Shuffling Risk

An Asset Class Reborn

About a week before Christmas 1997, traders on JPMorgan’s New York fixed income desk picked up their phones to pitch a new product. For months, the bank had been working on ways to shed credit risk without sacrificing relationships with borrowers. A few years earlier it had persuaded a third party to insure it against Exxon defaulting, but had struggled to scale the trade. Now, it had an entirely new structure that it was ready to sell to investors.

Named Bistro – short for Broad Index Secured Trust Offering – the structure bundled 307 credits from JPMorgan’s balance sheet, spanning corporate loans, bonds, and municipal debt. A special purpose vehicle would insure the portfolio’s risk, funded by selling notes to outside investors. If all went well, investors would earn a steady stream of fees paid for by the bank to compensate them for assuming the risk. If things went badly and defaults occurred, investors would be on the hook. Because defaults were expected to be low – Moody’s estimated 0.82% per year – the vehicle didn’t need to raise so much money. On a portfolio size of $9.7 billion, capital of only $700 million was deemed necessary – enough to cover losses in all but the most dire of scenarios.

JPMorgan gave investors a choice. They could sit first in line to take losses in the event of defaults via $237 million of high yielding Ba2 notes, or they could opt for $460 million of safer, though lower-yielding, AAA notes which would only take losses once the Ba2 tranche had been exhausted. The special purpose vehicle invested the proceeds in US Treasuries, guaranteeing the money would be there if called upon. Only if it was used up would JPMorgan need to take a hit on the so-called super-senior risk it retained.¹

Within a matter of days, investors snapped up all the notes. JPMorgan didn’t hang about. In early 1998, it conducted a second transaction and soon began marketing the service to others. Regulators gave the fledgling market a boost by agreeing to lower capital requirements on the super-senior slice. Against the standard 8% capital requirement for corporate loans, regulators allowed exposures supported by a Bistro structure to be backed by only 1.6% of capital. Now, not only could banks use the structure to fine-tune credit exposures, they could free up capital as well. In less than a year, JPMorgan printed five deals, transferring credit risk on $29 billion of exposure by selling $2.7 billion of securities.

“The overarching motivation for Bistro wasn’t to open up a new market or sell some funky product, but for JP Morgan to hedge its credit risk,” Bill Winters, former co-chief executive of JP Morgan’s investment bank, later recalled. “It was extremely effective in accomplishing that. It also had the effect of spawning a new industry.”

Over time, the spawned industry morphed. Bistros became known as synthetic collateralised debt obligations. Banks began dumping real estate assets including sub-prime mortgages into them while transparency eroded. Some accumulated huge super-senior positions on their books, blind to the risk building up. Others bought protection from monoline insurers that would prove largely worthless. By the time the financial crisis hit in 2007, outstanding volumes stood at $105 billion.

It took a while following the crisis for the market to recover but in 2017, after a wave of reforms, authorities in Europe published a paper clarifying how transactions would be treated from a regulatory perspective. Rebranded synthetic risk transfers or SRTs (or in the US, simply credit risk transfers) volumes have reaccelerated. Last year, banks issued $41 billion of SRTs, up from $29 billion the prior year and are on track to grow issuance by more than 20% again this year. JPMorgan has done some – in December 2023, it finalised a deal to buy $2 billion of insurance on a $22 billion portfolio – but other banks including Barclays and Santander have embraced the trend more actively.²

Alongside all the focus on private credit, SRTs are attracting scrutiny as a similarly opaque market, growing quickly. Over recent months, the European Central Bank, the Bank for International Settlements and the International Monetary Fund have all weighed in to warn that SRT-related risks could be building undetected.

This comes after the pioneer of the Bistro already sounded the alarm. Now chairman and CEO of PNC Financial Services Group, Bill Demchak ran the department that devised the structure within JPMorgan back in 1997. “I might have invented that product,” he told investors in 2024.

“In today’s world [it] is perhaps the cheapest way to create capital. But a complete arbitrage… If you’re actually executing and a professional takes the other side, you must presume that he’s charging you more for the risk you’re hedging than you would charge yourself internally or you never would have made the loan, you’d never be in the business. So this is a near-term band-aid to free up capital that you can double down and make the next mistake on.”

We’ve discussed emerging asset classes here before – private credit, infrastructure, litigation finance, GP stakes, supply chain finance, GPUs and more. Key to their durability is an equilibrium between supply-side factors and demand-side factors, with regulation often a pivotal catalyst.

To dig into those factors and explore how they shape the growth of SRTs – and the risks regulators fear are building inside them – read on.