Citi's Bringing Back The Synthetic CDO...But In A Way That "Insulates It From Any Losses"

Less than a decade after being forced to take a taxpayer funded bailout to avoid an embarrassing bankruptcy filing, Citibank, proving that they learned precisely nothing from the so-called "great recession," has put a 35 year old in charge of once again making the bank into a powerhouse in the Synthetic CDO market.  But please don"t worry about the risk because this time Citi says they"re building the business in a "way that insulates them from any losses."  Here"s more from Bloomberg:

It’s an astonishing comeback for the roughly $70 billion market for synthetic CDOs, which rose to infamy during the crisis and then faded into obscurity after nearly destroying the financial system. But perhaps the most surprising twist is Citigroup itself. Less than a decade ago, the bank was forced into a taxpayer bailout after suffering huge losses on similar types of securities tied to mortgages. Now, many in the industry say Citigroup is responsible for over half the deals that come to market, though precise numbers are hard to come by.

This time, Citigroup says, it’s doing things differently. The deals are tailored in a way that insulates it from any losses, while giving yield-starved buyers a chance to reap returns of 20 percent or more. The market today is also just a fraction of its size before the crisis, and few see corporate defaults surging any time soon. But as years of rock-bottom interest rates have pushed investors toward riskier products, the revival of synthetic CDOs may be one of the clearest signs yet of froth in the credit markets.

Danielle Romero-Apsilos, a spokeswoman at Citigroup, said synthetic CDOs are fundamentally different than they were before the crisis and that banks today aren’t managing market risk any more. That’s because every part of a synthetic CDO deal is distributed to investors, which also helps to prevent the market from growing too fast.

“Every single client we talk to always asks the differences pre-crisis and post-crisis,” said Vikram Prasad, who oversees Chen’s team as the head of correlation and exotics credit trading. “Everyone remembers the word CDO. Our clients are thinking the same thing, they are doing the due diligence.”

Of course, at least in our experience, levering a levered product in order to juice returns by 10x is almost always incredibly safe (can you taste the sarcasm?). 

The safest portion, which would typically return 0.6 percent a year, can be levered up to 6 percent in some cases. Equity tranche returns can reach 20 percent.

Meanwhile, it"s not just Citibank looking to recreate the financial crisis...other banks, including BNP Paribas, are looking to get in on the action as well...

Other Wall Street banks, which shunned the market since the crisis or struggled to establish a foothold, are angling for a bigger slice of the action. BNP Paribas SA is also active in synthetic CDOs and others are keen to follow suit, according to people familiar with the matter, who asked not to be identified because they aren’t authorized to speak publicly.

For those who have forgotten how Synthetic CDOs work, below is a quick primer.  To summarize, you go out and find a bunch of suckers willing to backstop trillions of dollars worth of credit risk in return for a few bps in annual premium payments.  You then tranche out the risk being taken by the CDO investors so that those at the top can get a AAA-rating and, in return, tell their investors that they"re taking no risk at all.  Those investors then lever up their capital another 10x so they can make 8% returns on a "risk-free" investment...it"s basically as safe as having you"re own printing press from the U.S. Treasury.

Typically, these CDOs pool together about 100 different credit-default swaps tied to various companies, which are then sliced into varying levels of risk called tranches -- senior, mezzanine and equity. Over the life of a deal, which generally lasts two to three years, the swaps generate a steady stream of income for “long” investors (and are paid by “short” investors on the other side of the trade who want insurance against a potential default).

The equity tranche has the biggest risk of getting wiped out if losses from defaults exceed roughly 5 to 7 percent, and nets the highest returns.

And guess who"s buying?  If you guessed 20-something year old pension and insurance fund investors who were in middle school during the last financial crisis then you"re absolutely right...congratulations.

Yet after years of rising markets, declining corporate defaults and tighter credit spreads, the trade is finally attracting greater interest. Increasingly, pension funds and endowments have become senior tranche investors in many of Citigroup’s synthetic CDOs. And because the CDOs are derivatives, they have small upfront costs and amplify returns.

“There is a whole generation of people in finance who never knew or forgot what the problems were with synthetic CDOs,” said Janet Tavakoli, a 30-year veteran of the financial markets who runs a consulting firm and has written books on structured credit and CDOs. “Just as derivatives can lever up the upside, they can lever up the downside.”

Conclusion:  "Short everything that guy has touched."

Fed Warns: "Asset Valuation Pressures Have Increased", "Leverage Remains Elevated"

It is a long-running Fed tradition to quietly incorporate material warnings (deep within) about asset prices in the semi-annual Monetary Policy Report submitted as part of the Chair"s congressional testimony, and it did not disappoint this time either, when it made the following warning: "Nonfinancial corporate business leverage has remained elevated by historical standards even though outstanding riskier corporate debt declined slightly last year. In addition, valuation pressures in some asset classes increased, particularly late last year."

