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.”