It seems at times like the noise is never ending. This is especially true if you have not yet employed one of the important survival techniques of the 21st century: Turn off the news channels.
For many years I kept the financial news network on in the office to make sure I did not miss any breaking news. In recent years I have found that it is more comfortable and profitable to miss the breaking news. The need to program 24 hours a day, seven days a week has turned news into noise.
Once I realized some very important facts, I became less enamored of being constantly informed. There is not more bad stuff in the world today. We just televise all of it. There are not more storms than ever before. We just have more people living in areas susceptible to storms thanks to air conditioning. We also have constant coverage of every storm including mandatory interviews of those who lost loved ones. Politicians did not get dumber. We just broadcast their every word to the four corners of the globe on a regular basis.
I can read the news at my leisure and digest it without the verbal assault of opinions and actually think about what I am reading. Less media induced pressure to act now makes better decisions. Calm and profits: A most desirable combination.
That’s why I developed the Easy Income portfolio. Owning a diverse set of financial instruments and vehicles that are not all correlated with each other can set up streams of consistent cash flow and protect against the worst of the market volatility. We cannot do anything about the gyrations of the financial markets. We can try to structure our portfolio to capture most if not all of the equity markets’ long-term returns with alternative vehicles that are somewhat less volatile.
It has been another solid month for Easy Income subscribers. 15 of our 16 positions are higher on the month. Dorchester Minerals is lower as crude oil prices have fallen a bit once it became clear that, for now, we have avoided Armageddon in the Middle East.
Year to date the average position is up about 1%. That’s not all that impressive until we add in the average yield of 9%. Now we have a sleepy little double digit return with most of it paid up front in nonreturnable cash. Add in the low beta of .67 and a daily range that is a fraction of that of stocks in the S&P 500 and it becomes clear that if sleepy and reliable cash returns are your goal, the Easy Income portfolio is probably your best vehicle for achieving that goal.
This month rather than going over the same ground we do every month I want to start taking a deeper dive into some of the portfolio’s holdings to help you understand what we own and how they are helping achieve our income-based returns.
The $70 Billion Market Most Investors Have Never Heard Of
There’s a $70 billion market that most investors have never heard of before. Banks are quietly moving massive amounts of risk off their books through sophisticated instruments that most people couldn’t pronounce, let alone understand. But here’s the thing: understanding this market could be the key to unlocking some serious income opportunities.
I have introduced this asset class into our Easy Income portfolio with solid results so far.
Picture this: You’re a bank CEO sitting on $2 billion worth of corporate loans. Under today’s regulatory regime, thanks to the fine folks who brought us Basel III after the 2008 mess, you need to set aside $85 million in capital just to satisfy the regulators. That’s $85 million that could be making you money elsewhere, but instead it’s sitting there like a lazy house cat.
Now, what if I told you there was a way to keep those loans, keep the customer relationships, keep the interest income, but slash that capital requirement to just $22 million? You’d probably ask what the catch is.
The catch is simple: you transfer the risk to someone willing to take it off your hands for the right price. Welcome to the world of Significant Risk Transfer securities, or SRTs as the cool kids call them.
A Market Born from Necessity
This isn’t some fly-by-night scheme cooked up in a Manhattan trading pit. This is a mature, sophisticated market that’s been quietly growing for decades. And in 2024 alone, banks worldwide are on track to issue between $28 and $30 billion worth of these instruments.
Like most financial innovations, SRTs were born out of necessity and nurtured by regulation. Back in the 1990s, banks started looking for ways to share credit risk with investors who actually wanted it. Novel concept, right?
The real action started around 2001 in Europe, where banks began using synthetic risk transfer instruments in earnest. Then came Basel II in 2004, which essentially gave regulatory blessing to the idea that banks could reduce their capital requirements if they could prove they’d transferred “significant risk” to someone else.
Of course, being bankers, they promptly found ways to game the system. The pre-2008 era saw an explosion of Arbitrage Synthetic Transactions (ASTs) that were basically leveraged bets designed to extract maximum profit with minimum actual risk transfer. We all know how that story ended.
But here’s where it gets interesting: after the dust settled from the financial crisis, the market didn’t die. Instead, it evolved. The focus shifted from arbitrage to genuine balance sheet management. Banks started using these instruments for what they were originally intended: actual risk transfer.
Europe Leads the Way
While American banks were busy explaining to Congress why they needed bailouts, European banks were quietly building the foundation of today’s SRT market. By 2011, European institutions were issuing Balance Sheet Synthetic Risk Transfer (BSST) transactions as traditional securitization became too expensive and cumbersome.
The Europeans had a few advantages. First, their banking sector is more concentrated: fewer, larger banks that could justify the overhead of sophisticated risk management programs. Second, their regulators actually provided clear guidance on what constituted acceptable risk transfer.
In 2017, the European Banking Authority issued a discussion paper that essentially gave banks a roadmap for structuring these deals. Suddenly, what had been a murky, relationship-driven market became predictable and scalable.
The results speak for themselves. By 2022, European banks were issuing over $200 billion in notional value through these instruments. French banks alone account for more than 30% of the market. Talk about liberté, égalité, and profitability.
How the Mechanics Work
Let me walk you through a typical transaction because the mechanics are actually quite elegant.
Start with that $2 billion loan portfolio I mentioned earlier. Under normal circumstances, with a 53% risk weight, our bank needs $85 million in regulatory capital. But here’s where the financial engineering gets clever.
