleep better tonight, knowing you got the best possible price. So where would you look to find the perfect mattress? In a little mattress store or Mattress Warehouse? Visit MattressWarehouse.com