Actionable Alternatives: Synthetic Risk Transfer (SRT)
Text on screen: Actionable Alternatives Synthetic Risk Transfer
Images on screen: Exterior building, data center, airplane departing
Kraus: Today we're going to talk about synthetic risk transfer transactions, or SRT as they're commonly referred to.
Text on screen: Kristofer Kraus, Portfolio Manager
Text on screen: PIMCO provides services only to qualified institutions and investors. This is not an offer to any person in any jurisdiction where unlawful or unauthorized.
SRT involves the purchase of credit protection on a portfolio rather than on a single asset and can be a useful tool for banks seeking to manage their overall credit exposure and the use of capital supporting the balance sheet. Today you see a wide range of underlying asset types from consumer related risk, such as auto loans and student loans, to corporate related exposures.
FULL PAGE GRAPHIC TITLE: Originating Bank. The graphic illustrates a Loan Pool example with a box on the left labeled Loan Pool in green, followed by an arrow in blue labeled SRT, which means Synthetic Risk Transfer. The arrow points to a purple box on the right labeled Synthetic Senior Tranche (larger top part of box) and a blue box labeled First Loss/Junior Tranche (smaller bottom part). An arrow next to that blue box points to a white box on the right labeled PIMCO.
Banks are able to free up capital by selling into the private credit markets, the first loss tranche, this can be the zero to 10% part of a capital structure, for example. And for that the investor will be paid a yield for the risk that they are taking.
The bank does continue to retain exposure to the portfolio and will bear losses which exceed the protection provided by the investor’s SRT purchase.
Images on screen: London exterior, bank transaction
We have seen banks in Europe use SRT for many years as an effective tool for managing capital in the early days of the Basel rule rollout and subsequent versions of that.
FULL PAGE GRAPHIC TITLE: US SRT Market Issuance: 2021-2024. The bar chart shows Reference Notional Issuance in U.S. dollars (millions) on the left hand scale for each year starting in 2021. The first quarter of each year is shown in dark blue, the second quarter in green, the third quarter in magenta, the fourth quarter in light blue, and estimated second half of 2024 in gray. In 2021, SRT issuance for quarter 1, 2 and 4 totaled less than $10 billion. In 2022, total issuance for quarters 2 and 4 was approximately $15 billion. In 2023, total issuance for all four quarters was approximately $62 billion, with the bulk of issuance in the fourth quarter. In 2024, total issuance for quarters 1 and 2 was approximately $24 billion, with the estimated issuance for the second half of 2024 reaching $50 billion.
It has been adopted more recently by US banks following the approval of the Federal Reserve in September 2023.
Our view is SRT issuance in the United States will match the level of issuance we've seen in Europe and will have done so in less than a two year period of time from its rollout into the market.
Text on screen: Mark Kruzel, Business Development, Capital Markets
Kruzel: From a bank perspective, the key benefits of SRT include balance sheet management, giving
FULL PAGE GRAPHIC TITLE: Benefits to the bank and Benefits to investors. The graphic shows Benefits to the bank on the left including Risk Mitigation, Free Up Capital, Balance Sheet Management, Cost Efficiency, and Flexibility. The box on the right shows Benefits to investors, including Unique access, Leveraged exposure, Diversification, Cost Efficiency, and Flexibility.
banks a tool to be able to dynamically manage their capital requirements, concentration risk, and credit risk. From an investor standpoint, SRT actually gives us access to bank originated assets in a way we might not be able to replicate in other forums.
So let's talk about a hypothetical example of a bank contemplating raising capital and looking at their various alternatives.
A bank might consider raising capital to either buffer their own capital ratios, fund organic growth, or even something as strategic as contemplating M&A. There's generally three different alternatives that a bank could have to raise capital.
FULL PAGE GRAPHIC TITLE: Three ways a bank can raise capital. The graphic shows three boxes. The box on the left labeled number 1 is titled Raise Equity, illustrated by dollar sign and a bar chart as graphic icons. The box in the middle labeled number 2 is Sell Loans, illustrated by a hand and dollar bill graphic icons. The box on the right is labeled number 3 and is titled Enter into SRTs, or Synthetic Risk Transfers, illustrated by left and right graphic icons.
Number one is going to the equity markets directly. In today's market conditions that could be very expensive but it is open selectively. Number two is they could contemplate selling loans, but given today's interest rate environments, that's generally quite difficult 'cause there's a lot of embedded mark-to-market losses just given how high interest rates are today. Or they can contemplate an SRT whereby they will sell the equity risk, the credit risk of a certain portfolio, relieve the capital requirements of that book, and keep the assets on their balance sheet without actually transferring them into a structure or incurring any mark-to-market loss there.
The bank will generally drive the conversation of what assets to put into an SRT.
Let's say the bank considers to move forward on a mortgage SRT, they will put forward a portfolio, a suggestion of where the starting point for that kind of transaction would be.
We would take a look at the underlying portfolio, suggest tweaks around the edges based on our own preferences for asset selection, and also engage in a conversation with them on how much protection we want to provide them under the SRT structure.
FULL PAGE GRAPHIC TITLE: Structure can be tailored for bank priorities, investor preference, or other objectives. The graphic shows four boxes. The first box on the left in green is Bank Loan Pool, followed by an arrow with SRT (or Synthetic Risk Transfer) written on it. The second box to the right of the arrow is labeled Synthetic Senior, with the largest, top part shown in magenta, followed by Mezz A (short for Mezzanine loans) and Mezz B in varying shades of blue for each row, with Mezz C and First Loss Tranche shown at the bottom rows in varying shades of gray for each row. The third box is labeled Synthetic Senior on top in magenta (the largest part segment), followed by Mezzanine Tranche in blue and a smaller First Loss Tranche in gray at the bottom row. The fourth box is labeled Synthetic Senior in magenta on the largest, top part, followed by First Loss Tranche in a smaller blue row at the bottom.
There's a regulatory minimum of the amount of protection the bank is going to need, but there's also a fair degree of flexibility to be able to say maybe we want to offer a less levered or wider tranche to the bank, which gives us a slightly different risk proposition as opposed to a more highly leveraged structure, but also gives the bank themselves a little bit more flexibility in a downside scenario.
Our advantage in these conversations is generally our ability to operate across multiple asset classes. We're one of the few entities in the market that is truly flexible across so many different asset classes there. And it's because we have the ability to tap all of the resources that are PIMCO and all of our asset expertise across all the different verticals that we touch as an asset manager.
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