The bank structures the portfolio into tranches: think of it like slicing a pie. The senior tranche gets 91.5% of the pie and carries only a 15% risk weight. The mezzanine tranche gets 6.5% and gets sold to investors. The first-loss piece, the riskiest 2%, usually stays with the bank.
Now here’s the beautiful part: after this restructuring, the bank only needs $22 million in regulatory capital instead of $85 million. That’s a 74% reduction in capital requirements while keeping the same assets and customer relationships.
The investors who buy that mezzanine tranche? They’re getting paid handsomely for taking on that risk: anywhere from 3% annually for low-risk stuff like residential mortgages to 17% for higher-risk corporate loans. And remember, these aren’t retail investors buying this paper. We’re talking about sophisticated hedge funds, insurance companies, and pension funds that understand exactly what they’re getting into.
The US Market Awakens
For years, the U.S. market lagged behind Europe. American banks were focused on other things, like explaining to shareholders why their tech investments weren’t paying off and dealing with an increasingly hostile regulatory environment.
Then came March 2023, and suddenly everyone remembered why risk management matters. Silicon Valley Bank, Signature Bank, and Credit Suisse reminded the financial world that concentrated risks can kill you faster than a heart attack.
American banks woke up fast. JPMorgan, never one to be late to a profitable party, started exploring synthetic risk transfers in a serious way. In April 2024, the bank was reportedly considering two large SRT deals totaling about $2 billion in bonds. By August, they’d actually executed a $531 million credit risk transfer on adjustable-rate mortgages: the first of its kind from the banking giant.
The Federal Reserve helped things along by clarifying the capital treatment of credit-linked notes in 2023. Suddenly, what had been a regulatory gray area became a legitimate capital management tool.
How Income Investors Can Play This Game
Now, you’re probably wondering how the average income investor can play this game. The short answer is directly; you probably can’t. These are institutional markets with minimum investments that would make your broker laugh.
But indirectly? That’s where it gets interesting.
First, understand that this market is creating massive opportunities for the institutions that participate in it. When banks can operate with dramatically lower capital requirements, they become more profitable. When hedge funds and credit specialists can earn 10-15% annual returns on sophisticated credit instruments, they attract more capital and generate higher fees.
Second, this market is reshaping the banking sector in ways that create opportunities for savvy investors. Banks that master SRT techniques can grow faster and more profitably than their peers. They can also weather credit storms better because they’ve already distributed the risk.
Third, the rise of SRT is creating a new class of yield-focused investment vehicles. While you can’t buy SRT instruments directly, you can invest in funds and vehicles that specialize in credit risk transfer strategies.
Your Direct Access: The BANX Play
Here’s where it gets practical for income investors. There’s actually a closed-end fund that gives you direct exposure to this market: ArrowMark Financial Corp (Ticker: BANX).
This isn’t some obscure fund that nobody’s heard of. BANX has been around since 2013, originally focusing on community banks before pivoting in 2019 to specialize in exactly what we’ve been talking about: regulatory capital relief securities.
The fund invests at least 80% of its assets in regulatory capital relief securities, which now comprise 87% of its portfolio. These are transactions where investors receive a premium from banks for assuming credit risk on portfolios of performing loans.
The numbers are compelling. BANX currently offers an 8.5% distribution yield that’s fully covered by earnings. In Q4 2024, the fund declared not just its regular $0.45 quarterly distribution, but an additional $0.20 special distribution from excess income. That’s what happens when you’re earning more than you’re paying out.
BANX’s top holdings include regulatory capital relief securities from major institutions like Citibank and Deutsche Bank: the same players we discussed earlier who are leading this market. The fund is essentially giving you a slice of the same deals that sophisticated institutional investors are clamoring for.
The structure makes sense from a risk perspective too. As of September 2023, regulatory capital relief securities comprised 86.7% of the portfolio, with structured debt at 5.8% and term loans comprising the remainder. This is focused exposure to exactly the market we’ve been analyzing.
Why This Market Has Real Staying Power
Here’s what has me genuinely excited about this market’s future: it’s solving real problems.
Banks need efficient ways to manage capital under increasingly complex regulatory regimes. Check.
Institutional investors need access to diversified, high-yielding credit exposures that aren’t available in public markets. Check.
The real economy needs banks that can lend efficiently without tying up excessive capital in regulatory requirements. Check.
This isn’t financial engineering for its own sake: it’s financial engineering that serves legitimate economic purposes. That’s the kind of innovation that tends to stick around and grow.
The numbers support this view. European SRT issuance has grown from practically nothing in 2011 to over $200 billion in 2022. The U.S. market, starting from a much smaller base, is growing even faster. Global issuance is on track to hit $30 billion in 2024, and there’s no sign of slowdown.
What’s Next?
Looking forward, several trends are converging to support continued growth in this market.
Basel III Implementation: As capital requirements continue to tighten, banks have increasing incentives to find efficient ways to manage their balance sheets. SRT provides exactly that.
U.S. Market Development: American banks are still early in adopting these techniques. As they get more sophisticated and regulators provide clearer guidance, the U.S. could eventually rival Europe in SRT issuance.
Product Innovation: We’re seeing expansion into new asset classes: renewable energy projects, trade finance, even green transition lending. This is creating new opportunities for both banks and investors.
Technology Integration: Blockchain and digital infrastructure are making these transactions cheaper and more efficient to execute and manage.
Institutional Demand: As traditional fixed-income yields remain historically low, institutional investors are increasingly hungry for the 5-15% returns that well-structured SRT instruments can provide.
That is all for this month. Next month I will take a deeper look at another of the unique vehicles for income based returns in our portfolio,
Until then, stay boring, stay sane, and stay profitable.