And elaborated:

Nonfinancial corporate business leverage has remained elevated by historical standards, and household borrowing has increased modestly, leaving the household debt-to-income ratio about unchanged. On balance, the ratio of aggregate nonfinancial credit to gross domestic product (GDP) has moved up a little in recent years to about its level in the mid-2000s but remains well below its recent peak. Valuation pressures in some asset classes have been rising, particularly late last year.

Asset valuation pressures have increased, on balance, since mid-2016, along with several indicators of investors’ risk appetite. Although yields on Treasury securities and term premiums increased as market expectations about future growth shifted higher in the fall, they both remain low. In addition, the spread of yields on corporate bonds over those on comparablematurity Treasury securities narrowed. Estimates of risk premiums in equity markets also declined. Outstanding riskier corporate debt edged down over the past year, but gross issuance of leveraged loans was strong and the share of bond issuance rated B or below remained in the fourth quarter at the high end of its range over the past few years.

Commercial real estate (CRE) valuations, which have been an area of growing concern over the past year, rose further, with property prices continuing to climb and capitalization rates decreasing to historically low levels. While CRE debt remains modest relative to the overall size of the economy and the tightening in bank lending standards for CRE loans in the second half of last year may reflect some reduction in the appetite for CRE lending, the heightening of valuation pressures may leave some smaller banks vulnerable to a sizable CRE price decline. Also, residential home prices continued to rise briskly through November.

Of course, considering that we are now nearly two years, and 300 points higher, after Yellen"s May 2015 warning that "I would highlight that equity market valuations at this point generally are quite high," adding that "there are potential dangers there", expect the market to fully ignore today"s warning too.

Meet The New, "Safe" Synthetic CDO's That Could Spell Disaster For The European Banking System

So what do you do if you"re a European banking regulator faced with the task of maintaining a safe, sustainable financial system amid a concerning growth in bank leverage.  Well, if you said sell down risk assets then you"re just being silly or completely ignoring your implicit obligation to engineer higher banking profitability at all costs.

If we can get serious for a moment, like in the early 2000"s, when all else fails you turn to synthetic CDO"s which, courtesy of some magical, if completely incomprehensible, math, slashes the risk of bank balance sheets while having a negligible impact on profitability.  It"s called the Synthetic Collateralized Loan Obligation and it"s all the rage in Europe.

Here"s how it works:

In a synthetic securitisation a bank buys credit protection on a portfolio of loans from an investor. This means that when a loan in the portfolio defaults, the investor reimburses the bank for the losses incurred on loans in that portfolio up to a maximum, which is the amount invested. This amount therefore provides credit protection for a slice of the portfolio, which is often called the ‘first loss tranche’. The size of this tranche is typically chosen in a way to cover at least the expected losses on the portfolio as well as a share of unexpected losses. The bank usually retains the rest of the risk, which is called the ‘senior tranche’.

Before closing, the bank and the investor agree on the terms of the transaction, such as the amount the investor is at risk for, the duration of the contract and the loans that are eligible for inclusion in the portfolio. Choosing which loans are eligible can be on a disclosed basis, where the investor knows the exact names of the borrowers of these loans, or on a blind pool basis, where the investor does not know the identities of the borrowers. In the latter case the loans are chosen based on criteria, such as the type of loans, sector, geography, credit risk, et cetera.

The term ‘synthetic’ comes from the fact that, unlike in a true sale transaction, the loans being securitised are not sold by the bank but are referenced, which means they remain on the bank’s balance sheet. This way, the bank reduces the credit risk on the securitised loans and remains in charge of managing the loans and the lending relationship with their client itself. Synthetic securitisations are often used for hedging the credit risk on loans that cannot easily be sold.

As Bloomberg points out, from the regulator"s perspective the logic is that these deals are usually fully funded, with investors posting the full amount that they"re on the hook to cover should a lot of a bank"s loans go bust. They"re not highly leveraged wagers similar to the pre-crisis synthetic collateralized debt obligations, which were backed by who knows what and sold to whomever.

Of course, the problem with that perspective is that it views the risk profile of the synthetic CLO in a bubble and completely ignores all other possible second derivative implications. 

One such second derivative implication can by linked back to the primary demand for these structures, hedge funds. 

Per the graphic above, hedge funds are all too willing to post the collateral required to backstop losses on a bank"s loan portfolio but only if they can juice their returns somehow.  So how do they do that?  Well, they borrow money from banks, of course.  Yes, you read that correctly, banks are lending money to hedge funds which use that leverage to backstop losses on the bank"s loan portfolio...effectively the bank is issuing loans to backstop loans.

We vaguely remember similar shenanigans occurring roughly 10 years ago when most of wall street"s modern day titans were still watching Power Rangers in their PJs...as we recall, in the end, it didn"t work out well.